Once you've identified a trend you want to invest in, how do you decide which individual stocks to buy? The diabetes treatment and medical marijuana are two of healthcare's most exciting research areas, but not all diabetes or marijuana stocks are created equal. On this Industry Focus episode, healthcare specialists Kristine Harjes and Todd Campbell explain what you need to consider before investing in these growing markets.

A full transcript follows the video.

 

Kristine Harjes: Do this, not that. This is Industry Focus.

Thanks for tuning into Industry Focus, healthcare edition. I'm your host, Kristine Harjes, and I'm joined by Motley Fool healthcare specialist Todd Campbell. Today, we wanted to do something a little different. We wanted to talk about investing smartly in trends. The healthcare sector is packed with companies doing new, exciting things, and there's a lot of hype around certain, new class of drugs and new approaches to treating major diseases.

Competition is fierce. As an investor, how do you know where to put your money? You spot this trend, you say, "That looks really promising," but how do you find a specific company that is going to be the best bang for your buck? We're going to dive into the medical marijuana market a little later, but first let's talk about some companies that are in the diabetes space.

Diabetes is a disease that affects approximately 29 million Americans, according to the Center for Disease Control and Prevention. That's 9.3% of the American population. That number is expected to grow, too. It's estimated to reach as high as 387 million around the globe and by 2035 to 592 million patients.

Todd, kick us off. If you're looking at this space and you say, "That looks like it has a lot of promise as an investor," where would you look to put your money?

Todd Campbell: I think it's one of the most interesting things and profit-friendly areas for investors to be considering in healthcare. There's a lot of reasons that the prevalence of diabetes is rising. You've got a lot of emerging markets [that] are getting wealthier, access to food is improving, you can argue that we're living more sedentary lifestyles.

As you mentioned, the International Diabetes Federation estimates that there are 387 million people worldwide with this disease and that number is going to grow by 205 million people in the next 20 years. That's astonishing. That's two-thirds of the population of the United States in global growth for this.

I think that's attracted a lot of investors to say "This is a massive market. If we could invest in companies that are improving outcomes, reducing the chance of diabetes related disease, like heart disease; that's smart investing." Let's find companies that could disrupt the market as we see it today. I think that's a big reason why a lot of people flock to one company that you and I talk a lot about: MannKind (MNKD).

Harjes: There is so much hope behind MannKind who has developed this inhalable insulin called Afrezza, which was finally approved by the FDA in 2014. It's being marketed by Sanofi, which sounds like that would be a really promising marketing partner because Sanofi was the maker of the multi-billion dollar, long lasting insulin Lantus. Sanofi begins their marketing and it's nothing short of disappointing.

You've got Q1 sales, when it first got into the market of €1 million, which is about $1.1 million, Q2 comes around, you've got the entire quarter on the market and they only sell 2 million. On the one hand, you say it doubled, but these are still really tiny numbers. $2.2 million.

Campbell: It's not cool.

Harjes: It's not even close to what people had hoped for this drug.

Campbell: It's nothing. People were thinking that patients would flock to doctors' offices to be able to cast aside the decades-long reliance on injecting insulin. Afrezza is obviously inhalable insulin. It's quick acting, but there's a lot of concern that if injectable are working well right now. Why do I want to go ahead and be inhaling insulin into my lungs, potentially taking on some risks associated with that?

I think there are pie-in-the-sky hopes associated with Afrezza going in because it's a potentially disruptive drug, looking at the way insulin is dosed. The reality is, great ideas don't always translate into commercial successes. I think the takeaway there for investors is that, when it comes to finding and exploiting these big trends -- in this case, diabetes -- try not to focus on companies that have one iron in the fire. One drug, one promising solution.

Doing so exposes you to a tremendous amount of risk. There are plenty of great companies out there working on next-generation diabetes treatments that investors can consider. You get the granddaddy of them all, Novo Nordisk (NVO -5.27%), who's the market share leader in diabetes care. They make insulin that's short lasting, rapid, long lasting; you name it, they make it. They control about 28% roughly of the whole of all diabetes treatment globally.

If you really want to play the long term, 20-year trend in rising diabetes prevalence, focusing on a big company like that can make a lot of sense.

Harjes: The interesting thing about Novo is you don't find a lot of companies of their size that are pure plays. They do have some other irons in the fire. They dabble a bit in hemophilia. They have some growth hormone therapy, but they're really a diabetes powerhouse. They've done great. Their key drug is called Victoza. They recently have this new, higher dosage of Victoza that's being marketed as Saxenda for obesity; they seem to really know what they're doing to work with this established group of drugs that has been absolutely excellent for them, and improve up on them and really be able to compete in this market.

Campbell: They get 80% of their sales from diabetes. It's a not a pure play on diabetes, but it's pretty close. I think what's exciting about what they're doing is that they have so many different research programs going on right now that could change the way that diabetes is treated in the outcomes. One of the most exciting things -- and something I think people should bear in mind to consider -- the ability to turn insulin into a tablet.

They're working on two different drugs that would allow you to take your insulin rather than through an injection, as a tablet. While inhaling insulin is an improvement over injection, a tablet has got to be the Holy Grail in delivery for insulin.

Harjes: That's another thing that makes investing in this trend a little bit tricky. You're not sure who's going to come out with this next, latest, completely revolutionary way of treating diabetes. I want to bring up one more name in this space that I think could continue to be really profitable, even if the way we treat diabetes starts to change.

That's because these guys are actually a device maker. They're called DexCom (DXCM -0.54%) and they produce and sell this product called a continuous glucose monitor. It's designed to show patients what their glucose level is constantly. You don't just get one single reading every time you check, you can actually get a trend. You can see if the line is going up or down.

These guys are expanding pretty rapidly. They've got partnerships with Google. Their life sciences team is working on making this tiny, cloud connected, glucose sensor that's the size of a bandage. Talk about convenience right there. DexCom's main driver right now is looking to ease the burden on patients who are trying to monitor their glucose levels.

They're going to be linked up with the Apple Watch, they have monitoring integration with the Apple iPhone, and this system will be available on Android eventually -- probably next year, I would say. One of the really interesting things about it is that it's got a razor and blades model. They sell this kit, and you've got the monitor itself, but then you need to keep buying sensors.

One only lasts for seven days. To me, this looks like a really good way of capturing part of this growing diabetes market. It's a more concentrated risk than your Novo Nordisk, but what do you think, Todd?

Campbell: I love the company. I've owned it in the past. I'm not currently invested in it, and I'm wishing that I was. I may have to revisit it. DexCom is something that everyone can benefit from. A significant number of patients don't have their glucose blood sugar levels under control. At any given point of the day, you're either high or low and you don't know it.

Often times you're delivering insulin after the fact. So being able to have something that's showing you real time -- almost like an interlay chart for us investors -- what's going on with your blood sugar levels... it could really improve patients' ability to administer their insulin correctly. That is really important because that could reduce the progression of the disease toward heart disease and some of these other things that could lead to death.

Harjes: This will definitely be an interesting space to watch going forward. Let's pivot a bit. As I mentioned earlier in the episode, we wanted to talk about medical marijuana, which is approved for legal, medical reasons in 23 states. You've also got four states and the District of Columbia that have approved marijuana for recreational use for adults.

The trend is certainly going upward as far as the percentage of people who approve of marijuana either being legalized recreationally or medically. It seems like this is an industry that investors would be smart to get in on now. There is so much hype around it, but what we want to know today is: is there a good way of investing in this industry/

Campbell: I think a lot of people look at the marijuana industry and they think -- look at what Reynolds and Philip Morris did with Tobacco. Can you imagine being one of the first investors in Reynolds, or Philip Morris? You start thinking that way and you think, "Wow! This is really exciting! I've got to go out and find these companies that are in Colorado that are growing, either wholesaling or retailing medical or legal cannabis.

I think while people are right in saying that getting in early on a trend that's likely to continue growing the way marijuana adoption is growing, there's a big risk in going out to buy these fledgling players, especially since so many of them are listed on pink sheets. For listeners and viewers that aren't familiar with pink sheets, it's not an exchange. It's really just a listing of "This is how much you can buy shares in this company for, this is how much you can sell them for."

It's an unregulated market, which means that any company can get on the pink sheets. You could end up with a shell company that's essentially worthless. You could end up with an inability to sell the shares when push comes to shove, if you need to get out of it. There's a lot of risk associated with these pink sheet companies, and I really worry that a lot of investors who are interested in building a portfolio of marijuana stocks are focusing too much attention on these names.

Harjes: When you look at these microcap marijuana stocks, it's definitely a danger zone. At The Motley Fool, we hold ourselves to a rule where we don't talk about anything too small because we don't even want the possibility of affecting a security's price. Maybe I'm just flattering myself on the popularity of our podcast, but rules are still rules.

There are two companies that I won't mention by name, but we used to talk about them back before their market caps fell completely under our limit. Looking at what has happened to them since makes me want to bank my head against the wall for people that are considering putting their money in these stocks.

One of the companies was late with their SEC filings three out of the last four quarters. Another one, their 10-Q for the first quarter of 2014, and then released a statement in June, saying, "That was wrong. We had this mistake and it was material." Meaning it was a big deal. Just sit tight and we're going to be redoing our statements.

As an investor, how are you supposed to trust these companies and put your money behind them, when they don't even know the state of their own finances?

Campbell: You can't. You have hundreds of operators out there who are all trying to move in and capture part of this market. There will be winners and losers. Right now, I think the odds are that you're going to have far more losers than you will winners. I think what makes more sense is, rather than focusing on the pink sheets and these smaller, unproven players; if you really want to have some exposure to the basket, consider those companies that are actually developing drugs on an FDA approved pathway.

There are two companies that are working on marijuana therapies that investors might want to consider: GW Pharma (GWPH), and Insys (INSY). Both companies have robust research programs that are dedicated to finding therapies that are based upon the cannabinoids that are within marijuana. THC is the psychoactive component of marijuana and there's already a marijuana drug based on THC that's been on the market since the '80s called Marinol.

There is some evidence that shows you can develop drugs, prove their efficacy, prove their safety through clinical trials, clear the FDA hurdles, and then once they reach the market they can become strong, top sellers. Both GW Pharma and Insys pose their own set of risks; they're certainly not risk free, but they definitely don't have the same level or risk associated with the marijuana stocks trading on the pink sheets.

Harjes: I would agree. If you're looking for a marijuana stock, these two are probably your best bets, even though Insys isn't quite a marijuana stock -- yes, they have marijuana research, but that's not their bread and butter, whereas GW Pharma is definitely qualified as a marijuana stock. For me, this industry is too risky, but if that's the trend that you're going after, the takeaway is at least go for some of these bigger companies that are trading on reputable exchanges that you can at least trust their financial statements.

Campbell: Exactly. The other thing on both of these companies, anything can happen. Clinical trials fail all the time. 90% of every drug that goes into phase 1 is likely to end up in a dust bin rather than on a pharmacy shelf. You can't put too much stock in a phase 1 result or a phase 2 result. You really have to just be patient. Let these drugs work their way through the pipeline and to the FDA.

It is good to know that both these companies have cash on the books. They're not heavily embedded, so they have money that they're using for these research programs, and they're not likely to go bankrupt anytime soon. That's a positive.

Like you said, this is a very risky area to be trafficking in. Make sure that if marijuana investing is something that intrigues you, you're keeping it very small and you're only putting a small portion of your money to work in that space.

Harjes: I guess that brings up that there are two levels of consideration. You want to pick what trends are the ones that you find most interesting, and are suitable for your risk tolerance, and then once you have your trends identified, you can dig down a bit more into specific companies.

Maybe in the end, the two things that we've talked about today -- diabetes and marijuana -- maybe they aren't the trends that are calling out to you. Hopefully you can use some of the same type of thinking that Todd and I have been through today to guide you toward the best investments in whatever trend you're looking at.

Whether it's Obamacare, healthcare reform, immuno-oncology, personalized medicine, there are so many different trends within the healthcare sector, and outside of it, too. Whenever you're looking to invest in any up-and-coming trend, just be on the watch for how much hype is baked into the valuation and be mindful of how much of a pure play you're looking for.

If you are interested in either of the two trends that we've talked about today, take a deeper look. Do a deeper dive on your DexCom or Insys of the world. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear.

Do your own research, have fun with it. They're both really intriguing spaces to dig into. Let us know if you have any questions about what you come up with -- any better ideas for investing in these sectors or different trends that you're looking at that you think could be better opportunities. Thanks, Todd, as always. Listeners, thanks for being with us today. We'll talk to you next week.