Is It Time to Make Money Investing in Genetic Testing?

So you heard about Pathway Genetics deal to sell its genetic tests at Walgreen (NYSE: WAG), and you're thinking it might be a good idea to get in on the next big thing. Not so fast, hot stuff. The Food and Drug Administration put the kibosh on the sales, and there's a couple of bigger problems that I see with the genetic testing industry.

iPod or pet rock?
There's basically three types of genetic tests. The ones offered by companies like Pathway Genetics and 23andMe that test a bunch of known genetic traits for a few hundred bucks. If you add a couple of zeros to that cost, you can get your entire genome sequenced, although that price is coming down quickly. Lastly, there are genetic tests for specific diseases such as Myriad Genetics' (Nasdaq: MYGN) test for the breast cancer susceptibility genes, BRCA1 and BRCA2.

The problem is that the first two provide more information than researchers -- let alone the average lay person -- know what to do with. Our knowledge of what the genetic information means is bound to increase, but until there's a medical reason for having the test, it seem to me that they'll remain novelty products.

Limited options
Even if you decide that there's a substantial market for genetic testing, your investment options are fairly limited. I don't know if it's because they have a great business model that they want to keep to themselves or an awful one that's not worthy of public consumption, but most of the genetic testing services are private companies. Pathway Genomics, 23andMe, Knome, and Navigenics aren't available on the public exchanges.

Google (Nasdaq: GOOG) is an investor in 23andMe, but it's a bit of a stretch to invest in the search engine just for its piece of 23andMe. And I wouldn't call Google's investment much of an endorsement of the industry since 23andMe's co-founder Anne Wojcicki is married to Google co-founder Sergey Brin.

You could invest in the companies that produce the machines that make DNA sequencing possible: Roche, Life Technologies (Nasdaq: LIFE), and Illumina (Nasdaq: ILMN). Fool co-founder David Gardner actually recommended Illumina for his Stock Advisor newsletter after taking a 23andMe test, urged on by his brother Tom. Illumina has since started offering complete genome sequencing directly, so it's the purest play of the three.

The rapidly evolving industry
The 1997 film Gattaca, where people stick a sample into a machine and out pops the DNA sequence, is rapidly becoming a reality. Pacific Biosciences -- another privately held company -- claims it'll have a machine available later this year that can sequence a genome for $100 in hours. And GnuBio, a company that my colleagues and I have never heard of, issued a press release this week saying that it's ready to unveil its $100 per genome machine next Wednesday at the Consumer Genetics Conference in Boston.

That's good news for drugmakers like Pfizer (NYSE: PFE) and Merck (NYSE: MRK) that can design drugs based on patients' genetic makeup, but it makes it really difficult for investors to stay ahead of the curve.

Have an exit plan
My biggest fear about investing in genetic tests is: What's next? In general, peoples' DNA doesn't change, so they only need it to be sequenced once. In other words, no repeat customers. That's a pretty lousy business model.

Sure, there are a lot of potential customers right now; most of the people that you know probably haven't had their DNA sequenced. But as the price of sequencing goes down, the barrier to entry for the industry is likely to fall as well. That could result in a low-margin business that's counting on a dwindling customer base.

My doomsday scenario is years away, and there's likely to be plenty of money to be made by companies in the interim. But if you're going to invest, keep in mind that the company you buy will need to adjust to the next big thing, or you'll need to plan on exiting before things head south.