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The Best Marijuana and Precision Medicine Stocks to Buy Might Not Be the Companies You Think

The marijuana market may be on its way to being worth $25 billion in 2021, and advances in DNA research could lead to next-generation precision medicine worth billions of dollars in annual sales. Yet, picking the winners and losers in these markets is a gamble.

Legislation could derail marijuana's momentum, and over 90% of medicines that enter clinical trials have historically ended up in laboratory dustbins, not on pharmacy shelves.

A better investment option might be to focus on Scotts Miracle-Gro (NYSE: SMG) and Illumina (NASDAQ: ILMN); two companies that supply the "picks and shovels" needed by companies that are targeting these market opportunities.

In this episode of the Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by investor Todd Campbell to discuss how big the market opportunity is for marijuana and precision medicine, and why investors ought to consider adding Scotts Miracle-Gro and Illumina to their portfolios. 

A full transcript follows the video.

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This video was recorded on Aug. 9, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm Kristine Harjes. It's August 9, and to talk healthcare with me, I'm calling Todd Campbell, a fool.com healthcare specialist. Todd, how's it going? I know you're prepping for a camping trip coming up, right?

Todd Campbell: Yeah, I'm going camping, and as part of getting ready to go camping I was doing some things around the house, including a lot of gardening this past weekend, Kristine. Digging holes and planting plants and adding lots of fertilizer in the soil. And do you know what I was using for all of that?

Harjes: What were you using?

Campbell: Picks and shovels.

Harjes: [laughs] You're spilling the beans too early! Let's dive right in, I guess, since we're already there. We're calling the theme of today's show Picks and Shovels. Some of you may be familiar with the term, whose origin is thought to come from the California Gold Rush of the mid-nineteenth century. The wisdom goes that some of the most profitable businesses in the Gold Rush were not the ones that were actually finding the gold, but rather the people who were providing the picks and shovels and all the other necessary equipment for the diggers. Hardly any of the miners actually struck gold and uncovered fabulous riches, but every single one of these thousands of people who tried needed supplies. In today's world, the phrase means any business that makes its money by providing equipment for a growing industry, rather than actually producing the primary end product of the industry itself. So, we're going to talk today about two modern day gold rushes, and these are marijuana and precision medicine. In the discussion, we will also unveil two picks and shovels ways to play these booming industries. Todd, are you ready to dive in?

Campbell: I'm excited, this is going to be great show.

Harjes: "Dig in" probably would have been the better question. Our first stock is not about the Gold Rush, but rather what I have heard referred to as the Green Rush, and this is the expansion of the marijuana industry.

Campbell: Green gold, if you will. As you know, Kristine, I write a little bit on the subject, with some of the other Fool authors, trying to help people steer in the right direction. One of the things that invariably comes up when I'm talking to investors is the question, how big could this market really be? Everyone wants to think, what is the size of this opportunity? And the answer that I always give is big, but we don't know how big, because there's so much that's going to go into determining how much money can be made in producing and marketing and selling recreational or medical marijuana. By estimates -- and those are the only things we can use at this point -- we're talking about a market that could throw to $25 billion by 2021. And that's a huge jump from where we are today.

Harjes: Right. This is an industry that is growing at an incredible clip. Legal weed sales grew by 34% in North America to almost $7 billion in 2016. As you mentioned, they're on track to continue growing at this kind of double-digit rate. The cannabis research firm ArcView predicts that weed sales will grow at a compound annual rate of 26% through 2021, which gets you to that $22 billion in five years. I also saw that investment firm Cowen & Co called for $50 billion in legal cannabis sales in the United States by 2026. As you mentioned, it's pretty tough to put such a precise number on this, given that there's so much regulatory uncertainty. But as of right now, 29 states have legalized medical cannabis, and residents in another eight states have said yes to having recreational weed also be legal. So, right now, you have a humongous black market in both these legal states and also all the states where it's not legal, and it's very difficult to put numbers on how much of that a legal market would eventually be able to take. But any way you slice it, this is a gigantic opportunity.

Campbell: Right. I think one of the biggest drivers of growth over the course of the next few years is going to be the passage of recreational marijuana laws last November in California, which is already the hugest market for medical marijuana, with its Emerald Triangle being one of the largest producing regions in the world of marijuana. There are already a thousand medical marijuana dispensaries operating in California, and theoretically, depending on how quickly the switch gets flipped to recreational, those could be up and running relatively quickly and providing a fairly quick ramp up for market sales. You mentioned the Cowen & Company prediction, which is just an eye-popping number, $50 billion by 2026. But, that comes with a huge caveat, and that caveat is, if recreational is legalized nationally on the federal level. Because, I think one of the things that a lot of people fail to understand is, yes, individual states are going ahead and legalizing either medical or recreational marijuana, but marijuana still remains illegal on a federal level.

Harjes: Right, and that raises some interesting challenges for the businesses that are operating in this space. Marijuana stocks have been on an absolute tear because of the hype around this industry. You hear these projections and it's hard to not get excited about, "OK, let me get in on the ground quickly, and I'm going to make millions in this." But if you actually look at the businesses themselves, they face some inherent disadvantages. For example, because marijuana is illegal at the federal level, these businesses can't take your normal corporate income tax deductions. Meanwhile, they also have pretty limited access to basic banking services like a checking account, because a lot of the financial services don't want to have this association to businesses that are technically not doing legal business at the federal level.

Campbell: Yeah. You create all sorts of risks there in the banking systems, as far as transferring money across state lines and all sorts of things. So, yes, you're talking about kind of a wild wild west rush, green rush, that we're seeing here. You have the regulatory concern. And not only is it still illegal on a federal level -- I think this is the other thing that's important for investors to recognize -- but, under President Obama, the decision was made not to get mixed up at the state level. The state said it was OK, they weren't going to enforce federally in those states. That could change under President Trump, because his attorney general is a guy named Jeff Sessions, who's been a pretty big vocal opponent to the legalization of marijuana. So, there's a lot of legislative risk and enforcement risk for these stocks. It's also still a Schedule I drug. Marijuana is still a Schedule I drug. That creates some additional risks and concerns that could limit the use of it medically, or its expansion into other states. 

Then, from an individual stock-picking level, there's this whole other component of, what stock do I pick? Because most of these stocks are fly by-night companies. They're started, and their shares go out on the over-the-counter market or the pink sheets. They're very high risk companies that aren't held to the same level of scrutiny for listing requirements as, say, the larger companies that are on the New York Stock Exchange or the NASDAQ. So, if you go out and you're buying these stocks, you're theoretically exposing yourself not only to the risk of picking the wrong stock, but of picking the wrong stock and having it be a fraudulent company.

Harjes: So, those companies we're going to consider our gold miners. But what we want to pitch to you guys today is the picks and shovels play here. It's a safer way to get some exposure to this industry by exposing yourself to a company that has a hand in the actual growing process itself. Todd, do you want to unveil what our company is?

Campbell: I mentioned at the beginning of the show that I was doing a lot of gardening this weekend, and I'd be lying if I didn't tell people exactly the products I was using. I was using products made by Scotts Miracle-Gro. They market brands like Miracle-Gro, the Scotts grass seeds, Ortho, which is used to deter pests, and they also market Roundup, which is the weed killer. And sure, all of those products are well-known to consumers who walk through the aisles of their local garden shop or home improvement center, but what they may not realize as they're using those products is Scotts Miracle-Gro is also the manufacturer of a very fast-growing suite of products that are used in hydroponic growing. And hydroponics is a big, big market in marijuana.

Harjes: Right. Hydroponics means growing plants without soil. This is huge, particularly for medical marijuana. While the company hasn't even identified marijuana as an opportunity for it yet, this wholly owned subsidiary called Hawthorne Gardening Company, which is focused on hydroponics, makes up about 10% of the company's total sales, and it's growing astronomically.

Campbell: We've got that segment growing at double-digits, 20% organic growth last quarter year-over-year. And that's just organic growth. Scotts has been extremely active in acquiring companies in this space. As a result, they now have all sorts of soup to nuts offerings across hydroponic gardening. Obviously, you can use hydroponics for other things other than growing marijuana, you can grow anything. Hydroponics, typically, when you use that technology, you can grow things 25-50% faster than you would in typical soils. So, you have the company now owning brands like Botanicare, that's an Arizona-based producer of plant nutrients in supplements that are used in hydroponic gardening. You've also got them owning a big stake of Gavita, which is a big maker of the indoor lighting systems and such that are used for growing different plants.

Harjes: What I really like about this company as a way to play on the marijuana industry is, as we mentioned, there's this safety net. Even if the marijuana industry were to completely fall apart -- which, I don't think that's going to happen -- you still have 90% of the business firmly based in an established lawn and garden care company. This is a $6 billion company. They have over a 2% dividend yield, they're consistently profitable. They are a far extreme from a lot of the marijuana penny stocks you see out there.

Campbell: Yeah. Their other business is a slow-growing, low single-digit business. But it's a steady eddy business that kicks off substantial cash flow that they can then use for buybacks and those dividend increases that income investors tend to love. Then, you've got this kicker in the hydroponics business, where you've got operating margins in that business of about over 20%, you've got sales in an increasingly larger percentage of the total haul taken in by Scotts Miracle-Gro. I wouldn't be surprised if it were approaching 20% of revenue over the course of the next year or two, just based on their acquisition activity. And, this business is growing pretty rapidly. There's a lot of demand as legalization occurs in these different states. And theoretically, since we're in the early innings, you have a long runway of that growth, which is also important. Who knows, maybe even down the line they even spin this company off to investors once it reaches a certain level of sales and profitability.

Harjes: That's a really interesting idea. All right, Todd, time to talk about precision medicine and a potential picks and shovels way to play on that market.

Campbell: This is an amazing and fast-moving opportunity that investors have to do some research on and become a little bit aware of. The reality is, as technologies are advancing, we're learning more and more about how the body works, what drugs work in the body to help improve outcomes for illness and injury, and as a result, there's a tremendous market opportunity out there for targeting medications, precision medicine, or personal medicine, they all mean the same thing.

Harjes: Yeah. As we learn more and more about DNA and how the makeup of your DNA influences your health outcomes, you get more and more tailored healthcare products and drugs that can improve your medical issues specifically based on what your body has to say. I almost think of this as, you're mining for information in the same way that the Gold Rush miners were mining for gold. You're digging into the body and all of the hidden things that DNA has to tell you, and you're extracting information. There's so many researchers out there looking into the implications for medicine and how we can better tailor it to a unique situation.

Campbell: Kristine, and digging into that DNA can produce billions and billions of dollars in revenue for companies that develop drugs based on whatever it is that they're learning. We're already seeing that. We have $300 billion a year that are being spent on prescription medications in the United States alone, and you have over $100 billion being spent on specialty medicines that are complex biologics that theoretically will get even more and more complex as we learn more and more about how genes overexpress and underexpress to create proteins that impact cellular functions.

Harjes: Yeah. You and I are both big fans of investing in these drug makers. We talk about them all the time on this program. But the picks and shovels way to play this is not in the drug makers themselves, but rather a company that we also have talked about on the show that does the sequencing on the DNA itself. This company is Illumina.

Campbell: Right. I think one of the things we've talked about in past on the show, I always like to hammer this point home because we never know if we have a new listener, is the fact that so many clinical trials fail. Over 90% of clinical cancer trials have come up short. What that means is, if you're going out and you're trying to pick that one individual company that's going to be the success story in personal medicine, well, the odds are stacked against you. Instead, it can be smarter, perhaps, to focus on a pick and shovel play like Illumina, because they're selling the systems that all of these researchers and all of these commercial drug makers and biotechnology companies are using to learn more about DNA and RNA and the impact of over and underexpression on disease.

Harjes: And importantly, Illumina has been able to bring down the cost of doing so to a degree that is unfathomable. When you look at the cost of the first-ever genome sequence, it was maybe $1 million, ballpark around there. It was very expensive to just get a single genome sequenced.

Campbell: And it took forever.

Harjes: Yeah, absolutely. This was this enormous endeavor to do the very first one. And Illumina has been working and working on bringing that cost down, making it a more efficient process. Their newest sequencing machine, called NovaSeq, could potentially bring the cost of a single genome sequence down to $100, which is absolutely mind-blowing. And that opens up so many possibilities, not just for researchers and not just for drug makers, but even for doctors, to be able to causally order a genetic sequence for their patients in order to find out the exact biomarkers of a cancer tumor, or any other number of countless things that you can find out from sequencing DNA in order to get the best personalized treatment.

Campbell: Yeah. We are complex creatures, and these are complex machines. And they're costly machines. These machines can cause $0.5 million to $1 million and more. And so far, there are other competitors out there that make gene sequencing systems, but Illumina is the granddaddy and it's the Goliath. It has over 7,500 of these systems spread out across the world. It gets a little bit more than 40% of its sales outside of the United States. So, it doesn't matter if you're talking about a researcher that's in Shanghai or a researcher that's in London, or a researcher that happens to be in Cambridge or San Francisco, they're most likely using an Illumina machine. And if they're using an Illumina machine, then not only did they buy the Illumina machine, but they're consistently buying all the other consumables that are used by these machines to do all of the sequencing. And that's why the reducing of the price to gene sequencing is such a good thing for Illumina's long-term story. Now, we're talking about, cheaper to sequence means more sequencing activity, which means more demand for those consumables.

Harjes: Yeah. This company is not only picks and shovels, it's also razor and blades model, which is something, as investors, we love. We love to see that consistent, steady income coming from the consumables.

Campbell: Yeah, absolutely. And they represent a large share of the company's sales. I think it's 61% in the most recent quarter came from that razor blade consumables side of the business. I think you're going to see the mix shift a little bit as this next new generation of machines, more of those get installed and sold, because they have lower margins. So, you may go through a little bit of growing pains in terms of earnings that might not grow quite as quickly, because the margins may slip a little bit because of product mix. Don't worry about that. Don't focus on the quarter-to-quarter machinations in this. You're still talking about a massive opportunity, double-digit grower, profitable company with deep pockets that's an innovator and at the cutting edge of this technology.

Harjes: Yeah. I do think some investors are a little bit concerned that the cheaper machines are going to cannibalize sales of the more expensive machines. But the way that I see it, one third of new orders for the NovaSeq machines have come from new customers, because it's a cheaper machine that brings the per genome sequence cost down as well. So, they're able to reach people who previously wouldn't be willing to spend this money to do their research or treat their patients. This company, as you mentioned, it does have a big growth trajectory in front of it. You have to think about long-term, because it's pretty darn expensive, as well. I don't have the multiples in front of me, but it is traditionally an extremely expensive company. And that's because it does seem like they're just getting started, and this entire wave of precision medicine is something that's very early going. 

Campbell: Yeah. I've heard some people say, "At some point, won't all the genomes be discovered? Won't all this research have been done? What will demand feel like long-term for these machines?" So, maybe you reach a point where there's a little bit of a tipping point where you have all of the machines installed everywhere, and maybe you have so much information that the pace of research slows a little bit. But you have to understand that this company isn't ignorant to that fact. They're already making some pretty big investments in the ways that this information can get used longer-term, that will diversify their revenue stream theoretically a little bit away from the systems. Again, we're talking about a multi-decade shift in this business. This is not something that's happening in a year or two. But the two different businesses that I think are most interesting for investors to take a look at are Grail and Helix, both of which Illumina owns a big stake in, and both of which are looking at new and unique ways of using all the genetic information we're developing.

Harjes: Yeah. Both of these, as you mentioned, are definitely long-term plays. They're doing revolutionary things. And you're right, even if the core business were to eventually hit a tipping point, it's entirely likely that at that point, it wouldn't matter, because Grail and Helix will hopefully have panned out by then.

Campbell: Yeah. And there's opportunities, obviously, to team up with these drug makers and take a small share in royalties, or who knows what, of sales further on based on whatever they've discovered. Grail is looking for early detection of cancer. Imagine being able to detect cancer at stage 1.

Harjes: Before you even show symptoms.

Campbell: Right, exactly. Cancer is so much more easily treated when it's caught early. The earlier that we can catch it the better. If Grail is able to do that, wow, that could be a huge driver for Illumina long-term -- again, multi-decade, looking further and further out. Helix is also intriguing, because you're talking about a warehouse that can store all of your genetic information and an app store that you can go out and be able to purchase different apps to learn more about your genetic code. So, there's different interesting ways that I think Illumina can benefit from this whole move toward personalized medicine. And it's a great pick and shovel type play on precision medicine.

Harjes: Absolutely. Sounds good, Todd. Listeners, thank you so much for joining us today. As usual, we'd love to hear from you at industryfocus@fool.com. Let us know what you thought of today's episode and if you have any topics you'd like us to hit in the future.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Illumina. The Motley Fool has a disclosure policy.