A Prescription for Growth

 | Jan 11, 2012 | 10:00 AM EST
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Frequently overlooked in the fundamental analysis of a new investment is the size of the potential market. Large markets offer opportunities not only for a company's sales prospects, but also for a sustained valuation premium of its common stock. Meanwhile, a business addressing a more constrained or defined market will likely have nervous investors always worried about levels of penetration that can trap valuation in what appears to be a cheap level. Having been pinned down by the latter, my experience suggests making sure that your investments have an ample runway for growth.

Considering the timing of this week's JP Morgan Healthcare Conference, I'll focus on two investments in the enormous, but very specific, market for diabetes care.

The statistics sizing the diabetes market are staggering and alarming. In 2011, the International Diabetes Federation projected that there would be 552 million diabetics worldwide by 2030, up from the current 366 million. In the U.S. alone, over the next decade, $3.4 trillion will be spent to care for the one in 10 Americans that currently have the disease.

Diabetes is broken down into two forms: Type 1 and Type 2. Type 2 is the most common and represents approximately 90% of the disease population. In this form, the body has lost its ability to make enough insulin or to use it properly. Type 1 diabetics, the remaining 10%, are completely unable to make the important Insulin that breaks down digested sugars in the blood stream.

The levels of care and treatment for Type 1 and Type 2 diabetics are quite different and highly personalized, but there is commonality in the primary objective of better controlling blood sugar levels that allows a business opportunity for some companies. To be successful, though, these companies must meet not only a therapeutic goal, but also a patient's need to make an already intrusive daily disease into something less intrusive.

Many companies (Pfizer's (PFE) inhalable insulin, for example) failed to recognize that diabetes is a uniquely self-managed disease, and unless a drug or product has an outcome AND ease of use that compares well against time-tested treatments, including self-injection of insulin, the likelihood of success is low. Much like Amazon's (AMZN) customer reviews can influence product sales, individual practical evaluations can determine the adoption of a drug or product as much as the results in an official and respected medical journal.

Two companies that understand this market are Novo Nordisk (NVO) and Insulet (PODD). The two could not be more fundamentally different. For example, Novo has $7.1 billion in insulin sales alone in 2010 compared with Insulet's $97 million in total 2010 revenue. The tie that binds them, however, is a dominant focus on the diabetes market and a deep understanding of the requirement to meet the unique needs of this self-managed disease.

Novo is a Danish company with a 90 -year history in the insulin market. Twenty-six percent of its common stock and 73% of its voting stake is held by its own Novo Foundation, with an objective to support endocrinological research. This unique controlling feature has kept Novo at the forefront of insulin advancements and held the common stock in the hands of long-term owners. Currently, Novo is amongst an oligopoly of companies, which includes Sanofi (SNY) and Eli Lilly (LLY), that are introducing a new drug category for use by Type 2 diabetics of an injectable natural hormone called a GLP-1 that stimulates the body's ability to produce insulin. In addition to the desirable effects of helping to better control blood sugar levels with less frequency of injections, these drugs also appear to help with weight loss. While the medical merits of each company's GLP-1 offering are in the midst of numerous comparative evaluations, Novo has an embedded culture of cautiousness, a market-leading diabetes sales force, and an almost exclusive focus on diabetes that serves as a competitive advantage in this large market opportunity.

While very different in scale from Novo Nordisk, Insulet has developed a medical device that, like GLP-1, has the objective of making diabetes easier to manage. Insulet's device is a modern insulin pump that has unshackled Type 1 diabetics from the tubes and bulkiness of tradition insulin pumps. Three-day disposable pods are controlled wirelessly and have a patented self-catheter that simplifies attachment to the body with few activity limitations. The market penetration for pump therapy is fewer than 25% of Type 1 diabetics in the U.S., despite endocrinologists' overwhelming support. Insulet has a rapidly growing fraction of this expanding market given its innovative design. This year is important for Insulet, with pending approval of its next generation of smaller and more efficient designs, as well as a selling infrastructure throughout Europe and Canada.

If you need additional reason to look at this large and growing health care market, consider its growing importance within the European coalition. Also, consider a report by Datamonitor that estimates the market for insulin in China tripling by 2019 to $2.1 billion in annual sales as the diabetes rate there soars.

Large markets, focused companies and products that address the needs of patients and influence medical outcomes worldwide are what bind these two companies. Investors should take notice.

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