3 Small-Cap Healthcare Stocks for Your Watch List

Where's the love for small caps? Yes, they can be riskier than the other guys. But careful, thoughtful investing can mitigate a ton of that risk. Don't be afraid! Introduce yourself to a small cap today.

In this week's episode of Industry Focus: Healthcare, hidden-gems aficionado Brian Feroldi shares three exciting healthcare small caps that don't stick investors with a mountain of risk -- LeMaitre Vascular (NASDAQ: LMAT), HealthEquity (NASDAQ: HQY), and NovoCure (NASDAQ: NVCR). What do these companies do? How did they carve out a niche for themselves? What does the competition look like? And, because you can't mitigate all the risk away, what risks should investors watch for? Tune in and find out more.

A full transcript follows the video.

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This video was recorded on Aug. 22, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Aug. 22, and we'll be talking healthcare. I'm your host, Kristine Harjes, and I'm joined by fool.com contributor Brian Feroldi via Skype. What's going on, Brian?

Brian Feroldi: Hey, Kristine! How's it going?

Harjes: Pretty good. I'm excited to have you on the show. Brian has 10 years of experience in the medical-devices sector. He now primarily covers healthcare stocks for fool.com. We're having him on Industry Focus because he loves sharing hidden gems -- small-cap stocks that go overlooked by Wall Street. Brian, kick us off and walk me through how you find these diamonds in the rough.

Feroldi: Small-cap stocks tend to get a bad rap among investors as being risky. That makes sense, because a lot of them do not have the competitive advantages that the larger companies do. That causes some people to stay away from them. But I just love scouring the markets for small companies, because they typically have much bigger growth potential than the larger caps do.

Having said that, I'm usually extremely picky with which stocks I pay attention to and like. I like to see that the company itself, even though it's small, it does something that makes it special or unique, so that it either has a strong competitive advantage in its industry, if it has a lot of competitors; or, the ideal scenario is that it's creating its own industry and it has no competitors at all. I also look for companies that have recurring revenue that's very predictable. I want a clear path to get to profitability if the company isn't there yet. I want to see a founder at the helm, or at the very least, a great culture. When you tick through all those things, it eliminates a lot of small caps from contention.

Harjes: We're going to pitch three stocks today that check off, would you say, all those boxes? Or at least most of those boxes?

Feroldi: I would say the vast majority of these boxes, yes.

Harjes: Awesome! Let's do it. Company No. 1 is called LeMaitre Vascular. Their ticker is LMAT. Brain, you're actually heading to their headquarters tomorrow.

Feroldi: Yeah, I'm going to go check it out and get to see some of the products up close. I'm pretty excited about that!

Harjes: And what are those products? What exactly do they do?

Feroldi: LeMaitre Vascular, as you probably guessed from their name, they cater to the needs of vascular surgeons. For those who don't know, vascular surgery is surgery of the veins and the arteries, the circular system, that takes place outside of the heart. What these guys do is, they sell 14 different product lines that are used in vascular surgery -- products like grafts, patches, tape, catheters, those kinds of things. Except, while the vascular market in general is pretty large -- it's about a $5 billion market -- what LeMaitre Vascular does to compete is, they focus on niche product markets. They look for product categories that have less than $150 million in annual sales. They look to dominate a whole bunch of niche markets, as opposed to competing against the large companies. By taking a niche focus, it insulates them from competition.

Harjes: They're basically going after the niches of the market that are too small potatoes for a Goliath like a Johnson & Johnson. They have these 15 different product lines. The vast majority of their products hold the No. 1 or No. 2 market share position, which means they're doing a pretty good job. They have this eye for quality, which is likely derived from the fact that this is a family business that was started by George LeMaitre, who was a vascular surgeon.

Feroldi: The story is, the business was founded in the 1980s by a vascular surgeon who was frustrated with the products that were available at the time. He hired an engineer to create some new ones. He ended up founding this business. His son actually took over as CEO of the business a few years in. That was 26 years ago. While they are publicly traded, it was started by a vascular surgeon, and it's been run by his son, the CEO, for the last 26 years. And while they were small, initially, they have, through organic product innovation and through making acquisitions, compiled together a pretty impressive group of products that -- as you said -- holds the No. 1 or No. 2 market share in their niches. When you cobble all those together, the company did about $100 million in revenue. That isn't an enormous number in the grand scheme of things, but that is still big enough for this company to be profitable, cash flow positive, and their balance sheet is just pristine. It has over $50 million in cash and zero debt. If you look at the financials of this business, it's very attractive.

Harjes: And given that they're only selling about $100 million in annual revenue right now, there's a huge potential for growth, too. Their total addressable market is supposedly $1 billion. There could potentially be a huge growth runway in front of this company. Given that they are a smaller company pursuing growth, something that really stood out to me about them as quirky is the fact that they pay a dividend. Why is that?

Feroldi: That's a great question that I'm going to actually ask management tomorrow. I would personally prefer to see them retain all of their capital and use it to either pump more into R&D or to make acquisitions. But since they're a family run business, perhaps the CEO just wanted to have some more income for himself. The insiders in general of this business hold about 19% of the total shares outstanding, so they do have an incentive to pay a small dividend.

But, to your point, Kristine, what I like about this company is, its growth strategy is pretty straightforward. Because they operate in these niche markets, they have much more pricing power than they would if they were competing against, like you said, Johnson & Johnson or Medtronic on a day to day basis. Each year, they push through 3-4% price increases on their products, and they add a few more sales reps to their team. They have about 100 in total. When you combine in occasional acquisitions, they've grown their revenue at a modest 11% rate over the last five years. They've translated that into something like 45% growth in earnings through margin enhancements. It's modest growth on the top line that translates into very strong growth in the bottom line.

Harjes: And the market has given this company a $717 million market cap, which has fluctuated a good bit. They fell pretty hard in April after reporting disappointing earnings. They still haven't fully recovered. By most every metric, they're pretty expensive. What do you think of their valuation?

Feroldi: I think it does boast a premium valuation, and that's because of their consistency, their niche focus, and all the attributes that we just ran through. Having said that, though, this company is up more than 500% since its IPO in 2006. It has already thrashed the market, and I see a pretty clear pathway to continue posting regular earnings growth. So, while investors would have to pay a premium price tag to get their hands on it today, it might be worth it.

Harjes: Awesome. As you go visit them tomorrow, what other questions are top of mind?

Feroldi: I always like to ask about their long-term strategy with M&A. I always like to dig into the culture of a business and learn more about how employees are recruited, trained, and retained. I plan on digging into that.

Harjes: Great! I'm sure you'll be writing an article after the trip?

Feroldi: You can look forward to it, yes!

Harjes: Listeners, if you're interested in it, shoot us a note at industryfocus@fool.com and we'll be happy to send it along once it is complete and published on fool.com.

The next hidden gem that we want to spotlight today is called HealthEquity. Their ticker is HQY. They are a $5.4 billion market cap health tech company that manages health savings accounts. That begs the question, Brian, what is an HSA?

Feroldi: An HSA is a way for people and employees to save money on their health spendings. Some people might be familiar with flexible spending accounts. An HSA is kind of that, but even better. The way an HSA works is that employees can put pre-tax dollars into them. The money then grows in the account tax-free. Then, as long as it's used to pay for qualified healthcare expenses, there's no tax on taking it out. It's kind of like this magical account that offers people a triple tax advantage.

Having said that, HSAs are only available to people that have a high-deductible healthcare plan. I believe that's something like more than a $1,300 per year deductible before their health benefits kick in. It's not available to everybody. But because of the general rise in insurance premiums, one of the benefits of high-deductible healthcare plans is that their premiums are much lower than they would be for a regular plan that just had a standard copay. So, because of the cost savings on the premiums, the popularity of HSAs has exploited in recent years, as more people have chosen high-deductible health plans.

Harjes: The Motley Fool just added an HSA high-deductible plan to our health plan here for employees, and I went for it. This is my first year of having an HSA. I think it's an awesome tax-saving vehicle.

Going back to the business model for HealthEquity, they basically partner between health plans and employers to offer these HSA plans to employees and members. They have four different sources of recurring revenue. That's the subscription fees from the health plans and employers, there's AUM fees -- assets under management -- there's payment fees, and there's investment fees. It seems like this is all adding up to really quick growth in revenue. What is differentiating this business model? Why couldn't some other company come in, do the same thing, take out a little bit of margin, and beat them?

Feroldi: That's a great question. They like to say that their advantage is in the services that they provide and the view they take on it. This company isn't based in Silicon Valley, but it's got that ethos up and down it. They really do what they can to put their members first. If you're a member and you go to their website, they will actually help you find local healthcare providers that charge lower prices for services. They have great customer service. When combined with acquisitions, that fact has actually allowed them to consistently take market share in the HSA market.

Rewind the clock to 2010, they had about a 4% market share in all HSAs. Fast forward to last year, that number was up to 15%. And all along the way, the number of HSA accounts in general was growing as they increased in popularity. HealthEquity's revenue growth over that time period has just been phenomenal.

Harjes: Yeah, this is a company that has crushed the market since its 2014 IPO -- much like LeMaitre did, as well. They are also a team where the culture matters, the founder is still involved, there's 19% insider ownership. It checks a lot of those boxes that you mentioned at the top of the show.

Feroldi: Just take last year as an example. Last year, their revenue grew about 29%. This business has already achieved enough scale to start producing free cash flow and net income. Because they have recurring revenue, and they've already built this platform, as they add more members to that, it doesn't cost them increasingly more money to service them. As a result, their net income has actually grown much faster than their revenue. For example, last year, they had 29% revenue growth. That translated into net income growth of 80%.

This is another business that, as you say, because of the recurring revenue, and because of the trend that it's riding, I could easily see revenue growing double digits and net income growing even faster than that for many years to come.

Harjes: I love seeing those economics in a business. Perhaps not surprisingly, this company is also "expensive" with traditional valuation metrics. What do you think about its valuation, which stands around $5 billion?

Feroldi: There's no doubt that this stock is pricey. It's trading for 22 times sales, 65 times next year's earnings. Investors are absolutely paying a premium if they're buying today. If you buy this stock, you truly have to believe that it can continue to grow its revenue and its net income for many years to come. I happen to believe that they can. I am personally a shareholder of this business, and I have no plans on selling.

Harjes: Great! Our third and final hidden gem for today's show has actually come up on Industry Focus before. Some of you may have heard of it. Brian pitched us NovoCure, ticker NVCR, back in October 2017. The stock is up 80% so far in 2018, now standing at a $3.4 billion market cap. For those who missed that initial episode, give us the basics on what this company does.

Feroldi: NovoCure is kind of an oddball company. They're a medical device company that's focused on cancer. The idea that they came up with many years ago was that electric fields that are produced by electric signals can actually work to inhibit cell division in cancerous tumors. Now, this idea sounds really crazy, but they actually had a product approved, called Optune, a few years ago. This device is on the market. The initial disease state that they targeted was called glioblastoma multiforme, which is a very deadly form of brain cancer.

Patients literally take this device -- which kind of looks like a swimming cap that has some cords attached to it -- and they put this on their head, and it emits very low-dose electric fields. Those electric fields are tuned to a specific frequency that inhibit cell division in brain cancer. When you combine this product with chemotherapy, surgery, and radiation -- which are the standard of care treatments for brain cancer -- this company has the clinical data to prove that this crazy idea actually works to extend life.

Harjes: The stock has been surging all year because last December, the company proved that adding Optune, the device, to standard chemo and therapy increased the survival chances of newly diagnosed patients with GBM by 37% compared to chemotherapy alone. I really like that it's additive. It doesn't have to battle against long-standing traditional methods of care for first-line treatment. It's something that a doctor can say, "Hey, this thing has been proven in the clinic to be an effective addition. There are no side effects." Why not add it on?

Feroldi: The idea of tumor treating fields, as it's called, is so out there that this company faced an intense amount of scrutiny when it first came on the market. Doctors were naturally skeptical because it was so different than what has been out there. But, to your point, as they've actually produced survival data, long-term clinical data that's proven that this technology actually works, more and more doctors have been willing to actually give it a chance, prescribe it to their patients. And that led to, NovoCure's revenue growth has just been phenomenal. I mean, in 2017, they posted 114% revenue growth year over year. Despite that huge growth, their penetration rates, just in the U.S., Europe, and Japan -- where they're currently FDA-approved -- is still very small in brain cancer. Without getting any more indications, they could literally grow their revenue by 10 times from here by just increasing their penetration.

Harjes: Which is pretty cool. They only have a little over 2,000 active patients right now. If you look at the total addressable market just in GBM, that stands around 13,000. They're also studying this in other cancers. They could potentially expand much beyond that.

Feroldi: That's really the lottery ticket with this business. What caught my eye about Optune, as you said, it's not invasive and there's really no side effects. You basically put this cap on, and it almost magically works against cancer -- which sounds crazy, but again, they have the clinical data to back it up.

They believe that Tumor Treating Fields and Optune have many uses beyond brain cancer. They're studying it in mesothelioma, lung cancer, ovarian cancer, pancreatic cancer, and brain metastases. They're in phase 1, 2, and 3 with those various cancers. If they can win approval in any of those, their total addressable market just explodes. You talk about a 25 times increase if they get, for example, lung cancer. Hundreds of thousands of people suffer from lung cancer every year.

Harjes: Because this is something that patients pay a monthly fee to use, talk to me a little bit about the pricing model and how they've been doing getting insurers covering it.

Feroldi: It is relatively expensive to use, as are many drugs that treat cancer. I believe the number that they bill is $17,000 per month. Now, they actually don't receive that, that's just the list price. They basically bill insurers on a monthly basis. The parts that the patient wears on their head, those are changed out every two to four days, about there. NovoCure bundles the whole thing up into one pricing model.

Because of the small numbers of patients with glioblastoma multiforme, insurers have been willing to cover this. It's covered by the vast majority of insurers. Patients that have Medicare can actually get access to this product through a compassionate program, even though NovoCure itself is not receiving payments from Medicare. They've been working with the government to actually get a coverage for Medicare. If they can do that, their revenue would pretty much instantaneously increase by 30%.

Harjes: That's awesome. These guys -- as usual with the companies that we're talking about -- look really expensive. Do you have any additional thoughts to add on their valuation?

Feroldi: There's no real way to value this company. They're not yet profitable. They're trading at something like 16 times price to sales. If you are buying the stock today, you have to be willing to hold it for many years, and you have to believe that Optune will eventually get approval, and they will have success in those other cancers. I believe that that's the case. But because this company is still losing money -- they're about a year or two away from profitability -- it's definitely one of the higher-risk ones.

Harjes: Because this has come up with all three of the stocks that we've talked about -- buying in at a high valuation when the company has already run up a good bit -- I want to talk about that more on a theoretical level. There's an instinct to not want to buy more of a stock that's already been climbing, since now it's more expensive. But, Brian, you seem to love adding money to the stocks in your portfolio that have grown a bunch. Talk to me about your "winners keep on winning" mentality.

Feroldi: That's something that's completely backwards to most investors. I will tell you, when I first started investing, I was absolutely the kind of investor that would rather buy a stock at a 52-week low instead of its 52-week high. It can be extremely challenging to buy a stock when, a year ago, you could have gotten it for half the price that it's trading at now.

However, one of the things that David Gardner -- one of the co-founders of the Fool -- has instilled in me is that winners tend to keep on winning. I've seen that happen enough with the investments that I've made over the years that I would now much rather buy a stock that has already gone up a lot instead of one that has fallen a lot. That's a counter-intuitive mindset that I'm happy to take on.

Harjes: The counter-argument would be that the stock market is generally looking pretty frothy, and these growth stocks are probably just the ones that will get hit the most in a market downturn, which is inevitable. What would you say to those that have that hesitation?

Feroldi: Oh, I completely agree. If the stock market did fall, the stocks that we talked about today, because of their premium valuations, would probably fall further than the market. As an investor, you do have to be comfortable taking on that volatility.

Now, my counter-argument for that would be, I'm not holding these stocks or buying them today because I want to profit on them in a month or three months or six months. I literally want to hold each of these businesses for five-plus years. If you assume fast growth rates for the next five years, their valuations do not look as extreme as you would think. But if you take a short-term mentality with these stocks, you could probably get hurt really bad.

Harjes: Just to close us out, if you had to choose just one of the three stocks that we talked about to add to your portfolio at today's prices, which would it be?

Feroldi: I knew you were going to ask that, too.

Harjes: [laughs] Am I that predictable?

Feroldi: If I had to pick one, I would probably take HealthEquity. The business has already achieved scale. They're already profitable, they're already posting fast revenue growth. I think this business has a huge runway for growth ahead of it. While it is expensive on a forward earnings basis, I could easily see this business growing into its valuation many times over.

Harjes: Great! Brian, thanks so much for joining me on the show today and shining a light on some frequently overlooked healthcare stocks, as well as the Foolish investing philosophy.

Feroldi: You know I love talking about hidden gems, so thanks for having me on!

Harjes: As always, people on the program may have interests in the stocks that 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. Today's show is produced by Austin Morgan. For Brian Feroldi, I'm Kristine Harjes. Thanks for listening, and Fool on!

Brian Feroldi owns shares of HealthEquity and NovoCure. Kristine Harjes owns shares of Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and Medtronic and has the following options: short October 2018 $135 calls on Johnson & Johnson. The Motley Fool has a disclosure policy.