Lynch Strategy Finds Health in Health Care

• ByJohn Reese, RealMoney Contributor
• On 1:08 pm EST, Friday November 6, 2009

Health care is front and center in today's political and economic discussions because the Obama administration has made health care reform one of its major goals. It's still too early to tell how health care reform will play out or if we'll even get any major reform to the health care system.

Assuming we do get some form of health care reform, which seems to me likely, the question is: Who will be the probable winners in the health care industry?

It's hard to tell, but the existing health care companies are certain to continue to play a major role. Even if we do not get health care reform, the existing industry players will do just fine. So I've taken a look at the health care industry to see if it has any interest among my Guru Strategies, which are computerized strategies I created based on the investment approaches of various well-known Wall Street investors.

One strategy in particular, based on the writings of Peter Lynch, is extolling the virtues of the health care industry. If you are unfamiliar with Lynch, you need to remedy that. In the annals of the mutual fund industry, there is probably no fund manager with a more sterling reputation. From the late 1970s to 1990, when he took early retirement, Lynch managed Fidelity Magellan, which became the largest mutual fund in the world as a result of his track record. During the years he managed the fund, it averaged a remarkable 29.2% a year, nearly double the S&P 500's 15.8% (which also seems pretty remarkable, given the returns the market has experienced during the past decade).

When I started setting up my Guru Strategies in July 2003, Lynch's was included in the initial group. I could not imagine talking about the strategies of the greats without including him. Since then, the Lynch strategy has produced one of the best returns of any strategy, which is 8.8% a year on average, versus the S&P 500's 0.7%. When the Lynch strategy says a certain industry is worth paying attention to -- as it is doing now with health care -- investors should listen.

One industry player liked by the Lynch strategy is Catalyst Health Solutions. Catalyst is a pharmacy benefits manager, which means it fills prescriptions for members of organizations, such as state and local governments, employers and unions that use Catalyst. The Lynch strategy classifies Catalyst as a "fast grower" because its growth rate exceeds 20% a year.

Lynch's most famous investment variable is the PEG ratio, where he looks at the price-to-earnings ratio relative to the company's growth. This is a way to measure how much you are paying for growth. The strategy sets a limit of 1 for this ratio; anything higher suggests you are paying too much for growth, and the lower the ratio is than 1, the better. Catalyst's PEG is 0.88, which is perfectly acceptable. When buying the stock at its current price, you are paying a reasonable amount for growth.

The strategy also places a limit on the P/E ratio. For companies whose annual revenue exceeds $1 billion, the P/E needs to be south of 40. Catalyst's revenues top $2.7 billion, and its P/E is 24.9.

Another plus for Catalyst is its equity-to-assets ratio. The strategy calls for this to be above 5%, while Catalyst's is a robust 52%. Finally, Catalyst's return on assets is also impressive. This has to be north of 1%, and Catalyst's is 8.3%.

Molina Healthcare is another health care company in the good graces of the Lynch strategy. This Medicaid- and Medicare-focused managed-care organization provides health benefits to 1.4 million who depend on government assistance for their healthcare. It operates in 10 states. Molina is considered by the Lynch strategy to be a "true stalwart," because its growth rate of 12.57% lies within the range of 10% to 19%. Molina's yield-adjusted PEG is 0.77, nicely below the 1 maximum allowed. It has an extremely healthy equity-to-assets ratio of 45%, and its return on assets is an acceptable 4.3%.

A third company to consider is the Unum Group, the largest disability insurer in the U.S. (the company also operates in the U.K.). It also sells other insurance products, including group life and long-term care. Considered a fast grower by the Lynch strategy because of its growth rate of 20.2%, Unum has a very desirable PEG ratio of 0.57. Note that the growth rates of Catalyst and Molina were based on the average of their three-, four- and five-year historical EPS growth rates, while Unum's is based on just its three- and four-year historical growth rates. This is a bit less desirable than for all three time periods, but the stock still gets a positive review from the Lynch strategy. Its P/E ratio is a nice and low 11.5, and its equity is 15% of its equity. Finally, its return on assets is 1.13%, just above the 1% cutoff point.

Humana is health and specialty benefits companies, with approximately 10.3 million medical members and 7.3 million specialty-benefit members that gets a high grade from the Lynch strategy. Its recent performance is also impressive. Its just-released third-quarter numbers show profits up 65% and revenue up 8%. Using the three-, four- and five-year historical EPS growth rates, Humana has a very impressive PEG of 0.27, which suggests you are paying a relatively small amount for growth. The company is considered a fast grower because its growth rate is 24.5%. Also in its favor is its equity-to-asset ratio, which is 39%, well above the 5% minimum required. Also well above the minimum is its return on assets, which is 7.2%, while the minimum is 1%.

Assurant is the final health care company that receives a high grade from the Lynch strategy. This is a diversified insurance company whose products include health, property and casualty and other insurance offerings. It falls under the "true stalwart" category, as its growth rate, based on the three-, four- and five-year historical growth rates is 12.2%. Its yield-adjusted PEG is an impressive 0.41, its equity-to-assets ratio is 19%, and its return on assets is 2.4%, all impressive.

All five of these companies are well-positioned in the health care industry and have the backing of the Lynch strategy. Whichever way the wind blows regarding changes in the health care industry, these companies are worth considering as additions to your portfolio.

Buzz up!