Realize Success with Lynch's Strategies

Physician's Money Digest, December 2005, Volume 12, Issue 16

One of those renownedgurus is none other thanPeter Lynch, who made aname for himself whilemanaging the Fidelity Magellanmutual fund. From 1977, whenLynch took the helm, to 1990, when heretired, Magellan was a star performer,steering this fund to a total return of2510%, or 5 times the approximate500% return of the S&P 500 Index.

Find a Hidden Gem

Lynch is probably best known for his"buy what you know"investing philosophy(ie, investors should put theirmoney into companies they know andlike). If you know of a small, undiscoveredrestaurant chain, retailer, or medicaldevice manufacturer, he wouldadvise that the company is worth consideration,because such an opportunitymay become an undiscovered gem thatgrows into a major enterprise.

Physician-investors can greatly benefitfrom this logical strategy, since physiciansoftentimes have insights into newdrugs and medical technologies thatcould be huge breakthroughs for theindustry. The result of these innovations,as we know, could result in massiveshareholder value creation.

Fundamental Analysis

One Up on Wall

Street: How to Use What You Already

Know to Make Money in the Market

But finding the next Amgen orMedtronic is not as easy as it mightseem and also carries a substantialamount of risk. To the surprise of many,Lynch's approach was not completelyqualitative. Rather, he employed a veryrigorous quantitative methodology, outlinedin his book, (Simon & Schuster; 2000). Physician-investorscan learn many lessons by followingLynch's techniques.

The first step is to divide companiesinto the following three categories:

1) Slow-growers, mature companiesthat pay high dividends and grow at lessthan 10% annually;

2) Stalwarts, which hold the potentialfor 30% to 50% stock price gainsover a 2-year period, yet experience anannual growth of 10% to 19%; and

3) Fast-growers, Lynch's favorite,small, underappreciated companies withan annual growth of 20% to 50% a year.

Let's take a closer look at Stalwartfundamental analysis. Slow-and fast-growersare analyzed differently, althoughmany of the metrics employedare similar to the following:

•Yield-adjusted PEG ratio. Lynchis best known for his belief that theprice-to-earnings (P/E) ratio of any fairlypriced company will equal its historicalgrowth rate (G), what Lynch calls itsPEG ratio, where P/E = G. For Stalwarts,he likes the P/E to be 1/2 or lessthan the growth rate plus the yield.

•Inventory-to-sales ratio. Accordingto Lynch, when inventories increasefaster than sales, a red flag should goup. However, an increase of up to 5% isconsidered bearable if all other ratiosappear attractive.

•Earnings per share. For a companyto pass Lynch's test, it must havebeen profitable over the last 12 months.

•Debt-to-equity ratio. Lynch doesnot like to see an excessive amount ofdebt. To that end, if a firm's debtexceeds 80% of its equity, it would failthis particular criterion.

•Net cash-to-price ratio. Lynch definesnet cash as cash and marketablesecurities minus long-term debt. Accordingto this methodology, a high valuefor this ratio dramatically cuts down onthe risk of the security. Lynch likes to seea net cash-to-price ratio above 30%.

My advice:

Learn from Lynch'sstrategies, which have proven successful.If you discipline yourself and followhis guidance, you will give yourself thebest chance for outperformance, even inthe toughest of markets.

John P. Reese, is chief executive officer of

Validea Capital Management (Validea.com),

a money management firm that utilizes

strict principles to manage money for high-net-worth individuals. His book, The Market

Gurus: Stock Investing Strategies You Can Use from Wall

Street's Best (Dearborn; 2002), has sold over 30,000

copies. A columnist for RealMoney and MSN Money, Mr.

Reese is a graduate of Harvard Business School and holds

two US patents in the area of automated stock analysis.