America's 100 best small corporations, Business Week's annual ranking of Hot Growth Companies, was featured in the May 22 issue. To discuss the list--and investing in small companies--the May 14 guests were Gary L. Pilgrim of the PBHG Growth Fund and BW's Jane Sasseen.
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OnlineHost: Good evening and welcome! Tonight, Business Week Online brings you a conference based on the Special Report featured on the cover of the May 22 issue, Hot Growth Companies. The centerpiece of the report is BW's annual listing of the top 100 small corporations.
A special guest tonight, to answer questions about investing in small companies, is Gary L. Pilgrim, president and chief investment officer of Pilgrim Baxter & Associates. Among his responsibilities is managing the portfolio of the PBHG Growth Fund--which received the highest rating in Business Week's Mutual Fund Scoreboard. Gary Pilgrim's screen name is GarPilgrim.
Also on stage is Business Week Associate Editor Jane A. Sasseen (JSasseen), who is in charge of the magazine's coverage of corporate strategies and was deeply involved in the Hot Growth Companies project. She rejoined BW in 1994 after eight years in Paris, the last five years as senior editor of International Management.
The moderator tonight is Jack Dierdorff (JackBW), consulting editor of BW Online. Now, on to our discussion with Gary Pilgrim of the PBHG Fund and BW's Jane Sasseen--and answers to the questions you send us via the Interact button.
JackBW: Good evening to all of you on AOL. And hi, Gary Pilgrim and Jane Sasseen.
GarPilgrim: Hi, Jack.
JSasseen: Hi, Gary. Hi, Jack.
JackBW: Jane, we'll start with a pretty basic question for you.
Question: How does a company get on the BW list of the 100 best small corporations?
JSasseen: The first cut is made on a few basic criteria, Jack. To be considered, a company has to have sales between $10 million and $150 million, have a market value of over $1 million, and have shares trading for over $2 each. Then comes the hard part--they've got to excel in three ways: three-year sales growth, earnings growth, and return on capital. Then a final ranking is made, with 50% weighting given to return on capital, and 25% each to earnings and sales growth. There aren't many companies left at the end.
JackBW: Gary, here's a question to get you started on investment strategies in the growth area.
Question: Gary Pilgrim, the stock market is pretty exciting these days. What kind of market is it for small growth stocks?
GarPilgrim: It's a good market for small growth technology companies. Small in general has been relatively weak compared with the large-company indexes.
JackBW: Jane, let's flesh out the rankings a bit.
Question: Who are the top small companies on BW's list this time around?
JSasseen: No. 1 is a New York company called Happiness Express. They make kids' accessories--and they're soaring now, thanks to a line of Power Rangers stuff. Next is Elcotel, a Florida-based company that makes telephone booths. Then No. 3 is Media Arts, which makes home collectibles, followed by Fore Systems, which makes networking software. And No. 5 makes caller-ID equipment.
JackBW: Gary Pilgrim, try this one next.
Question: As a portfolio manager, what are the major criteria you look at for investing in a small growth company?
GarPilgrim: You look for high profit margins, plus some measure (at least a few years) of sustainable high growth rates, high numbers for return on equity and return on capital--any evidence that shows the company will have good future growth.
JackBW: What about startup companies that have yet to show profits or other such numbers?
GarPilgrim: Forget it. A lot of money is lost anticipating the future with companies that have no serious business prospects.
JSasseen: Gary, how many years' performance do you look for--what's a minimum?
GarPilgrim: I'd like to see at least a couple of years of profitable operations.
JackBW: Hensley asks how you check on companies.
Question: Do you ever go out to the companies and investigate their operations?
GarPilgrim: We do all kinds of company checks, including seeing them at their facilities. We see them at conferences, and there's a constant stream of these little companies coming to see us at the office--at least five a year, maybe more, especially IPO candidates.
JackBW: Dbg29 has an appropriate question for an online event.
Question: Gary Pilgrim, would you comment on the likely effect of many smart and knowledgeable people doing their own investing online, with info provided online (here, e.g.) on the market?
GarPilgrim: I think everyone ought to be in mutual funds and forget individual investment. The reason I say that is that I believe being an investor is a full-time job, and unless you can give it 18 hours a day, you're likely to miss a few things. Of course, you should invest in mutual funds, where the manager works 18 hours a day.
JackBW: But do you see any market impact from many of us having real-time info like the brokers?
GarPilgrim: I don't think that there's any incremental impact from everyone having information instantaneously. The impact is already there. Professionals in the biz have so much info so quickly that having the public have the same doesn't make any incremental difference.
JackBW: Jane, here's one about the staying power of the BW 100 companies.
Question: What are the chances that a company on this year's list will turn out to be a winner year after year?
JSasseen: That depends. Some do a very good job year after year. Look back two years ago and one of the top companies then, U.S. Robotics, is nearly three times the size today and still strongly profitable. But others stumble-- they have problems with one product or can't manage the rapid growth. Investors definitely need to keep this in mind as they comb through this list looking for prospects. It's a starting point, but you need to look at some of the same kinds of things Gary mentioned a minute ago.
GarPilgrim: U.S. Robotics is one of our most important holdings--a very successful company.
JackBW: WC Sysop has one now. Incidentally, he says he owns a small amount of PBHGX and calls it his "Thrills & Chills Fund."
Question: What percentage of your new picks are stocks that are "in the groove" and appropriately valued vs. "undervalued" and "hidden virtues" stocks?
GarPilgrim: We look for companies that are currently doing very well, experiencing high and accelerating growth. We aren't too concerned about valuation. We always want to own America's best and fastest-growing companaies.
JackBW: AlgeeW has a salient question.
Question: When do you sell?
JackBW: Gary?
GarPilgrim: We sell when we think something may be changing, or we sell when something does change, but the objective is to stay on top of a company's business trends and sell at the earliest sign of negative change. We don't sell for valuation reasons, we sell for fundamental reasons.
JackBW: A question now about big volume in small stocks.
Question: Gary, I see what looks like huge daily volumes in some pretty small stocks on the NASDAQ. What's going on? How much of this volume is from individuals like me who are just adjusting their portfolios?
GarPilgrim: In a general way, volume can be interpreted as being positive or negative. Big volume in a rising stock means more people are discovering it. Big volume in a declining stock means more people are concerned. In general, I don't see anything new in a volume sense.
JSasseen: Gary, go back a second to the question of selling. How long, on average, do you hold on to stocks? Do fast-growing companies tend to peak out fairly rapidly in the market?
GarPilgrim: Our average holding period is 18 months. As to peaking out, it would be hard to generalize. Exceptional growth companies don't often grow at exceptional rates for very long. So maybe they peak out early. But the mission is to find companies that experience exceptional growth for three to five years. That's how you make 5 to 10 times your money. Or as Peter Lynch would say, a 10-bagger.
JackBW: Skekko looks at a specific sector.
Question: Gary, what do you think of the temporary employment sector (Manpower, Kelly, Robert Half, Adia, etc.)?
GarPilgrim: First, those are really cyclical growth companies, and I would not be very interested in most of those names, because I think most of the growth in this cycle is behind those companies.
JackBW: Jane, Woodcut has a question about the BW list. And perhaps you can go on to tell us what sectors are hottest in the 100.
Question: Why did you leave financial services companies off your list?
JSasseen: We leave them off because their numbers aren't easily comparable to service or industrial companies. Return on capital, for example, is something with a different meaning there. As for what's on the list, high-tech companies dominate-- anything computer-related, not surprisingly. They're a quarter of the list. Telecommunications had about five companies. Health care also. Then there are hot non-tech sectors like restaurants, retail, and service. They always add about four or five companies each. After that, it's a smattering of everything.
GarPilgrim: Just to add: There are very few high-growth-rate companies in financial services. And I agree with Jane on technology companies. They're about 35% of our typical portfolio.
JackBW: LeshaB wants to know how long to hold on to an apparent loser.
Question: GarPilgrim, how much time would you give a fund that stumbles before selling?
GarPilgrim: It's very difficult. First, you have to figure out, did a fund stumble relative to its peer group? Most funds have a strong investment style, so you have to put the fund in the right investment style, then analyze it relative to its peers. If it's doing poorly relative to its peers, I'd give it about 18 months to straighten out, and then I'd shoot it. However, I would also look for reasons for the problem-- perhaps a manager change, perhaps too much growth in the fund, perhaps a sector the fund invests in is temporarily out of favor. A fund that chronically invests in technology can have volatile peer-group comparisons.
JSasseen: Gary, one of the other fund managers we talked to said he's starting to see money flowing out of cyclicals and into growth stocks again recently, after a pretty dry year last year for the growth sector. Are you seeing signs of that?
GarPilgrim: I can't really say, because all we follow are growth companies, but I think it's clear that growth companies are becoming more attractive as people worry about an economic slowdown--whatever kind of landing we have.
JackBW: As an observer of high tech, do you have any comment on this from RRAJR?
Question: Are not the computer companies reduced to primarily design houses and then quickly losing manufacturing to offshore companies?
GarPilgrim: I don't have an opinion about that, but I do notice that not many computer companies qualify for emerging- or high-growth companies. We don't own a computer company because we can't find any that are attractive. The box makers increasingly are in a very difficult business for a variety of reasons.
JackBW: WC Sysop is back with another sector question.
Question: Gary, Is health care's cycle about over also, or was the recent action premature?
GarPilgrim: There's a danger in generalizing about health care. The recent underperformance of health care has been caused by a concern over potential cutbacks in Medicare and Medicaid. Also by a concern over medical reimbursement rates for medical rehabilitation companies. That's cast a cloud over the sector, but a lot of companies continue to do very well, and you have to look at it company by company.
JackBW: LOU111 wants your view on one type of fund vs. another.
Question: When is a pure growth fund with no dividends better than an income-producing fund? Doesn't income always offset potential setbacks later? Why go for a growth fund that may do well until you need to pull the money out?
GarPilgrim: I think you should look at a mutual fund with respect to its total return. I would be relatively indifferent as to whether the return was in income or capital gains. And look at it relative to your time horizon and volatility considerations. Growth funds tend to be more volatile than growth and income funds, but they tend to offer a higher return.
JackBW: Gary, what's the best performer in your current PBHG Growth holdings?
GarPilgrim: Let me look for a second. The best stock, year to date ('95), looks like Tencor Instruments. It's a semiconductor equipment company. I would also throw U.S. Robotics into that category.
JackBW: GOORU1 has a logical follow-up, if you can answer this.
Question: Gary, your top speculative pick for the next six months would be?
GarPilgrim: (Laughing)
GarPilgrim: We have a portfolio, we don't have top picks. But I'll tell you my top three or four holdings: Tencor, U.S. Robotics, Glenayre Technology, Zebra Technology. Those are my four largest holdings, so I'll submit them as my four favorite stocks.
JackBW: Is this too close to the bone? People ask BW about Forbes and Fortune.
Question: Perhaps unfair question, but...which other fund do you consider your closest competitor?
GarPilgrim: Let me think about that...for a second. Certainly the Alger Small Cap Growth Fund is similar. Montgomery Small Cap is another. I think Founders Frontier, maybe Berger Small Company.
JackBW: Now Jane Sasseen has another question.
JSasseen: It's another one perhaps close to the bone. We always hear about the best picks from fund managers. But how many don't work out? How many stocks end up doing little for the portfolio or dropping?
GarPilgrim: That's a great question. And that's why I hate to highlight three or four stocks. Most of the time when I highlight three or four stocks, three or four of them don't pan out. That's why we own 70 or 80 stocks. And the dropout rate is probably 30% or 40% a year of stocks that don't live up to expectations. That's why we don't bet the ranch on three or four stocks. High-growth, small company is a very risky area, and that's why you need active management.
JackBW: RCstaten has an appropriate final question--I can guess Gary Pilgrim's answer.
Question: How do you find these growth companies to invest in? Through technical magazines? Through newspapers, etc.?
GarPilgrim: We start out the simplest possible way: We screen hundreds, if not thousands, of companies looking for exceptional earnings performance. Just like Business Week does in making up its list.
JackBW: And for the individual investor, shopping for a growth fund might be the answer.
JackBW: Thanks, Gary Pilgrim and Jane Sasseen. And thanks to the audience for interesting questions--not all of which we had time for.
OnlineHost: Thanks to Gary Pilgrim of the PBHG Fund, BW's Jane Sasseen, and the Business Week team for tonight's conference. If you'd like to continue the discussion, we invite you to move to the BW Online Chat Room or to post your comments and questions on the BW Online Message Boards (try the Economics & Finance category).
Transcripts of all BW Online conferences are available for downloading soon after the event (look under Special Events, Talk, or Search BW). While you're at it, explore all the features of Business Week Online (keyword: BW).
Tune in Tuesday, May 16, for a special BW Online conference. We will have as our guests Charles A. (Chip) Morris of T. Rowe Price and BW's mutual-fund guru, Jeffrey Laderman, to talk about investing in science and technology (8 pm ET, Coliseum). Plus every Sunday at 9 pm ET, Business Week Online presents a conference here in the Globe. Thanks again and goodnight!
Copyright 1995 by The McGraw-Hill Companies, Inc. All rights reserved.
