To discuss Business Week's annual list of the fastest-growing small companies -- and investing in growth stocks -- the guest on May 19 was Gary Pilgrim, president and CEO of Pilgrim Baxter & Associates and investment manager of the PBHG Growth Fund. He was joined by Jennifer Reingold, corporation editor of BW, who edited the stories accompanying the list.
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OnlineHost: Welcome to Business Week Online! Tonight we're talking about BW's list of the top 100 U.S. growth companies (featured in the May 27 issue) and the investment spectrum for growth stocks. The guests are Gary Pilgrim (GaryPilg), manager of the $4.5 billion PBHG Growth Fund, with the top 10-year record among diversified stock funds, and Jennifer Reingold (JENNREIN), BW's corporation editor.
JackBW: Good evening to all of you on AOL. I'm Jack Dierdorff of BW Online, your moderator. Welcome, Gary Pilgrim of PBHG Growth Fund. Delighted to have you on stage.
GaryPilg: Hi, Jack and Jennifer. Nice to be here.
JENNREIN: Hi. Gary and Jack. Good evening, everyone online.
JackBW: Jennifer, we'll start tonight by asking you about the list in this week's BW.
Question: Jennifer, can you explain briefly how BW decides which are the 100 fastest-growing small companies for the annual Hot Growth list?
JENNREIN: Sure. Companies must have sales between $10 million and $150 million, have a market value of more than $1 million, and have shares actively trading for more than $2, and a market value of over $1 million. Then, they are ranked in three ways: According to three-year sales growth, earnings growth, and return on capital. Return on capital gets a 50% ranking, with 25% rankings to earnings and sales growth. It's tough to make the list.
JackBW: Now it's your turn, Gary, for a somewhat similar question.
Question: Gary, the PBHG Growth Fund has its own list of growth companies, changing from time to time. How do you as the investment manager, with a top 10-year record to defend, go about selecting companies for your list?
JackBW: And how does PBHG's list compare with BW's?
GaryPilg: Well, we start by throwing a wide net out for companies currently growing in excess of 20%. It's a matter of simply looking at earnings. If they have market cap of $50 million or so, and if it looks like a growing company -- sales and earnings up in excess of 20% -- we're looking for companies that are really growing. You look at why they're growing, and talk to people who are familiar with them, and if their growth looks sustainable, we'll keep track of them, and in a few quarters start to bring them into our accounts. But the first net you throw out is for companies that are growing at exceptional rates.
JackBW: Walmarc asks the question I threw in as a footnote.
Question: Mr. Pilgrim, do you own any stocks in the BW Hot Growth list?
GaryPilg: Funny you should ask. As we look at BW's list of the top companies with respect to absolute level of earnings, we have [owned] or do own every one of those companies. If I go down the entire list BW has, I would find very few I don't know anything about, and I would guess we own 30% or 40% of the list, though I haven't made that calculation. These are for the most part very familiar companies.
JENNREIN: Gary, we measure our companies over three years. What's your time frame?
GaryPilg: My time frame is that a company should have recent results that attract our attention as growth investors. We find that most companies that are doing well on a short-term basis are also doing well on a long-term basis. We don't have any mandatory period. Most small companies stumble now and then when they're small, and we understand that. We don't believe too much in screening. We look for good earnings, and then go find out what's going on.
JackBW: MikeMerc in South Plainfield, N.J., has this about the BW list of hot growth companies.
Question: Jennifer, do you know if there are a lot of (or any) companies on this year's list that have also been on previous years' lists?
JENNREIN: Just looking at the top 20, there are 6 repeaters from last year: The top performer of those is Unicomp, a software maker based in Georgia. It's No. 6. No. 7, too, is a second timer: Retirement Care Associates, which runs nursing homes in the Southeast. But lots of companies don't repeat. It's tough to keep up these growth rates.
JackBW: This comes in from GlobalAlex in Milwaukee.
Question: What industries do you see growing at above 30% to 40% a year during the next three to four years?
GaryPilg: We find that almost everything I own I expect to grow at 30% to 40% a year for the foreseeable future. Internetworking is a large position -- companies that have a combo of networking products and Internet support products. [These are] companies such as Ascend, Fore Systems, Cascade, U.S. Robotics. That's the largest sector weighting in our portfolio. Also client-server software companies, such as PeopleSoft, Atria, Arbor Software.
And as we look at health care -- another major sector -- physician management practice companies: Phycor, American Oncology, Physicians Reliance. Another large sector for us is consumer-retail specialty: CompUSA, Sunglass Hut, General Nutrition, Office Max. These are all industries we see with open-ended growth opportunities. We believe we've identified the highest growth-rate companies on the domestic landscape. The position-weighted earnings-per-share growth rate of the companies in our portfolio is 55% over the past 12 months. The PBHG Growth Fund is probably a little above the size of the companies in the BW survey.
JackBW: Next, Walmarc is back to ask when the captain throws some cargo overboard -- and why.
Question: When do you sell a stock?
GaryPilg: You sell when you either observe or believe you're going to see a negative change in the rate of growth, or a company is about to or does disappoint consensus expectations on growth and earnings.
JENNREIN: Gary, let's talk a little more about retail. Isn't that a sector that's had problems?
GaryPilg: Laughing. Is there another part to that question? You would note that the retailers I mentioned are not what one thinks of in the general world of retailing. They're in specialized niches. It's true that the generalized retailer is struggling. Among those, you have to search far and wide for good growth rates.
JackBW: Eyebawl wants some more insight on when to sell.
Question: When do you sell a stock that might get ahead of itself such as a price/earnings ratio of more than 3X growth rate?
GaryPilg: Ignore valuation when you have a great company that's beating the market consistently. Where the growth rate is three or four times the market growth rate, you'd be best to ignore the valuation and hold on to the stock. Valuation analysis as applied to growth stocks is vastly overestimated.
JackBW: Some IPOs are hot these days -- and here's a question on strategies for them.
Question: Gary, did you ever buy an IPO [initial public offering], flip it, and than buy it back?
GaryPilg: Yes. That's usually what we do. I think the problem with buying IPOs and holding onto them is that a couple years later a large percentage of them have failed fundamentally. Our research suggests that it's possible to buy and flip them, then come back in a few quarters and make sure the hype of the IPO offering is matched by the performance of the company.
Question: I'm still waiting to see who the top companies are. Can you name the top five in BW's list?
JENNREIN: Sure. Coming in at the No. 1 spot is Remedy Corp., which makes software to help companies with their own computer problems. Then there's Eltron International, which makes bar-code printers for inventory tracking. No. 3 is Logic Works, another software company, which designs databases for customer orders, etc. The No. 4 company is APAC Teleservices, which lets companies outsource customer service for such things as orders and complaints. Finally, there's Datastream systems, which writes Windows-based software for industrial automation.
JackBW: Screen name Jaysass sends us this query.
Question: A number of companies listed were related to or a part of the computer industry. With the recent downturn in this industry's stocks, where do you see these stocks going in three months? One year?
GaryPilg: Without getting into the specifics of individual companies, I've never made any money thinking about the next three months. I want to own the companies that are growing exceptionally in the current environment. So if the computer or any other industry is slow, I pay little attention to that and keep looking for companies that are doing well and keep investing in them as long as they're doing well. I don't even see much value in strategizing about sectors or industries or the economy.
JackBW: Last Sunday we discussed the possibility of soaring food prices. Here's GlobalAlex, who wants some strategic advice if there's inflation.
Question: What is the best way to take advantage of a rise in inflation (higher commodity prices, higher cost of money, etc.)? What industries should I be looking at (gold, grains, mining, food, etc.)?
GaryPilg: That's beyond the scope of my investment strategy thinking. I believe the process of identifying exceptional growth companies transcends inflation, the environment, natural disasters, etc. I don't have a strategy that is altered in the face of macroeconomic variables. I think investing in companies is the thing you want to keep your eye on, not global dislocations of any particular sort. Keep your eye on fundamentals.
JENNREIN: Gary, does this mean your choices are based on numbers only? Is there any management component?
GaryPilg: Well, I find that good managements are often uncovered behind good numbers, and if I've got bad numbers, I don't really care how good the management's supposed to be. If the numbers are good, I'm going to assume that the management's pretty competent. Yes, I mostly care about financial statement analysis. Behind every impressive set of numbers is a great story. It's all part of the same package, whether you start with the chicken or the egg. I don't believe you can define good managements very well, except by results. As Warren Buffett says, if you have good management and a bad business, the bad business usually wins.
JENNREIN: What about competition? Aren't there companies that have one great product until a much larger company muscles its way in?
GaryPilg: Conceptually, that's fairly obvious. You always wonder about small growth companies. My general approach is that, yes, that's a risk, and that I'll stay with a company as long as it's successful. One of the most common fears is that a small company can only go so far, and it won't be long before another company pre-empts it. But it's also my expereicne that there's more apprehension about that than necessary -- and that investors should hold on until the situation changes. I think for the most part it's a good strategy to wait and see instead of looking for a spook behind every new-product bush. A lot of times companies with good positions get acquired by would-be competitors.
JackBW: This might be a good time, Gary, to hear a little about PBHG Growth Fund, its size, and its performance.
GaryPilg: The PBHG Growth Fund has among the best 10-year records among diversified stock funds. It has a five-star rating from Morningstar for each of the periods they rate -- 3-, 5-, and 10-year periods. We've also been listed as one of the Stylebox Champs by Morningstar for each of the last two years. They've noted that we're one of the champs in our stocks. The fund size today is about $4.5 billion, and it's a no-load fund. I think any way you look at it the PBHG Growth Fund is one of the top two or three funds for the periods commonly looked at.
However, in spite of that glowing commercial I've just given, it is a volatile fund, given the nature of the companies it tends to invest in, and investors shouldn't be overly aggressive in how they use the fund in their overall investment mix. If they don't have a three- to five-year holding period, they should probably look for funds that are less volatile. We are not interested in shareholders who can't tolerate a short-term loss of 30%, which is in line with the short-term volatility of this fund. We don't want shareholders who pull out and go home mad. That's not what we're after.
JackBW: LBrown1727 sends us this question for Gary Pilgrim of PBHG Growth Fund.
Question: Many people worry that many of the name mutual funds are getting too big to be effective. Is that a concern of yours?
GaryPilg: I think it's a fair question, and our response is that so far our investment returns have held up in the face of dramatic growth of our funds. We think we understand the challenge of managing larger amounts of money. I would direct the questioner to a study by Morningstar on mutual fund performance and size a few months ago. They concluded that if anything, there was a tendency for larger funds to do better. The hypothesis was that larger funds have more resources, such as research resources. However, I think the jury is still out. We hope to do better than the average, even though I understand the principle that larger is harder than small. I think our challenge is to prove that we can handle the challenge.
JackBW: GrievAngel, who says she's an executive traveler, asks this one.
Question: Could you please comment on the restaurant stocks and your view on whether they are a stable investment?
GaryPilg: My experience is that most restaurant concepts tend to mature fairly quickly -- even McDonald's -- and that you have to be very careful with growth restaurants because they tend to exploit their niche quickly. So the growth opportunity for restaurants is often fragile and short-lived. You have to watch them carefully and realize at the first sign of slowing that it's probably the beginning of the end. Pay close attention to same-store sales, capital investment trends, etc. It's one of the more treacherous areas to achieve long-term investment success in.
JENNREIN: We do have a few restaurants on our list, including No. 9, Logan's Roadhouse.
GaryPilg: We own Logan's Roadhouse, and for the moment it looks like one of the winners in the restaurant industry. But we have a short leash on it. Things can change quickly in that business.
JackBW: Here's one of a couple of similar questions.
Question: Gary, what portion of your fund is invested in international stocks?
GaryPilg: International stocks -- zero. We purposely avoid foreign stocks because we've consistently told our shareholders that we aren't knowledgeable in foreign stock investing. We're a domestic growth stock investor, and I expect that to stay the same for the foreseeable future.
JackBW: I don't know how bullish or bearish you are at the moment for the overall market, but try this question.
Question: Gary, how is your fund prepared for a bear market?
GaryPilg: The same way it's always prepared -- by fully investing in the most dynamic and interesting growth companies we can find. That's somewhat tongue-in-cheek, but the point is we do not invest or prepare for bear markets, and investors who have bear markets on their mind should not use our fund.
JackBW: Now try this.
Question: Gary, what are the top five holdings in your fund?
GaryPilg: That's easy -- in descending order: Ascend Communications, U.S. Robotics, Fore Systems, Cascade Communications, and Clear Channel Communications.
JackBW: LBrown1727 is back with another question about broad trends.
Question: A recent article said that mutual funds are hot because of boomers, and that as they start retiring, the funds are really going to drop. Do you think that's correct?
GaryPilg: I think it's a reasonable analysis that says people's investment tendencies reflect their age. And as people move through this aggressive accumulation phase into a consumption-of-that-capital phase, they'll begin to do exactly what the questioner suggests. When and how that plays out is anybody's guess. It's conceivable that all our savings will sustain us, and we'll pass a lot on to our heirs -- or that we could have a 10-year bear market. We don't know.
I think the questioner is right in suggesting that this population bubble is behind this massive increase in mutual fund flows. Another major factor in that, though, is corporate retirement plans moving from defined benefit plans to defined contribution plans, such as 401(k)s. That's a redirection of money into the mutual fund business.
JackBW: JOHNSBOYD contributes the next question.
Question: How do you see small growth companies performing as an asset class compared to securities of emerging markets?
GaryPilg: If he means emerging markets as markets of less developed countries, I have no view of those markets because we don't invest in them. My simplistic view is that no matter what market you're in, companies whose revenues and profits grow at 30% to 40% annually are all engines of possible capital appreciation.
JackBW: Here's a lollapalooza...
Question: Gary, youf fund has been very consistent. Do you see yourself or Christine Baxter leaving this industry with the stature of a Peter Lynch?
JackBW: Explain who Christine Baxter is to those who may not know.
GaryPilg: Well, I think Peter Lynch's record and stature are somewhat unique in this business. I hope that we're able to be among the best at what we do. I hope to be remembered as having one of the best funds over any period of time. Whether we can achieve the legendary status of Peter Lynch is beyond the scope of my aspirations. Christine Baxter is the manager of the PBHG Emerging Growth Fund. As of June, she will have three years on that fund, and that fund will have, I believe, one of the top two or three investment return records of any fund around. The questioner obviously knows how well she is doing. She may aspire to be the next Peter Lynch. I shouldn't speak for her. I hope she is the next Peter Lynch!
JackBW: That's it for tonight. Thanks so much for being with us, Gary Pilgrim of the PBHG Growth Fund. And thanks, Jennifer Reingold of Business Week.
GaryPilg: Thanks, Jack and Jennifer.
JENNREIN: Thanks, Gary and Jack. Goodnight.
JackBW: You can read all about Hot Growth Companies in the current issue of BW -- or read it here in BW Online. Transcripts of this and all BW Online conferences are available soon after the event. Thanks again and goodnight.
Copyright 1996 by The McGraw-Hill Companies, Inc. All rights reserved.
