Sticking to His Guns

Gary Pilgrim’s shareholders have had a rough ride over the last year, but most seem to be giving him the benefit of the doubt.

After several years of spectacular gains as manager of the PBHG Growth Fund, Pilgrim’s hot hands have cooled considerably. His $5.3-billion fund, among the country’s largest and best-known aggressive-growth stock funds, plunged in value in the second half of last year and again earlier this year, as smaller growth stocks were pummeled.

Yet despite a numbing 17% loss over the last 12 months, Pilgrim says most shareholders have stayed with him. They’ve been rewarded with a sharp rebound in many smaller stocks since late April: PBHG Growth has surged about 12% over the last four weeks.

Pilgrim, who has steered the fund to a 25.6% average annual return over the last five years, remains a firm believer in the long-term appeal of young growth companies.

Pilgrim, the son of an Oklahoma oil field worker, got his first serious investment schooling as a credit-loan trainee at Philadelphia National Bank, where he stayed for 15 years, working his way up to chief investment officer. In 1982, he co-founded Pilgrim, Baxter & Associates in Wayne, Pa., and launched PBHG Growth in 1985.

Originally just afterthoughts to the firm’s institutional business, mutual funds now account for $9 billion of the firm’s $14 billion in assets.

Pilgrim was interviewed by Russ Wiles, a mutual funds columnist for The Times.

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Times: At least until very recently, the last year has been brutal on investors in small growth stocks.

Pilgrim: Absolutely. This [recent bull] market has been fairly narrow. Beginning from the recovery from the correction in the middle of 1996, leadership has shifted dramatically to larger companies. Small growth stocks have lagged just about everything.

Times: Why has the small-stock sector been hit so hard?

Pilgrim: Small growth stocks peaked in terms of valuations around June 1996, after a five- or six-year period of outperforming most everything else. We finally reached a point where the average small-growth company was selling at over 40 times earnings [per share].

That situation ran smack into the first correction and the rising concern about where we were in the economy, with the possibility of a recession and the likelihood of interest rates going up.

In a nutshell, many investors became more risk-averse. Cash flows into smaller-growth funds diminished dramatically. Some funds, on balance, had to redeem shares.

Times: So you’re saying that all of those factors combined to create a poor environment for the highest-flying small growth stocks. Their prices tumbled. Yet now, suddenly, many of those stocks are hot again. What’s happening?

Pilgrim: In terms of relative valuations, that prior condition [of rich price-to-earnings, or P-E, ratios] has been corrected.

Times: What is the average P-E ratio of stocks in PBHG Growth today, relative to the P-E of the Standard & Poor’s 500 index of blue-chip stocks?

Pilgrim: It’s about 1.2 times that of the S&P; 500. Historically, the range has been between 1.2 and 2.0 times. You see the same with T. Rowe Price New Horizons fund, a small-stock fund with more than a 30-year history.

So if you want to throw money at small growth companies, the recent under-performance and relatively low P-Es suggest that this is a less-risky time to do that.

Times: Many Wall Street pros were arguing a year ago that smaller growth stocks, particularly technology issues, were ridiculously overvalued. Some say there is still a lot of overvaluation out there. But you have said many times in the past that you have no problem paying higher P-Es for smaller stocks.

Pilgrim: I mean those smaller companies that you could characterize as having a high growth rate. Typically, they [always] sport above-market price-earnings ratios. That’s our ballpark.

Times: Let’s talk about your specific stock-selection process. How do you identify appealing growth stocks?

Pilgrim: What we’re really trying to find are companies able to grow by 30% or 40% a year for three to five years. At that rate, they will double in size every 2 1/2 years or so. That type of compound growth is what ultimately produces above-market returns for investors.

We would like to have a portfolio exclusively of companies that are accelerating their earnings growth. But, frankly, they’re hard to find. As long as a firm can produce exceptional growth in line with expectations and appears to have its growth under control, we’re happy.

The problem with growth companies is that it’s very difficult to know just how long they can continue to do that, so you really have to monitor their achievements carefully. You have to become intimate with managements and analysts to understand what’s going on. You have to analyze the financial statements, looking for signs of trouble. We’re always on conference calls and going to see managements.

In addition, we constantly evaluate each stock in our portfolios using a ranking system that contains the attributes that we consider important--things like absolute growth rates or earnings-estimate revisions.

Times: What is the typical size of companies in PBHG Growth today?

Pilgrim: Our median holding has about $1 billion in market capitalization. I buy stocks in the $500- million to $1.5-billion range. The average company in the portfolio has annual revenues of $300 million to $700 million.

We’re looking for firms that aren’t in their earliest stages but typically have operated for five to seven years as a public company. They have a pretty good record going, but they’re still in a high-growth stage.

Times: Name a few examples among the fund’s top holdings.

Pilgrim: I’m always reluctant to emphasize any one or two stocks, but our larger holdings are typical of what we like. One company is Corrections Corp. of America [$36.25 on Monday, New York Stock Exchange], which is helping to privatize the prison system. This is a vast market, for which the opportunities for growth are enormous. This company is the leader in this area and has executed almost flawlessly for the last three or four years.

A couple of semiconductor stocks I like are Altera [$52.75, Nasdaq] and Microchip Technology [$35.625, Nasdaq]. These are good companies, with high profitability. They went through a slowdown in their growth rates that ended in the middle of last year, and their orders picked up. Orders continue to accelerate. Both Altera and Microchip are cyclical growth companies.

Another company we like is Apollo Group [$36.50, Nasdaq], which specializes in education services. It’s an example of a company that’s exploiting an unusually attractive niche at a time when the market is expanding. It’s meeting the education needs that exist at the adult level.

Times: PBHG Growth mushroomed from under $1 billion in assets as recently as 1994 to about $5.9 billion last year, then earlier this year dropped back below $5 billion. Has that decline mostly reflected market performance, or have shareholders been bailing out?

Pilgrim: Almost all of that movement came from fluctuations in market value. Over the entire period, cash flow has remained positive. The bulk of the fund’s growth occurred in the first half of 1996, when it took in over $3 billion in a six-month period. We peaked at about $6.2 billion in assets before the correction began. During the correction, assets fell to below $4.5 billion, and they’re currently at $5.3 billion.

Times: So Wall Street’s constant fear that individuals will exit stocks in droves when the market hits a rough patch hasn’t been borne out?

Pilgrim: I think people do understand our investment style and, at least for the moment, are being patient about it and even adding to their investments, as they should.

We have tried at every opportunity to articulate that this is a volatile segment of the market and that we’re trying to achieve above-market returns by taking more risk. I think the message actually has gotten through to some people.

I’ve never had to sell one share of anything because of redemption pressures. This fund regularly has had positive cash flow. Even during the correction, the negative days were pretty spotty.

Times: Another one of your funds, PBHG Limited, made history by raising $100 million and closing its doors to investors on its very first day. If you had closed PBHG Growth, would that have helped the fund’s performance this year?

Pilgrim: We’re sensitive to the potential for asset growth impacting a fund’s returns. We have closed PBHG Limited and PBHG Select for exactly those reasons. When your style includes high turnover [trading stocks actively], you face a problem if you have a lot of assets.

But our style [with PBHG Growth] involves taking a meaningful position in a concentrated way in the best growth companies we can find and holding them for as long as nothing goes wrong. That’s not a high-turnover approach. Therefore, we don’t believe assets under management are an issue until you begin to over-diversify, or own too many stocks to accommodate your large assets.

PBHG Growth has owned 80 to 120 stocks through most of its period of growth. At the moment, it holds 87 stocks. We have big positions in these companies, but that has always been our style.

Times: You have often said that you don’t try to time the market, but you must have some general thoughts about where the market might be heading.

Pilgrim: Our overview is that the market appears to be in decent shape. I see no particular reason why it should be unusually vulnerable at this point. Perhaps the period of declining interest rates is behind us, but no abrupt upward trend appears to be imminent. The economy is in good shape, and inflation is low.

As for market sectors, it’s clear that medium to small growth stocks have underperformed for a year, making them relatively attractive. Companies are cheap in terms of relative P-Es and in terms of growth rates. And the most interesting part of a growth manager’s universe, the technology stocks, is equally depressed. I think it’s a good time to lean in this direction, with the caveat that you shouldn’t do so any more than you feel comfortable doing.

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PBHG Growth Fund

Strategy: Seeks capital appreciation by investing in stocks of fast-growing small and mid-size companies.

VITAL STATISTICS

Year-to-date total return: --9.6%

YTD total ret., avg. small-stock fund: +3.0

1996 total return: +9.8

1996 total return, avg. small-stock fund: +20.2

Five-year total return, through March 31: +165.0

Five-year tot. ret., avg. small-stock fund: +87.0

Five biggest holdings as of April 30: 1. PeopleSoft 2. Altera 3. Corrections Corp. of America 4. Clear Channel Comm. 5. Microchip Technology

Sales charge: none

Assets: $5.3 billion

Min. investment: $2,500

Phone: (800) 433-0051

Morningstar risk-adjusted performance rating, 1-5: HHH

Sources: Lipper Analytical Services, Morningstar