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WALL STREET, CALIFORNIA | MANAGER'S FORUM

Sticking to His Guns

Smaller growth stocks have only recently begun regaining lost ground. But PBHG's Pilgrim hasn't lost his faith in the appeal of young companies.

June 03, 1997

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.

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