"The Stock Is the Leading Indicator"

Rockland's Dick Gould talks about the signs he ignored, and the companies he likes now for his small-cap fund

By Robert Barker

After years of big gains, these are painful days for growth-stock pickers. Rockland Small Cap Growth Fund's (RKGRX ) Dick Gould is no exception. Despite winning five stars from Morningstar and posting an annual average return since inception of nearly 27% -- double the average for rival funds in that group -- Gould's has lost 13% this year as of May 16.

Because Gould has most of his own wealth tied up in the $75 million fund, I wanted to see how he's coping and how he's positioning the portfolio. I reached him by phone at his office in Rockland, Del., the other day, just ahead of some good news: Energy producer HS Resources (HSE ), the fund's top holding, is being taken over at a premium price by Kerr-McGee (KMG ). Here are edited excerpts of our discussion:

Q: What are the lessons of the past year for you as a small-cap growth investor? Anything that you wish you did differently, or some moral to the story?


I think one moral to the story, and I think one of the reasons why a lot of people underperform in bear markets, is that they have certain favorite stocks that they hold on to longer than they should...Cisco (CSCO ) was certainly a darling of all the large-cap managers. I had my share.

Q: Such as?


TranSwitch (TXCC ), for example. I didn't completely ignore the signals. TranSwitch I had pared down quite a bit in the $57-$56 level, after it had already broken to $28 and then rallied. But in hindsight, [the charts showed] a large topping formation. The volume had shifted to the downside. I should never have ignored that. I knew the [chief financial officer] very well and he was still seeing terrific [revenue] visibility, with new customers coming on. But that's the way it works: The stock is the leading indicator and it's telling you what's going to happen even before the management actually sees it.

Q: So, what industries are you focusing on now?


One area is retail and restaurants, certainly. Buca (BUCA ) is one example.

Q: Buca? Buca di Beppo?


Yeah, Buca.

Q: I've been to one out in California.


Did you like it?

Q: It was packed. We had a reservation and still we had to wait a long time. Now this was a little more than a year ago, but they were doing a huge business in Encino.


O.K., well that's a great trade-check for me. They have the highest return on investment of any restaurant concept I've ever seen in my life. It's a family-style pasta [place] primarily, with no menus. They actually just write the menu up on the wall. The costs are very low. And they give the managers ownership and huge incentives.

Q: How many locations do they have?


They had 51, and they were going to add 17 this year. They've said that, over a five-year time horizon, they can do at least 30% earnings-per-share growth annually. And they'll do well over 40% this year. So I just think it's a concept that probably has legs. It's far from getting anywhere close to being saturated.

Q: Another name?


Career Education (CECO ). Career Education probably has one of the best earnings and revenue visibility of any company in the portfolio, or certainly among the top 10. Their student-enrollment growth, back in December, was about 40%.

Q: Tell me, what kind of students are these?


It's a post-secondary education company.

Q: What we used to call a trade school?


Sort of a trade school, but in disciplines such as information technology as well as design technologies. They even have a culinary arts school. So they make their money by enrolling students and collecting tuition. Now they can [raise] tuition every year, and have.

They actually reported a tremendous quarter a couple of weeks ago, 70% revenue growth, 33% earnings per share growth. They can sustain very high growth in the 30%-plus area for many years, I believe. They're one of the few companies that say they have between one-half and 1% of operating margin improvement coming, per year, every year for the next several years.

Q: Is that because of economies of scale and spreading their overhead over more outlets and students?


Yes, it's partly that. It's also having pricing power. It's huge for margins because it's all incremental money right to the bottom line. So being able to increase tuition every year by even single-digit rates is definitely going to help the margin.

Q: Any retailers?


I've got a little bit of Hot Topic (HOTT ) in the portfolio. It's a specialty retailer of music-licensed and music-influenced apparel and accessories. That sort of thing. They've been putting out great numbers. They're growing at a 30%-to-40% clip, and it looks like they'll be able to sustain that. They're really sort of selling to the MTV crowd.

Q: I was just going to ask you, what do you think the average age of a shopper is at Hot Topic?


I would guess high school. And that's a pretty fickle fashion crowd. So it's a name that I like, but I'm watching it carefully.

Q: Are you staying away now from technology issues, or are you finding some new names there?


I'm not staying away from technology, although, some of the slant on some of the technology is a little bit different.

Q: Explain, please.


For example, one of the holdings I have is eFunds (EFDS ). And eFunds helps companies manage their debit cards [transactions] and electronic funds transfers.

Q: Was this the spin-off from Deluxe (DLX )? A: Yes. It's a great little business. They've got real blue-chip customers, like Citigroup (C ), Wal-Mart (WMT ), Target (TGT ), and Wells Fargo (WFC ). And what they're doing is they're using technology to their advantage. And it's a situation where the margins are in a huge ramp-up phase. I think last quarter, they were in the 7%-8% area and they're probably going to get up to the 10% to 12%.

Q: This is net margin or operating margin?


Operating margins. The [EPS] estimate for next year is $1.20, so it's under 20 times earnings and for a company with a recurring revenue stream with contracts and 20% to 30% top-line growth, that's pretty cheap. And I think it's underfollowed because it was a spin-out and institutional investors are going to keep discovering it.

Q: Any areas or names that you're particularly staying away from?


I'm a little bit leery of the personal-computer area still. I'd like to stay with areas that are actually seeing good business and no flatness or deterioration. One area that has been just as hot as can be is the whole oil-service area.

Q: How much of the portfolio is in those stocks?


I would, I don't have the exact number because I've been moving things around, but I would say about 20% to 25%. Companies like Hydril (HYDL ),a little company that went public. They specialize in pressure-control products and pressure-connection products. These aren't your average connection products. They're for deep wells, where pressures sometimes get up to something like 30,000 pounds per square inch. They have to be extremely well engineered, and these guys are seeing very good demand. And there's going to be quite a lot of margin expansion coming out.

Q: How about the oil refiners?


I think the refiners are going to be big beneficiaries. I think also the transporters, the people who own the pipelines and who own the ships. I have one shipping company, Frontline (FRONY ), which owns 40-some oil tankers, and that stock just keeps marching ahead. A lot of earnings power there and good pricing.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His column appears every Friday, only on BW Online.

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Edited by Patricia O'Connell

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