Q: What is the history of the fund?
The fund was started at the end of 1984 and is defined by two essential characteristics.
First of all, we take a value approach to investing. We are essentially bargain hunters who like to buy good companies when they are down. Secondly, we are responsible investors. We look for companies that treat employees well, practice environmental responsibility, are generous with shareholder contributions, and follow ethical business principles.
Earlier on, the fund employed a deep-value strategy and we were taking more chances. Because of the performance of some of the riskier stocks, our strategy has become more conservative in recent years. At present, we have approximately $750 million of assets in the fund.
Q: How do you define your investment philosophy?
We assume companies that treat employees well tend to function better as businesses. Employees who are treated well will work harder, help you save money, generate more sales, and build a much more efficient operation. Companies with satisfied employees will have lower turnover, which greatly reduces the time they need for recruiting and training. It may also be true if you treat suppliers and other stakeholders well, by bringing them into the process and paying them a fair price, it may make a big difference.
Environmentally responsible companies tend to be progressive and belong to the same kind of companies that treat their employees well. People used to think that being environmentally responsible was expensive, but when a company is careful to use fewer materials, for example, that actually leads to saving money.
Our philosophy is to own good businesses at attractive valuations.
Q: How do you transform this philosophy into an investment strategy?
When a company’s stock price is unjustifiably down, that is where we come in.
To determine if it is good value, we look at standard ratios like price-to-earnings, price-to-sales, price-to-book, and price-to-cash-flow. These valuation measures are not compared to an absent standard, but examined historically. Ratio analysis shows whether a stock is trading at a bargain relative to its price pattern over the last five years. When it is, it becomes a candidate for further analysis. For example, if a company has a P/E ratio of 12, but over the last five years the P/E ratio has been 15, the stock is cheap.
Earnings can go down for extraordinary reasons in one quarter or one year, making the price ratio seem very high. In these situations we try to normalize earnings as much as possible by looking at the P/E and other ratios over time—instead of quarterly or annually—to see if they make sense.
When a stock is down, we ask why and whether it is possible or likely that it will come back. Our considerations include the market, the quality of the product, the quality of the management, whether the company has a special position in the marketplace, or a competitive advantage or “moat,” as Warren Buffet calls it. Because predictions can be risky, we also make reasonable assumptions and estimates based on the past, while keeping in mind that future events may not be the same as previous ones.
Q: What is your research process and how do you look for opportunities?
I work with a team of analysts to identify companies that have a sustainable competitive advantage and quality management teams.
One stock we like now is Applied Materials, Inc., a manufacturer of equipment for use in manufacturing semiconductors. The stock is now trading below $16 a share, but was closer to $30 not too long ago.
What happened to force the price down was that Intel Corporation, one of its biggest customers, has delayed its new generation of smaller semiconductor chips. That slowdown means Intel does not need as much new equipment as was generally expected. As a result, Applied Materials is trading at a bargain price at the moment. In my view this situation is temporary because of the continued demand for semiconductor tablet equipment in addition to the way the industry is trying to shrink the size of chips.
I expect that by late next year, or sooner, Intel will increase its budget for capital equipment. In fact, many other companies are in a similar situation. Our analyses go beyond the current year, the current few months, or the current situation, to take advantage of depressed valuations and buy them.
Another example to demonstrate how we identify opportunities is American Express Company, which is down to around $77 a share. It was trading higher previously but lost a contract with Costco Wholesale Corporation. A low-cost operator, Costco wanted American Express to reduce the amount it charged Costco every time shoppers bought goods with their Amex cards.
American Express commands a much higher charge per transaction than either Mastercard Inc or Visa Inc. But because American Express could not make money in the Costco situation, it refused to lower its transaction fee. The company will lose a lot of its cardholders who shopped at Costco. Some will continue to use their cards elsewhere, but new people and those using American Express only at Costco will no longer be there.
However, American Express has done well in the past and I expect it to do well in the future too. This is another example of a name that we are holding in the portfolio because it is trading at a very reasonable valuation.
Q: Would you describe your portfolio construction process?
Certain SEC regulations must be followed as we go about creating positions, and these provide the starting point for constructing our portfolio. With regard to 25% of the portfolio, we cannot have more than 5% of assets in any one company.
We have a unique situation with Altera Corporation where we have a higher percentage than that by design. Intel is offering to buy Altera, a maker of programmable chips, for $54 a share.
Until recently Altera was trading at around $50. It was an anomaly to find a big spread between the $54 Intel was paying and the $50 price where it was trading. Because we were confident the deal would go through, we increased our percentage to 9%, which is very unusual for us—but it was almost as if we had a guarantee. As a rule, all our holdings are below 5%.
After we buy them at a low price, some companies may then depreciate. They might drop by 2% or 3%, so they are a hold rather than a buy. Depending on our level of conviction, we can go as high as 5% or as low as 1% or 2%.
The SEC also requires that the portfolio not be more than 25% in any one industry. Other than that, we do not have an industry focus; we focus on companies instead. Normally the portfolio contains about 35 companies. Since we invest only in those that we know very well, that number does not increase. Following approximately 35 companies takes a lot of work when done well.
Dividends are not a critical factor when making investment decisions. Another of our funds, the Parnassus Core Equity Fund, pays a lot of attention to them – about 80% of its portfolio is in dividend-paying stocks. We do not have that same restraint; if we think a company is paying a high dividend and we also think it is a good deal, we may consider it.
Q: What is your benchmark?
Our benchmark is the S&P 500 Index. We are a multi-cap fund so there is no upper limit. Because of liquidity or other concerns, if a company does not have a market capitalization of at least $1 billion, it is unlikely we would invest in it. Generally speaking, we are in the mid- to large-cap range. Our average would probably be above $5 billion or $6 billion in market capitalization.
Q: How do you define and manage risk?
We pick companies without much debt. One ratio we like to use examines long-term debt to equity. If you take the balance sheet equity and divide it by long-term debt, it should be no more than 60%. With $100 of equity, you do not want more than $60 of long-term debt.
Contrary to popular belief, I do not consider volatility a key risk. When I buy a stock, quite often its price has fallen considerably, which shows up with a higher beta, a measure of volatility. That increased volatility does not concern me. I would rather pay attention to the quality of management, the product, and the company debt on its balance sheet.
