Jerome Dodson's Q2 Commentary for Parnassus Fund

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- By Holly LaFon

As of June 30, 2017, the net asset value ("NAV") of the Parnassus Fund - Investor Shares was $49.23, resulting in a gain of 4.19% for the second quarter. This compares to a gain of 3.09% for the S&P 500 Index ("S&P 500") and a gain of 2.76% for the Lipper Multi-Cap Core Average, which represents the average return of the multi-cap core funds followed by Lipper ("Lipper average"). For the year-to-date, the Parnassus Fund - Investor Shares is up 9.47%, compared to a gain of 9.33% for the S&P 500 and 8.31% for the Lipper average.


Below is a table comparing the Parnassus Fund with the S&P 500 and the Lipper average over the past one-, three-, five- and ten-year periods. The Fund is ahead of both benchmarks for all time periods. Most striking is the ten-year average return. At 9.66% per year, the Fund's annualized gain is 2.49% ahead of the S&P 500 and 3.76% ahead of the Lipper average.

Second Quarter Review

The Parnassus Fund posted a strong gain for the second quarter, beating both of our benchmarks and pulling ahead for the year. Sector allocations helped performance, led by our overweight position in healthcare, the S&P 500's best-performing sector, and our underweight positions in telecom services and energy, the two worst-performing sectors. As a fossil fuel-free fund, we do not invest in energy stocks.

Stock selection added to our performance as well, as our three biggest winners contributed a total of 139 basis points to the Fund's return, overcoming the 76 basis point drag caused by our three biggest losers. (A basis point is 1/100th of one percent.)

Our worst performer was International Business Machines (IBM), one of the world's largest providers of information-technology solutions and services. The stock fell 11.7% from $174.14 to $153.83, reducing the Fund's return by 49 basis points. Investors were disappointed by IBM's weak quarterly operating margins, and questioned whether the company will be able to meet its annual earnings guidance. The stock fell again when famed investor Warren Buffett (Trades, Portfolio) sold a third of his shares. While we recognize the near-term challenges, we believe IBM's transition to a software-and analytics-oriented business will create a lot of value, so we're holding onto our position.

Semiconductor giant Intel (INTC) trimmed 14 basis points from the Fund's return, as the stock dropped 6.5%, from $36.07 to $33.74. The stock fell after Intel's data center business reported lower-than-expected growth and margins. We expect the second half of 2017 will be better for the data center business, driven by new product launches, healthy demand and cost control. Longer term, the outlook for Intel's chips is fantastic thanks to a myriad of technological advancements, including cloud computing, artificial intelligence, machine learning, driverless cars and the internet of things (IOT).

Creditcard issuer Capital One Financial (COF) dropped 4.7% from $86.66 to $82.62, reducing the Fund's return by 13 basis points. The stock fell in April after the company increased its guidance for credit losses. This issue hurt the stock again in June, when Capital One was the only bank required to resubmit its capital plan under the Federal Reserve's Comprehensive Capital Analysis and Review. We're disappointed by management's inaccurate credit-loss forecast, but we're holding onto our position. We believe investors have over reacted, as Capital One still expects its recent credit card vintages will be among its most profitable ever. Furthermore, the stock is trading at a bargain valuation of less than 10x expected 2018 earnings.

Our best performer was Whole Foods (WFM), a leading retailer of organic and natural foods, whose stock soared 41.7% from $29.72 to $42.11, adding 51 basis points to the Fund's return. The stock jumped in April after activist investor Jana Partners (Trades, Portfolio) took a nearly 9% stake in the company. Jana demanded management accelerate its turnaround or sell the company. The latter occurred in June, when Amazon announced it would acquire Whole Foods for $42 per share, or $13.7 billion.

Industrial gas supplier Praxair (PX) added 45 basis points to the Fund's return, as the stock jumped 11.8% from $118.60 to $132.55. During the quarter, Praxair announced a merger of equals with Linde, a German competitor. The merger will create the world's largest industrial gas supplier, combining Praxair's leading position in the Americas with Linde's strong presence in Europe and Asia. The combination of Praxair's operational excellence and Linde's engineering and technology leadership should accelerate earnings growth.

Auto insurer Progressive (PGR) added 43 basis points to the Fund's return, as its shares rose 12.5% from $39.18 to $44.09. Progressive's stock climbed higher as its nascent home insurance product accelerated the company's revenue growth. As the company predicted, customers are bundling their home and auto policies together to save money and time.

Outlook and Strategy

The U.S. economy continued to chug along during the second quarter, helping the S&P 500 reach record highs. The unemployment rate dropped to 4.3%, its lowest level since 2001, while the Federal Reserve increased its projected 2017 GDP growth rate to 2.2%. As the economy has picked up steam, corporate earnings have also improved. Earnings from S&P 500 companies are expected to have grown an impressive 10% in the second quarter.

We're now in the ninth year of a bull market, and we believe many of these positives are already reflected in valuations. The S&P 500 has climbed to 17.5 times forward earnings estimates, which is near a 15-year high.

Although the market continues to move higher, we were able to find several undervalued stocks during the quarter. The first new holding is Public Storage, the largest owner of self-storage facilities. While the short-term outlook isn't pretty, as new supply is pressuring occupancy and rental rates in several markets, the long-term opportunities are as great as they've ever been. Tenants will continue to be attracted to Public Storage's convenient locations and ubiquitous brand, while its concentration in fast-growing, supply-constrained markets like Los Angeles, San makes is evaluated on its financial return and the amount of carbon emissions it reduces, a unique focus that reminds us of our own "principles and performance" directive. Hannon Armstrong is investing on the right side of climate change, a generational tailwind that should support earnings and dividend growth for many years to come.

We sold one stock during the quarter, primarily for valuation reasons. After owning the stock for more than a decade, we said goodbye to Ciena, a leading manufacturer of optical equipment used in telecommunications networks. The company recently posted better-than-expected earnings, causing the stock to jump 16%. The shares had a great run over the past year, so they no longer looked undervalued to us.

At quarter-end, the Fund has a nice balance of offense and defense. The portfolio is overweight the financial and technology sectors, which tend to outperform when the economy is humming along. On a combined basis, the Parnassus Fund is 48% invested in these sectors compared to 37% for the S&P 500. Offsetting this, the portfolio is significantly underweight two cyclical sectors: consumer discretionary and energy. These two sectors represent 4% of the Fund compared to 18% for the benchmark. Additionally, the portfolio is overweight healthcare, a more defensive sector. Given these weightings, we believe the Parnassus Fund is well-positioned for any market environment.

Yours truly,

Jerome L. Dodson

Robert J. Klaber

Ian E. Sexsmith

Lead Portfolio Manager

Portfolio Manager

Portfolio Manager

This article first appeared on GuruFocus.


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