Hunting for value companies is always tricky. Hunting for companies with values makes the job nearly impossible.
That's what makes the
Parnassus Equity Income fund's record doubly impressive. The fund follows socially responsible investing guidelines, which rules out Big Tobacco, nuclear power and a host of other "sin" industries. Meantime, the fund also maintains a strict discipline: It only buys stocks that are trading at a discount to their intrinsic value.
The results have been outstanding. Parnassus Equity Income's one-, three- and five-year average annual returns rank in the top 1% of all large-cap blend funds, according to Morningstar. The fund has returned 10.86% a year over 10 years -- good for the top 8% and good for a top billing in
Five Winning Funds column on socially responsible investing funds.
We spoke with Todd Ahlsten, skipper of the fund, about how he has managed to blend value investing and values investing with such ease in these turbulent markets. Ahlsten took sole stewardship over the fund from Parnassus founder Jerome Dobson in 2002, but he has spent his career at Parnassus and shares the same approach as his predecessor. Read on to hear his thoughts on socially responsible investing, and how his bargain-hunting style leads him to big health care companies such as
and away from most of tech.
What does socially responsible investing mean to you and how does it get applied to your fund?
The companies we invest in have to meet two criteria. First, they have to be socially responsible. For us, that means no alcohol or tobacco, no gambling, no weapons, no nuclear power. But we also have positive screens: We look for companies that treat their employees well, give back to the community, respect the environment and are ethical in their business dealings.
Second, we look for companies that make financial sense. A company's fundamentals have to look good, and the stock's valuation has to be attractive. These are extremely important; some socially responsible fund firms will buy companies that are ethically strong but don't have good return on capital. We will not invest in one without the other.
The SRI industry has gotten a bad reputation for focusing on lower return with great ethical measurements. There was some truth to that, but I think it's changing.
Is there a correlation between socially responsible behavior by companies and their returns, or do you find they run at cross-purposes?
That's a good question. Well, I've been in the business since 1994. Back then, when I picked up an annual report, maybe one company in 10 had a section on social responsibility -- their community initiatives or environmental efforts. It didn't mean that only one in 10 was actually socially responsible, it just meant that some didn't think it needed to be highlighted.
Now, I'd say 60% to 70% of companies have a section on social responsibility. I can say there has been an explosion of awareness between 1994 and 2003. More and more companies have tilted toward social responsibility -- in part because they know a group of investors are paying more attention.
I also think the
of the world have been a wake-up call for companies -- many are learning that staying off the front page, not just the corporate scandals but for bad behavior, has real benefits.
How do you screen out the genuine good corporate citizens from the companies that are just paying lip service and behaving altogether differently?
We talk to employees of the company. We read every story in the business press going back several years. We try to read from conservative publications and liberal publications -- the truth usually lies in the middle. But these searches give us a relatively good idea about a company's behavior.
You and Jerome Dodson, your predecessor at the fund and the president of Parnassus Investments, both hail from University of California, Berkeley. That might make some investors think yours is a lefty fund. Is this a fair or unfair assessment?
(Laughs.) We believe that we have liberal and conservative investors. Usually at the political extremes, the conclusions converge, oddly enough. That said, I don't think it's right to categorize us as a liberal fund.
Yes, Jerry and I went to Berkeley, so a liberal perception of us is natural, but it's not an accurate picture. We are not running out and hugging trees; we aren't ideologues or activists. We look for good, ethical businesses that are sustainable investments. Also, we wear a coat and tie five days a week.
We understand how Corporate America works. There is no perfect company. But when we go to bed at night, we want to feel confident that the companies we own are responsible companies that are trying to do good for the society instead of skirting by with the absolute minimum.
We don't want to invest in
. We think their tobacco products cause a lot of harm in society, plus it makes them vulnerable to a great deal of lawsuits that make the stock risky. It's the same with oil companies that are big polluters.
The fund has had an astonishing record, much of which came under your predecessor. How do you plan to keep the fund on top, and does your philosophy differ greatly from Mr. Dobson's?
I started here in 1994 as an intern, 1995 as an analyst. Every day I have been here, Jerry has been here. We have a very similar viewpoint. We look for good value companies.
On the investing side, I pay close attention to return on invested capital, clean balance sheets, companies with strong, growing cash flow and businesses with sustainable competitive advantages.
I go to the Warren Buffett conference every year. I really look to marry his value investing with the socially responsible approach.
As far as keeping the performance strong, I've run the research department since 1998 and I've been working on the fund since October 2000. I plan on being here my entire career and I think Jerry and I work great together. There's not a big change or a big difference in mindset.
Let's talk about putting that mindset to work in the fund. Currently, the fund's three biggest holdings are Johnson & Johnson (JNJ) - Get Johnson & Johnson (JNJ) Report, Pfizer and Merck. Do you like the sector specifically, or are these just bottomup stock picks?
These are three companies that really stand for everything we look for in companies. Not only are they good corporate citizens and good employers, but they have marvelous businesses. Each one has strong return on capital, defendable market conditions. If their pipeline ever looks like it's drying up, more will always come.
Plus, we bought each of them at prices below intrinsic values. That's vital in this market. I often laugh when I look at what people are buying on the
. People are paying rich prices for companies that don't have profitable businesses and are vulnerable to competition. It doesn't make any sense to me.
Every once in a while (like last fall), some good tech stocks, like
, get cheap enough to buy. But that's rare.
But Johnson & Johnson, Pfizer and Merck are three companies that really dictate our investing style. We're not going to buy companies with ridiculous multiples. With tech, most times you just don't know who will be the survivors in five years. With health care, you can feel confident that these three companies will still be on top.
Unlike many funds, Parnassus Income Equity isn't afraid to get cash-heavy when the market looks rich. Where are the cash levels these days?
I'm not a market timer, but we will go to cash in large amounts when we can't find value. Right now, we're about 45% cash. We felt there would be a post-war rally, but we think we're in the old "irrational exuberance" territory once again.
As the rally continued, we trimmed our equity stake a bit. Had I known it would be this crazy over the last week or two, I would've stayed in the market a little longer. (Laughs.)
Another big holding in your fund is Arthur J. Gallagher (AJG) - Get Arthur J. Gallagher & Co. Report. It's a well-run insurer that not many investors follow. It's been a 10-bagger over the last decade or so. When did Parnassus buy it and what do you like about it?
Actually, I wish I would've bought it 10 years ago. But I got interested in the company when I attended an insurance conference about a year-and-a-half ago.
Arthur J. Gallagher just has everything we like to see. A great management team, they produce results year in and year out, they never complain about market conditions and they just keep growing their business.
Right now, the stock is about a 2% position in the fund and I imagine it will be in there for a long time to come.
It looks like most of the fund's tech and telecom holdings, apart from a small Cisco stake, are convertible bonds. What are you holding here and why?
Right now, the fund is 1% tech stocks, which is very underweighted. We think this is a "Peter Pan" rally in technology, to borrow a phrase I read recently.
We also own
, which is really a dividend-yield play. They have a price-to-earnings multiple below the market average and a yield of 4.3%, more than double the market average.
You're right, most of what we do own is convertible-bond exposure. About a year ago, a number of tech and telecom companies were losing tons of money, but had plenty of cash. They were offering convertible bond deals that promised huge, double-digit yields, and the underlying companies had enough cash to cover themselves. We loaded up 10% to 15% of the fund with bonds of
and a few others. Right now, about 14% to 15% of the fund is in those convertibles. I wish there were more today, but they offer about 6% or so now.
Does anything look cheap to you now?
Very few areas are undervalued right now. Even at today's levels, you can buy Merck, Johnson & Johnson and Pfizer at a discount. And Arthur Gallagher is still a great opportunity at these levels.
If you are buying here, you are really speculating that there will be a huge economic rally. If you believe in a huge rip in the second half, God bless. If you are in my camp, you see the economy growing at about 2% and slow economies in Asia and Europe, you don't see a big IT upgrade -- even
Larry Ellison acknowledges that. With that mindset, it's going to be tough to have a lot of positive surprises.
The bond market is telling me one thing, and the stock market is telling me something else. Bonds give the sign of a very slow economy. On the margin, the bond market is more intelligent than the adrenaline-based stock side.