US > Mid-Cap > Core
Q: What is the history of the company?
Parnassus Investments was founded by CEO Jerome Dodson in 1984. Jerome’s goal was to create a responsible investment fund that achieved superior long-term returns. He was determined to value environmental, social and governance factors as well as rigorous financial and strategic analysis. He was not willing to sacrifice principles or performance.
There weren’t many of these types of funds then, as it was generally believed that refusing to invest in certain companies or industries reduced one’s investment universe to where such a fund would inevitably underperform. Jerome disagreed.
Over the years, assets under management have grown from roughly $300,000 at inception to about $25 billion today.
Early on, Jerome found that hiring investment personnel through an internship process provided far more insight into genuine talent than a simple interview. That approach continues today. At Parnassus, all our equity research staff were interns at Parnassus, so all our talent is homegrown. We have four core values at Parnassus: to be principled, collaborative in our approach, always learning (which we particularly emphasize in our research team), and that any success is shared.
Q: How has the fund evolved since inception?
Jerome launched the Mid Cap Strategy in 2005, and in 2008 Lori Keith and I took over its management, when the asset base was about $5 million. Ben Allen was also a PM on the Fund originally but left to manage the Core Equity strategy in 2012. Today, the Parnassus Mid Cap Fund has assets of about $2.5 billion.
In the three down markets of 2008, 2011 and 2015, we outperformed our benchmark, and in the up years since 2008 we’ve done a good job of capturing upside. Overall, we’ve generated strong returns with a beta below the market, about 0.85.
Q: What core beliefs drive your investment philosophy?
We are specifically focused on our high-quality mandate, owning businesses for long periods of time, and working hard to protect value when the market declines.
We buy good businesses at attractive valuations, and use a specific protocol, four main factors, to determine what constitutes a good business. It must: 1) offer increasingly relevant products or services; 2) display moat, meaning clear and sustainable competitive advantages; 3) feature a quality management team, with appropriate incentives; and 4) possess positive environmental, social and governance factors.
We use a specific model for valuation before putting companies into the portfolio. Our in-house, three-year IRR [internal rate of return] model includes low, base and high cases, which are then probability-weighted to calculate what we believe will be each stock’s ultimate return over that period.
Q: How would you describe your investment process?
We are active managers, and the fund has high active share. We select securities one at a time, using a team-oriented, bottom-up, quality-biased research process. Any macro factors like commodity prices, or interest rates, are modeled at the security level. We’re not making big calls on the economy. As the director of research as well as portfolio manager, I manage the firm’s research effort, but everything we do here at Parnassus is about teamwork.
For example, when we create a memo for a potential idea for the strategy, we circulate it to the entire team for feedback, even if it is not their area of expertise, or they don’t cover that sector.
Every week in our research meeting, we review these memos and make sure everybody gets the opportunity to give feedback. We believe a dozen people thinking about an idea is better than having a single person making a recommendation. It’s an involved process but essential to our success.
Q: What constitutes your investment universe?
Our average market cap is generally within about 10% of the average of the Russell Midcap Index. We currently have companies in the portfolio ranging from about $2 billion to larger than $30 billion. The larger companies generally enter the portfolio when they have market caps within the mid-cap range but have grown over time. One of our attributes is that we have consistently delivered a stylistically pure core mid-cap portfolio with predictable characteristics.
Our investable market capitalization range lies between $2.4 billion and $29.4 billion, the current range of the Russell Mid-Cap Index, either at time of purchase or current valuation. So, our investable universe is approximately 1,000 companies. Through our process, we eventually whittle that down to about 150 companies which meet relevancy, moat, ESG, and management criteria, from which we choose, using valuation criteria, the 40 stocks in the strategy.
Because we are an ESG fund, we don’t invest in companies with more than 10% of revenue from industries like tobacco manufacturing, alcohol distilling, weapons, casino operation and nuclear power generation. We also don’t invest in companies that do business in the Sudan. Outside of these quantitative screens, we’re looking for companies with positive environmental, social and governance attributes.
Q: What other criteria are involved in your process?
When considering the possible investment universe, we look at criteria like revenue growth relative to GDP, cash flow return on investment relative to cost of capital, and leverage metrics, among others. We have certain thresholds regarding certain sectors. Using those types of quantitative screens, we narrow down the potential universe to about 400 or so companies, before doing deeper dives using our four major quality factors—relevancy, moat, management and ESG.
From there, the bottom-up process kicks in, where we use our checklists to assess businesses. For example, we consider whether the company is increasingly relevant in the marketplace, which can be a proxy for revenue growth.
In terms of moat, we look at whether the company has a sustainable competitive advantage in different types of markets, one that’s reflected in cash flow return on investment over time.
We also look for a management team that is properly incentivized and examine how those incentives may have changed over time. We consider board structure and diversity in that context too and investigate how board and management interact and create value. We evaluate capital allocation and how management has allocated capital relative to stated expectations.
Regarding the ESG criteria, we think beyond the exclusionary screens to governance, workplace quality, environment, the impact the company has on its community, and the relationship it maintains with its customers.
While these assessments may strike a lot of investors as esoteric or even irrelevant, for us, they are not. For example, we believe that a company with great governance is often more focused on creating shareholder value. Another example is the value of superior workplaces in technology. We believe this is an important metric for longer-term performance, because it’s difficult to find high-quality employees, expensive to hire new ones, and important to attract the best talent to achieve superior results. Furthermore, if a healthcare company doesn’t have good client relations and has a lot of product recalls, that company is going to struggle in its marketplace, and its stock is likely to suffer.
Once we get down to a list of about 150 high-quality companies, we develop a three-year IRR model on each business, understanding and writing narratives about what goes into the low, base and high cases. This assures that the portfolio managers understand exactly what the analysts are projecting. Then we look at the difference between the low and base cases, and the base and high cases, and attempt to identify businesses with significant asymmetry in risk/reward, specifically those with much higher upside than downside. For example, we would likely find a high-quality business interesting if it is currently a $20 stock, and in three years it could be worth $35 in a bull case and $16 in a bear case.
Our portfolio turnover has been under the 20% range historically, because once we find these good-quality businesses, we tend to hold on to them for long periods of time. At the same time, we will pare back a position if it gets too expensive.
Q: Can you illustrate your research process with a specific example?
There are a lot of businesses that were identified using our process and have created shareholder value. One we recently sold is Insperity, Inc., a PEO, which stands for “professional employer organization.”
PEOs provide large-company human resources (HR) services to small- and mid-sized businesses. Services offered include, among other offerings, time and attendance record keeping, online web portals and benefits like discounts at retailers. Most importantly, they provide more benefits from a healthcare perspective, like wide-ranging health plan access. They do all of this by bundling small companies together to achieve pricing leverage from suppliers.
Insperity is currently about a $2 billion market cap company. We were first attracted to Insperity, because it is a quality, growing business with competitive barriers, a high degree of recurring revenue and a strong workplace and light environmental footprint.
When we first looked at the stock years ago, we loved the core business, balance sheet, competitive advantaged and good workplace and liked the veteran management team, which included one of the industry’s founders. One of the main issues was that, to a certain extent, the company was being run like a privately-owned business. Management wasn’t managing their understaffed sales force professionally, and they were missing on certain metrics. Moreover, they were expanding into different types of businesses, like ancillary HR services, but weren’t seeing good return on their investment. Finally, management had underutilized its balance sheet and had excessive perks, including private aircraft access and country club memberships.
We initially bought the stock in the $20s and felt that over a three-year investment period we could get up to 3x out of this business with limited downside. Our upside case was based on revenue growth per sales force improvements and expense reduction coming in-line with peers. Our downside case was supported by client retention metrics and conservative health care cost modeling.
We meet with the management teams of our companies, and Insperity was no exception. In my interactions with management, I expressed concerns about the need to improve the sales force, reduce expenses and buy back shares to improve revenue, profitability and earnings growth. Management was slow to respond initially, and valuation went as low as seven or eight times EV/EBITDA compared to competitors like ADP and Paychex, who had growing portions of their business in this area, and were trading at 12 to 14-plus times.
Fortunately, we weren’t the only investors who saw value in this excellent but under-managed business. Two activist investors eventually joined the fray, and the stock ran. We sold our last lot of shares in the high $80s, before it hit a high in the low $90s. This investment was a big win for the fund and was one of the highest attribution stocks for a couple of years.
Q: How do you construct your portfolio?
Having about 40 names allows us to know our names well. We also believe that this number provides enough diversification for our investors. Our average position size is about 2.5%, but the range is generally between 1% and 5% when we buy. The size of a position is based on the quality of the underlying business, the valuation, especially the downside risk, and how it correlates to other holdings in the portfolio, as we consider industry weightings.
We have specific guidelines that dictate we are not to be over 2x a sector in the market, but we can go zero, as we have done in telecommunications services for the last several years. Also, the top 10 positions in the portfolio generally represent 30–40% of the total portfolio, as they are our highest-conviction names, ones we believe have that special combination of high quality and asymmetric risk/reward, especially the downside risk protection we look for.
We can add to or subtract from a name when a company-affecting event or a valuation change in the business occur. For example, if a quality business in our portfolio is at a 1.5% position because valuation was too high, but they have a lousy quarter or two and valuation falls 20%, we will consider adding capital if the quality profile hasn’t changed, and we believe the stock price will recover in the near-term. In this scenario, once the stock price recovers, we would reduce that “opportunistic” portion of the capital. It is not uncommon for us to add and reduce capital and positions in names we own.
We reassess our investment theses regularly, any time there is a quarterly call or a major event with the stock such as a divestiture, merger, acquisition, or management change. Again, our culture is focused on always learning.
Q: How do you define and manage risk?
Risk management at Parnassus is primarily addressed on the security level. Understanding the quality of our portfolio companies by digging into the relevancy, moat, management and ESG factors is the first line of defense in understanding risk. Our three-year IRR, with the base, low and high cases, also helps us understand what could happen to businesses in different scenarios and how that translates into numbers. This exercise helps us gauge the potential for permanent loss of capital, something we try to avoid.
We also work to understand from a top-down level how different regulatory or economic environments could impact the businesses we own. So, going back to the individual security level, when we do our modeling, we incorporate different macroeconomic or commodity price scenarios, making sure we understand the ranges of outcome.
Finally, we have use quantitative software to understand other types of risk, but again, the primary risk management focus is on the individual security level.
2024 | 2023 | 2022 | 2021 | 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | 2014 | ||
---|---|---|---|---|---|---|---|---|---|---|---|---|
PARMX | -0.5 | 9.9 | -25 | 10.8 | 14.5 | 23.5 | -6.7 | 15.8 | 16.1 | -0.9 | ||
PFPMX | -0.5 | 10 | -25 | 11.1 | 14.5 | 23.5 | -6.4 | 16.1 | 16.3 | 0 |
in percentage
The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.
The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.