As of March 31, 2017, the net asset value (“NAV”) of the Parnassus Fund – Investor Shares was $47.25, resulting in a gain of 5.07% for the first quarter. This compares to a gain of 6.07% for the S&P 500 Index (“S&P 500”) and a gain of 5.47% for the Lipper Multi-Cap Core Average, which represents the average return of the multi-cap core funds followed by Lipper (“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 the S&P 500 for the one-year, five-year and ten-year periods, but behind on the three-year period. We’re well ahead of the Lipper average for all time periods. Most striking is the ten-year number, where we have gained an average of 10.10% per year, which is 2.60% per year ahead of the S&P 500 and 3.81% per year ahead of the Lipper average.
Company Analysis
Eight companies each contributed 25 basis points (a basis point is 1/100th of one percent) or more to the Parnassus Fund’s return this quarter, while no company subtracted as much as 25 basis points. Our worst performer was Gilead Sciences, the biotechnology firm that makes therapies for HIV and Hepatitis C, as its stock dropped 5.2% from $71.61 to $67.92, subtracting 20 basis points from the Fund’s return. Revenue declined again in the company’s Hepatitis C (HCV) franchise, and investors were disappointed with management’s 2017 guidance. HCV sales are expected to fall by more than 40% due to lower new patient starts, continued pricing pressure, increased competition and a shorter duration of treatment. We added to our investment because we think the stock is a bargain at the current valuation. Investors have become too pessimistic and are giving the company little credit for its robust cash flows, expanding HIV franchise and strong drug pipeline.
Micron Technology (MU, Financial) was the Fund’s best performer for an impressive fourth consecutive quarter, adding 67 basis points to the return, as its stock soared 31.8% from $21.92 to $28.90. Micron makes two kinds of memory chips, DRAMs (dynamic random access memory) and NAND flash. Prices for both memory chips continue to rise, and the company expects its earnings to reach an all-time high next quarter. Micron has worked hard to move down the cost curve and qualify its products for higher-value uses, which has led to an amazing increase in earnings per share, from a loss of $0.05 only three quarters ago to next quarter’s forecasted gain of $1.50.
Allergan (AGN, Financial), a pharmaceutical company best known for developing Botox, increased the Fund’s return by 61 basis points, as the stock jumped 13.8% from $210.01 to $238.92. The shares rose after the company reported better-than-expected earnings and provided an optimistic outlook for 2017. Allergan’s strong cash-pay businesses and recently launched products—such as Vraylar, a drug used to treat schizophrenia—continue to drive growth. During the quarter, Allergan extended its dominance in the aesthetics market by acquiring Zeltiq for $2.5 billion. Zeltiq’s CoolSculpting system is the #1 non-invasive fat reduction procedure in the U.S.
KLA-Tencor (KLAC, Financial), a semiconductor equipment manufacturer, contributed 48 basis points to the Fund’s return, as its stock surged 20.8% from $78.68 to $95.07. KLA’s quarterly shipments, revenue and earnings all exceeded management’s guidance range, and bookings reached an all-time high. Continued investments in DRAMs and 3D NAND are driving demand for the company’s wafer inspection tools and measurement solutions.
Axalta Coating Systems (AXTA, Financial) is a leading paint provider for auto manufacturers, truck manufacturers and auto body shops. Its stock jumped on takeover speculation, rising 18.4% from $27.20 to $32.20 and boosting the Fund’s return by 41 basis points. In March, PPG, a competitor, made a takeover bid for rival Akzo Nobel. Akzo turned down the offer, but may respond by acquiring Axalta to fend off PPG. However, famed investor Warren Buffet already owns 10% of Axalta, and he may buy the rest to combine it with his Benjamin Moore Paints subsidiary. We don’t know who, if anyone, will become dancing partners, but we continue to hold our shares due to Axalta’s leading position in the high-margin coatings industry.
Auto insurer Progressive (PGR, Financial) added 41 basis points to the Fund’s return, as its shares rose 10.4% from $35.50 to $39.18. Progressive’s stock climbed higher as its underwriting profits rose, in sharp contrast to many peers who are struggling with the increase in distracted driving. Progressive’s Snapshot, a device that users plug into their cars to monitor their driving, provides the company with the most precise and real-time data in the industry. This data allows Progressive to identify safe drivers and reward them with lower prices than other insurers can offer, while avoiding unsafe drivers who are unprofitable.
Pentair (PNR, Financial) manufactures pumps, filters, valves and thermal solutions for the water and electrical markets. The company contributed 36 basis points to the Fund’s return, as its stock increased 12.0% from $56.07 to $62.78. While Pentair expects the challenging global industrial environment to continue through the year, it noted early signs of improvement in some of its markets. Management also hired a chief marketing officer and is instituting commercial excellence programs to accelerate its revenue growth.
Patterson Companies (PDCO, Financial), a leading dental and animal health distributor, climbed 10.2% from $41.03 to $45.23, adding 31 basis points to the Fund’s return. The stock rose after the company delivered better-than-expected earnings, driven by solid results in its companion animal distribution business. The stock moved higher again after several competitors indicated that demand for dental consumables is improving.
International Business Machines (IBM, Financial), one of the world’s largest providers of information technology solutions and services, rose 4.9% from $165.99 to $174.14, contributing 27 basis points to the Fund’s return. Robust demand for its analytics and cloud software drove better-than-expected earnings. The company also saw growth rebound in China, aided by an increase in large mainframe upgrade deals with Chinese banks.
Outlook and Strategy
The S&P 500 continued its march higher in the first quarter, as investors’ enthusiasm around the strong U.S. economy was bolstered by the Trump administration’s pro-business policies, namely tax reductions, infrastructure spending and financial deregulation. However, the failed healthcare reform bill is a reminder that Trump is an inexperienced politician, and he may not be able to accomplish all his goals. This could increase the stock market’s volatility.
We’re not political experts, and we don’t know what’s happening behind closed doors in Washington. Instead, we focus on building a portfolio of socially responsible businesses with good prospects, low debt levels and attractive valuations that are well-positioned to outperform in any environment.
This quarter, we did some spring cleaning, and reduced our exposure to the semiconductor sector. Semiconductors are highly cyclical, and while everything looks good now, the sector’s all-time high revenue has prompted our contrarian instincts. Applied Materials and Micron were our two biggest winners over the past year, so it should come as no surprise that value investors like ourselves took profits after such huge gains. We sold Qualcomm after the company was sued by the Korea Fair Trade Commission, the U.S. Free Trade Commission and its largest customer, Apple. We believe these lawsuits could threaten the long-term viability of Qualcomm’s licensing business. We’re holding onto chip giant Intel due to its broadly diversified portfolio and leading-edge technology, as well as semiconductor equipment manufacturer KLA-Tencor, because its process-control equipment is increasing in importance as chips get smaller and defects become harder to find.
With the market at all-time highs, it’s difficult to find undervalued stocks with attractive prospects. However, we uncovered a few that we believe are hidden gems. Our first new addition is Novartis (NVS, Financial), the Swiss pharmaceutical giant. Management is focused on turning around Alcon, its leading eye-care franchise, whose sales have been soft the past few years. We recently met with Mike Ball, the CEO of Alcon, and we’re impressed with his vision to reinvigorate this great business. Meanwhile, investors are giving the company little credit for its enviable portfolio of innovative therapies that should drive revenue growth, including Entresto, an exciting new treatment that provides hope for chronic heart failure patients.
The second stock we added was Cognizant (CTSH, Financial), the information technology (IT) consultant. The company’s revenue grew at an amazing 30% annualized rate between 2005 and 2015, as technology transformed business models in its focus areas of financial services and healthcare. Over the past year, growth has slowed to an 8%-10% range as some IT projects have shifted to data centers and the cloud, while banks and health insurers have reduced spending due to regulatory uncertainty. Even if Cognizant grows at a high single-digit clip, we believe our upside is significant due to management’s newfound focus on increasing margins and returning cash to shareholders.
We believe these portfolio changes leave the fund well-positioned for the future, and we hope to write about Novartis and Cognizant as winners in future reports.
Yours truly,
Jerome L. Dodson Robert J. Klaber Ian E. Sexsmith
Lead Portfolio Manager Portfolio Manager Portfolio Manager
