As of March 31, 2018, the net asset value (“NAV”) of the Parnassus Fund – Investor Shares was $46.62, resulting in a loss of 3.42% for the first quarter. This compares to a decline of 0.76% for the S&P 500 Index (“S&P 500”) and a loss of 0.75% 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 that summarizes the performance of the Fund, the S&P 500 and the Lipper average. The returns are for the one-, three-, five- and ten-year periods ended March 31, 2018.
First Quarter Review
The Parnassus Fund – Investor Shares fell 3.42% for the quarter, trailing the S&P 500 by 266 basis points (one basis point is 1/100th of one percent). Sector allocation helped our relative performance, with the most beneficial effects coming from our underweight positions in energy, consumer staples and telecommunication services, the three worst performing sectors. However, poor stock selection overwhelmed the benefits accrued from our sector weightings. Our worst performer was Patterson Companies (PDCO, Financial), a distributor of dental and animal health products. The stock cut 106 basis points from the Fund’s return, as it plummeted 38.5% from $36.13 to $22.23. Shares plunged after the company reported disappointing sales and lowered guidance. The company experienced a sharp decline in demand for its dental consumables and equipment due to the loss of exclusivity with its largest manufacturing partner, Dentsply Sirona. On top of this issue, Patterson experienced disruption from its internal sales force changes and increased competition from online players such as Amazon. We’re disappointed with the company’s performance but hopeful that newly appointed CEO, Mark Walchirk, will move with a sense of urgency to improve performance and drive sustainable earnings growth.
Shares of Alliance Data Systems (ADS, Financial), a leading digital marketing firm and credit card issuer, subtracted 86 basis points from the Fund’s return as its shares fell 16.0% from $253.48 to $212.86. The stock dropped because the company’s credit card charge-offs were higher than investors expected. While the elevated loss rate was disappointing, Alliance Data’s portfolio remains highly profitable and its industry-leading growth rate should still generate very attractive returns.
We believe that investors over-reacted to the bad news, so we took advantage of the opportunity and increased our position at bargain-basement prices. Dentsply Sirona (XRAY, Financial) is one of the largest manufacturers of dental equipment and consumables. Its stock sank 23.6% from $65.83 to $50.31, cutting 63 basis points from the Fund’s return. Investors were surprised by the company’s decision to replace its interim CEO, which followed broader turnover at the end of last year. Shares fell further after the company provided lower than expected earnings guidance, reflecting increased investments in its sales force and product development. Despite the recent challenges, we believe the newly appointed management team is focusing on the right strategic actions to deliver sustainable growth over the long-term. We expect the stock to rebound as the company benefits from its sales force investments, a robust pipeline of innovative imaging and implant offerings, and synergies between its Sirona and Dentsply segments.
Our biggest winner was Motorola Solutions (MSI, Financial), the largest global provider of mission-critical communications solutions. Shares rose 16.6% from $90.34 to $105.30, adding 65 basis points to the Fund’s return. The stock surged after the company reported revenue and earnings that exceeded expectations, as recent natural disasters and terrorist threats have emphasized the importance of dedicated, secure and resilient communications networks for public safety professionals. Investors also cheered the acquisition of Avigilon, a provider of video surveillance systems, as Motorola’s reputation and relationships should stimulate Avigilon’s growth.
Auto insurer Progressive (PGR, Financial) contributed 45 basis points to the Fund’s return as its shares increased 8.2% from $56.32 to $60.93. The stock rose alongside the company’s earnings, as Progressive’s bundled home and auto insurance package is gaining market share, while its policy loss rates remain low.
Semiconductor giant Intel (INTC, Financial) added 41 basis point to the Fund’s return, as its stock jumped 12.8% from $46.16 to $52.08. The stock dropped in January due to concerns over a chip security flaw, but bounced back after management reassured investors that the financial impact was immaterial, and revealed updated chip designs to address the security and performance concerns. The stock continued to move higher after Intel reported stellar earnings, as the company achieved its most profitable quarter ever due to broad-based demand for its high-performance products.
Outlook and Strategy
After nine consecutive quarterly gains, the S&P 500 did something different during the first quarter of 2018 – it fell. While a loss of 0.76% doesn’t sound like much, the intra-quarter activity was more volatile. The market started the year on a tear, ripping 5.6% higher in its best January since 1997. In February, stocks tumbled 10% from their all-time highs due to concerns over inflation and rising interest rates, before regaining some of their lost ground as those fears proved premature. The market fell again to end the quarter, as investors worried about President Trump’s protectionist trade policies and a flattening yield curve as long-term interest rates declined.
While economies around the world are growing, and America’s already robust economy is now being stimulated by tax reform, the stock market is judged against future expectations. After the nine-year bull market pushed the S&P 500 to an all-time high, expectations are similarly high, and we weren’t surprised by the increased volatility. We were surprised, however, that Growth continued to outperform Value, as the S&P 500 Growth Index’s 1.9% return during the quarter trounced the 3.6% loss of the S&P 500 Value Index. Our contrarian strategy continued to be out of favor in this momentum- driven market.
However, some chinks are starting to appear in the armor of the large capitalization technology stocks that have been leading the Growth Index, and the overall market, higher. Facebook is dealing with a data scandal that could open the door to government regulation of personal data. President Trump has attacked Amazon, claiming it is taking advantage of the U.S. Postal Service while bankrupting other retailers. Meanwhile, several high-profile crashes of autonomous cars have caused the industry to pump the brakes on the technology, a negative development for companies like Tesla and chip manufacturer Nvidia. We don’t own any of these high-flying stocks due to their extreme valuations, and we believe our portfolio should significantly outperform when investor sentiment rotates back in favor of value.
During the quarter, we reduced the Fund’s technology weighting by selling IBM and trimming KLA-Tencor, the semiconductor equipment manufacturer. This is the first time the Parnassus Fund has been underweight the technology sector since 2004, due to our view that the sector’s rich valuations and high expectations don’t reflect its cyclicality. We also sold Wells Fargo, as Ben Allen described in the cover letter, but we maintained our overweight in the financial sector by increasing our positions in First Horizon, the Tennessee-based bank, and data provider Thomson Reuters. We continue to believe that interest rates are more likely to rise than fall, which should benefit all of our financial holdings. We initiated a position in CVS Health, the drug store operator. We believe the proposed acquisition of health insurer Aetna will transform CVS into a vertically integrated health care company, which should enable more coordinated care and greater savings for patients and the health care system. Amazingly, we were able to invest in this industry leader for less than 10x forward earnings estimates.
In our 34 years of managing the Fund, we’ve never seen a “perfect year” like 2017 before, where the market rose in every single month. Already in 2018, we’ve seen the return of a more typical market environment, characterized by ups-and-downs and volatility. We’re seeing signs that the momentum trade is beginning to unwind, which gives us confidence that our tried-and-true contrarian strategy is poised to outperform. We’re excited about our Fund’s prospects for the remainder of 2018.
Yours truly,
Jerome L. Dodson Robert J. Klaber Ian E. Sexsmith
Lead Portfolio Manager Portfolio Manager Portfolio Manager
