Jerome Dodson's Parnassus Endeavor Fund 1st-Quarter Commentary

Discussion of markets and holdings

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Apr 28, 2020
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As of March 31, 2020, the net asset value (“NAV”) of the Parnassus Endeavor Fund (Trades, Portfolio)—Investor Shares was $28.62, so the total return for the quarter was a loss of 25.04%.

This compares to a loss of 19.60% for the S&P 500 Index (“S&P 500”) and a loss of 22.22% for the Lipper Multi-Cap Core Funds Average, which represents the average return of the multi-cap core funds followed by Lipper (“Lipper average”).

There are several reasons we underperformed this quarter. First, we have a lot of technology stocks in the portfolio, and we believe they tend to be more sensitive to economic trends and international exposure. They are very cheap right now, and we believe they should snap back sharply once we emerge from this difficult period.

Our airline stock, Alaska Air Group, and our retail-related stocks (Hanebrands and Alliance Data) also dropped much more than the market. In our view, they should also make a strong comeback once we make a recovery.

To the left is a table showing the returns for the Parnassus Endeavor Fund (Trades, Portfolio) Fund, the S&P 500 and the Lipper average for the one-, three-, five and ten-year periods. Although we beat the S&P 500 last year, the sharp move down in the current quarter combined with our weak performance in 2018, makes our three-year returns below the S&P 500 and the Lipper average. We’re ahead of the Lipper average for the five- and ten-year periods.

As I look at the prices of the stocks in our portfolio, I’m amazed at their market valuations. In my 35 years at Parnassus, I’ve rarely seen such a disconnect between market price and intrinsic value. In just the current quarter, the drop in the S&P 500 has wiped out the entire gain since June 30, 2017. In just the last two months, from February 1 through March 31, the S&P has dropped 27.2%. On an annualized basis, that’s the equivalent of a drop of 97.8% or almost a complete destruction of the value of all the companies in the S&P 500, which means most of the economic value of the United States.

Clearly, the stock market plunge is not a reasonable indicator of economic value. During March, the S&P plunged by 9.51% on the 12th, soared by 9.21% on March 13, cratered by 11.98% on March 16, then shot up by 9.38% on March 24. These moves are completely irrational. Investors have hit the panic button, selling everything one day because of fear, then buying everything the next day based on hope. Right now, the valuations make no sense. The only rational move in the current situation is to hang on to your stocks or if you have idle cash, buy after a big move down. It may take a year or more, but at some point, sanity will return to the stock market.

Company Analysis

Clothing retailer, The Gap (GPS, Financial) hurt us the most during the quarter, slashing 316 basis points from the Fund’s return. (One basis point is 1/100th of one percent.) During the quarter, its stock fell an astonishing 59.7% from $17.68 to $7.04.* Prior to the coronavirus outbreak, Gap made steady progress on its turnaround, canceling the spin-off of Old Navy, appointing Sonia Syngal as the new chief executive and slowing the decline in comparable store sales. However, shares plummeted when the pandemic forced the temporary closure of all its stores in North America. The stock fell further after management cut the company’s cash dividend and suspended share repurchases to strengthen the company’s balance sheet.

A little over a year ago, Gap traded around $30 a share, and it dropped to $5.50 a share during the first few days of April, so it’s trading at only 18% of its former value for a drop of 82%. Gap’s book value is $8.94, so it’s trading at only 62% of its book value. Even more astonishing is that Gap has $1.65 billion dollars in cash plus $316 million in receivables for a total of $1.97 billion. Since there are 371 million shares outstanding, that translates into $5.31 per share in cash and receivables. At a stock price of $5.50, it’s basically selling for the amount of cash and receivables on the balance sheet. At some point after the pandemic is over and the stores are open again, the stock should make a strong comeback.

Alaska Air Group (ALK, Financial) cut 279 basis points off the Fund’s return, as the stock dove 57.7% from $67.75 to $28.47. Alaska is the fifth-largest airline in the country by miles flown with its legacy routes primarily on the West Coast in addition to some cross-country routes acquired after the acquisition of Virgin America. The company has a strong balance sheet, a cost-efficient fleet and shareholder-oriented management. Nevertheless, the stock hit the skids as the coronavirus outbreak engulfed the U.S., resulting in collapsing demand for air travel. Management has cut flights, suspended stock buybacks and the dividend and suspended salaries for top executives and the board in an effort to conserve cash during the crisis. The shares are now beset by panic-selling, but we believe passenger demand will return in the long run. In the meantime, the government is allocating $50 billion in assistance to the airline industry. This should be enough to get the airlines through the crisis, but if not, the government would certainly step in again to save the U.S. airline industry.

Private-label credit card issuer Alliance Data (ADS, Financial) cut 263 basis points from the Fund’s return, as the stock fell 69.8% from $112.20 to $33.65. Alliance’s retail partners have been hit hard by the sharp drop in retailing, because of the coronavirus, so the company’s revenue for operating retailers’ credit card programs will drop substantially. Meanwhile, the recent jump in unemployment could lead to rising credit losses. We’ve decided to hold onto the stock, because we believe the company has the capital to withstand the economic turbulence, and we expect the company should emerge stronger when the economy recovers, because of steps taken by new CEO Ralph Andretta.

Applied Materials (AMAT, Financial) cut 224 basis points from the Fund’s return, as its stock dropped 25% from $61.04 to $45.82. The company is one of the two main suppliers of equipment used in manufacturing semiconductors. Applied has had strong growth because of the increasing manufacturing complexity and the demand for more chips. Demand should keep increasing for years, given the strong growth in high-data applications and smart devices. The stock price has sunk due to concerns around possible disruption of the supply chain and lower customer spending. We view this weakness as temporary, and we’re confident of Applied’s future growth.

Hanesbrands (HBI, Financial), a leading manufacturer of undergarments and athletic apparel, sliced 203 basis points from the Fund’s return, as the stock fell 46.4% from $14.85 to $7.87. The company is facing multiple disruptions as it navigates retail store closures, mall traffic collapse, spending cutbacks and inventory decline. Given the uncertainty, the company drew down its revolving credit facility to increase its cash position. It also withdrew its first-quarter and full-year earnings guidance given the economic uncertainty. Separately, the chief executive, Gerald Evans, announced his retirement at the end of fiscal year 2020, after almost four decades with the company and four years as CEO.

Micron Technology (MU, Financial) cut 172 basis points from the the Fund’s return, as its stock fell 21.8% from $53.78 to $42.06. The company makes dynamic random-access memory chips (DRAM) and other types of memory chips used in personal computers, smartphones and data servers. While Micron had pretty good quarterly results, the stock dropped, because of concerns that the coronavirus will disrupt both its supply chain and consumer demand. We believe the disruption will be temporary, and Micron should survive the global pandemic because of its strong balance sheet and the strong demand for the quality memory chips it supplies.

Gilead Sciences (GILD, Financial) was our best performer during the quarter, adding 36 basis points to the Fund’s return, as its stock jumped from $64.98 to $74.76 for a total return of 16.2%. The company had a very strong quarter, due to early data that suggest that their drug, Remdesivir, might be an effective therapy for COVID-19. Gilead released positive pre-clinical results; data from human trials are expected in April. Given the urgent need, the company is already working to ramp up production for a possible quick approval from the FDA. In addition, sales of their HIV medicine continues to generate strong cash flow.

Outlook and Strategy

Casting about for an idea to fill this section, I thought about how the stock market foreshadows and precedes actual events. One idea that came to mind was when the stock market dropped 23% over eight days in May of 1940, when Hitler invaded France, then dropped again 3% on one day and 3% the next day after the Japanese attacked Pearl Harbor. These drops are easy to understand. What’s not so easy to understand, though, is that the Dow started to rise on May 7, 1942 and continued moving higher when the outlook was terrible and Japan appeared to be winning the war. A month later, the Battle of Midway took place from June 4 to 7, which ended up being one of the most stunning and decisive blows in the history of naval warfare. The Americans sank all four Japanese aircraft carriers as well as a cruiser. The U.S. lost one carrier, the Yorktown, and one destroyer, Hammann, but two carriers survived, as did seven heavy cruisers and 15 destroyers.

I decided that it was an interesting phenomenon that the stock market climb foreshadowed an American victory, but I didn’t want to read too much into it. At that point, I began thinking about the Great Recession of 2008 to 2009, and how it had taken such a toll on our country, lasting until July of 2009. The stock market, though, began climbing on March 9 of 2009, four months before the end of the recession.

As these events were floating through my mind, I happened to read an article in the March 26, 2020 issue of Forbes magazine by John Jennings, president and chief strategist of The St. Louis Trust Company. He argues that the economy is not a good predictor of future stock prices, but rather stock prices are a predictor of future GDP. He presents data showing that there is little correlation between GDP and the S&P 500 in the same year. Quite often, the S&P 500 will soar while the economy is still in a recession. He concludes the article by saying that right now, we don’t know if the stock market has hit bottom, and we won’t know when it hits the bottom. The next bull market will probably start when the financial news is still dire.

In March, I started adding to my account at the Parnassus Endeavor Fund (Trades, Portfolio) which I do any time there is a big move down in the market. I have never been able to invest at the absolute bottom, but I add to my account as the market moves lower. At the time, it’s nerve-racking when I put money into the Fund, and it promptly moves lower, since I have no idea where the bottom is. The process requires that I steel myself against doubt and keep investing. It’s only after the market starts moving higher that I can relax. Of course, by that time, it may be too late to invest, so you have to start the process when there’s still a lot of uncertainty. Over the years, I’m amazed at how well I’ve done following this sometimes painful process.

Yours truly,

Jerome L. Dodson, Lead Portfolio Manager

Billy Hwan, Portfolio Manager

The average annual total return for the Parnassus Endeavor Fund (Trades, Portfolio) – Institutional Shares from commencement (April 30, 2015) was 4.93%. Performance shown prior to the inception of the Institutional Shares reflects the performance of the Parnassus Endeavor Fund (Trades, Portfolio) – Investor Shares and includes expenses that are not applicable to and are higher than those of the Institutional Shares. The performance of the Institutional Shares differs from that shown for the Investor Shares to the extent that the classes do not have the same expenses. Performance data quoted represent past performance and are no guarantee of future returns. Current performance may be lower or higher than the performance data quoted. Current performance information to the most recent month end is available on the Parnassus website ( Investment return and principal value will fluctuate, so an investor’s shares, when redeemed, may be worth more or less than their original principal cost. Returns shown in the table do not reflect the deduction of taxes a shareholder may pay on fund distributions or redemption of shares. The S&P 500 is an unmanaged index of common stocks, and it is not possible to invest directly in an index. Index figures do not take any expenses, fees or taxes into account, but mutual fund returns do. The estimated impact of individual stocks on the Fund’s performance is provided by FactSet.

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