As of September 30, 2016, the net asset value (“NAV”) of the Parnassus Fund – Investor Shares was $43.37, resulting in a gain of 8.97% for the third quarter. This compares to a gain of 3.83% for the S&P 500 Index (“S&P 500”) and a gain of 4.54% for the Lipper Multi-Cap Core Average, which represents the average return of the multi-cap core funds followed by Lipper (“Lipper average”). So we beat both benchmarks for the quarter. For the year-to-date, the Fund is up 7.19%, compared to a gain of 7.80% for the S&P 500 and 6.13% for the Lipper average. While we’re pleased with our performance for the quarter, we still have work to do to pull ahead of the S&P 500 for the year.
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 behind the S&P 500 but ahead of the Lipper average for the one-year and three-year periods. Longer term, the Fund is beating both benchmarks for the five-year and ten-year periods. We’re especially proud of the ten-year period, where we have earned 9.66% per year compared to 7.22% for the S&P 500 and 6.24% for the Lipper average. This is 2.44% per year more than the S&P 500 and 3.42% per year more than the Lipper average.
Company Analysis
Eight companies each contributed 50 basis points or more to the Parnassus Fund’s return this quarter, while only one subtracted 20 basis points or more from the return. The Fund’s weakest performer was Whole Foods, a leading retailer of organic and natural foods, as its stock dropped 11.5% from $32.02 to $28.35, cutting 25 basis points from the Fund’s return. (A basis point is 1/100th of 1%.) The stock fell after revenue growth missed expectations. The company is offering products at more affordable prices, but continues to lose market share due to increased competition from stores such as Costco, Kroger and Trader Joe’s. Despite the competitive environment, we’re holding our position, because the stock is on the bargain table, and we think the company’s growth initiatives will soon gain traction.
Micron Technology (MU, Financial) was the Fund’s best performer for the second consecutive quarter, adding 119 basis points to the Fund’s return, as its stock soared 29.2% from $13.76 to $17.78. Micron makes semiconductor memory chips, and its stock climbed higher as prices for dynamic random access memory (also known as DRAM) continued to rise, spurred by a recovery in demand for personal computers and strong smartphone growth. Since production capacity is growing at a slower rate than demand, we think DRAM prices have further to run, so we’re holding onto the stock.
Charles Schwab (SCHW, Financial), the San Francisco–based bank and brokerage firm, jumped 24.7% from $25.31 to $31.57, adding 78 basis points to the Fund’s return. During the quarter, investors started anticipating an increase in interest rates. This matters for Schwab, because higher rates improve the company’s ability to profit from its bank assets and money market funds.
Ciena (CIEN, Financial), a leading manufacturer of optical equipment used in telecommunications networks, saw its stock climb 16.3% from $18.75 to $21.80, contributing 75 basis points to the Fund’s return. The company delivered strong revenue growth and gained market share, driven by higher spending from telecom companies. Ciena’s gross margin also exceeded expectations, reaching its highest level since 2010. We believe Ciena is well-positioned for future gains because of its expanding presence in data centers and international markets, as well as increased spending by telecom carriers.
Applied Materials (AMAT, Financial), the semiconductor-equipment manufacturer, boosted the Fund’s return by 70 basis points, as its stock surged 25.8% from $23.97 to $30.15. Following an impressive earnings report in August, where both new orders and total backlog hit all-time highs, the company presented a compelling case for long-term growth at its annual analyst meeting in September. The management team outlined additional market-expansion and share-gain opportunities, particularly around new transistor architectures and advanced display technologies that are expected to grow revenue and expand margins.
Qualcomm (QCOM, Financial), a provider of software and semiconductor chips used in mobile phones, boosted the Fund’s return by 67 basis points, as its stock rose 27.9% from $53.57 to $68.50. Investors cheered the company’s progress in China, as it signed licensing agreements with several smartphone manufacturers and its new Snapdragon chips gained market share in the country. In late September, the stock jumped on reports that the company was in talks to acquire NXP Semiconductors, a leading provider of semiconductors to the automotive industry. If the deal occurs, it would be significantly accretive to earnings, as Qualcomm would add a new, fast-growing revenue stream while putting its $31 billion cash balance to work.
eBay (EBAY, Financial), best known for its global online marketplace, soared 40.5% from $23.41 to $32.90, contributing 66 basis points to the Fund’s return. The stock rose after the company reported better-than-expected earnings, driven by strength in its StubHub and Classifieds businesses and a modest reacceleration in its core Marketplace segment. We’re optimistic that the company’s efforts to improve the Marketplace shopping experience will push its earnings, and its stock, even higher.
Motorola Solutions (MSI, Financial), a provider of communications services and networks for public safety workers, added 58 basis points to the Fund’s return, as its stock rose 15.6% from $65.97 to $76.28. The stock climbed after the company reported quarterly earnings that exceeded expectations and guided to an acceleration in revenue growth in the second half of 2016. Demand for Motorola’s network support services in North America is increasing, while the recent acquisition of Airwave, Great Britain’s public safety communications network, is providing a significant boost internationally.
Mortgage-insurer Essent Group (ESNT, Financial) gained 22.0% from $21.81 to $26.61, contributing 53 basis points to the Fund’s return. The stock rallied, as the company reported a 20% increase in new insurance written and a 40% surge in earnings per share. This growth was generated by low interest rates, which caused a pick-up in mortgage originations, and a healthy housing market, which helped loan losses decline.
Outlook and Strategy
The S&P 500 moved higher in the third quarter as the U.S. economy continued to hum along. After bouts of sharp volatility in the first half of the year due to concerns around China’s economic slowdown, falling commodity prices, the rising U.S. dollar and Britain’s vote to leave the European Union, the third quarter was a welcome calm for investors.
However, this is no time to be complacent. In the fourth quarter, investors will deal with the uncertainty of the U.S. election, the likelihood of another interest rate hike from the Federal Reserve and a constitutional referendum in Italy. We’re stock pickers, so we’re not going to try to predict how these events will play out. We spend our time researching socially responsible businesses with good prospects, low debt levels and attractive valuations that are well-positioned to outperform in any environment.
During the third quarter, we added two new stocks and sold two others to make room for our new positions. The first addition was KLA-Tencor (KLAC, Financial), the semiconductor-equipment manufacturer. KLA’s technological expertise in process-control equipment generates industry-leading margins, and the company’s moat is widening as chips get smaller and defects become harder to find. The stock has underperformed its peers, as semiconductor equipment spending has been concentrated on memory chips, instead of logic chips, which is KLA’s core market. In addition, uncertainty around KLA’s pending acquisition by Lam Research held the stock back. After the quarter ended, KLA and Lam called off the deal, which will shift investor focus to the improving demand for KLA’s equipment, and should move the stock higher.
We also added Alliance Data Systems (ADS, Financial), known as ADS, an issuer of private label credit cards. ADS differentiates itself with leading digital marketing capabilities, which draw on a proprietary database of cardholder transactions to create personalized promotions for its retail partners. ADS generates the highest return on capital and the fastest growth rate in the credit card industry, but the stock has underperformed over the past year due to rising credit losses. ADS has maintained its underwriting standards, and the U.S. consumer is in good shape financially, so we expect credit losses to stabilize and the stock to rebound.
We sold Perrigo (PRGO, Financial), a producer of store-brand generic drugs, due to our concerns that the generic pricing environment would get worse and that it would take longer than expected to improve the company’s European platform. Additionally, we sold credit card issuer American Express, because we believe its moat is narrowing. Intense competition for the company’s affluent cardholders is pushing up rewards costs and marketing expenses, thereby lowering the company’s return on capital.
We’re pleased with the Parnassus Fund’s performance this quarter. We hope this report provides you with some assurance that we’re working hard, we’re staying true to our investment principles and we’re always on the lookout for bargains.
Yours truly,
Jerome L. Dodson Robert J. Klaber Ian Sexsmith
Lead Portfolio Manager Portfolio Manager Portfolio Manager
