Jerome Dodson's Parnassus Fund 3rd Quarter Commentary

As of September 30, 2017, the net asset value (“NAV”) of the Parnassus Fund – Investor Shares was $49.85, resulting in a gain of 1.26% for the third quarter. This compares to a gain of 4.48% for the S&P 500 Index (“S&P 500”) and a gain of 3.96% for the Lipper Multi-Cap Core Average, which represents the average return of the multi-cap core funds followed by Lipper (“Lipper average”). For the year-to-date, the Parnassus Fund – Investor Shares is up 10.85%, compared to a gain of 14.24% for the S&P 500 and 12.65% for the Lipper average. We’re disappointed with our performance for the quarter, but we’ve taken advantage of the weakness in a handful of our stocks by adding to our positions at bargain prices. We believe this will boost our performance going forward.

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 Parnassus Fund – Investor Shares is trailing the S&P 500 for the one-year period, but is ahead on the three-, five- and ten-year periods. We’re well ahead of the Lipper average for all time periods. We’re especially proud of the ten-year period, where the Parnassus Fund – Investor Shares has returned 9.46% per year, compared to 7.44% for the S&P 500 and 6.20% for the Lipper average. This is 2.02% per year more than the S&P 500 and 3.26% per year more than the Lipper average.

Third Quarter Review

The Parnassus Fund – Investor Shares gained 1.26% for the quarter, but trailed the S&P 500 by 322 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 consumer discretionary and consumer staples, the two worst performing sectors.

However, the negative impact of our stock selection overwhelmed the positive impact from our sector weightings. Toy manufacturer Mattel (MAT, Financial), best known for its iconic brands including Barbie, Hot Wheels and Fisher-Price, was the Fund’s biggest loser this quarter. The stock dropped 28.1% from $21.53 to $15.48, reducing the Fund’s return by 80 basis points. The shares slumped after the company reported disappointing sales and lower gross margins. The stock fell further in September after Toys R Us, the largest U.S. toy store, filed for bankruptcy protection. While we recognize the near-term challenges facing Mattel, we added to our position because investors have become too pessimistic on the company’s prospects. We believe in new CEO Margaret Georgiadis’ plan to reinvigorate Mattel’s brands by creating online media content, shortening the product development cycle and strengthening the innovation pipeline, and we expect the upside to be significant when her efforts start to bear fruit.

Patterson Companies (PDCO, Financial), a leading animal health and dental distributor, sank 17.7% from $46.95 to $38.65, cutting 60 basis points from the Fund’s return. The stock declined after the company delivered disappointing sales results, driven primarily by poor execution and the loss of exclusivity with its largest dental manufacturing partner. Turnover in the dental sales force and the ongoing uncertainty around the CEO search process further weighed on the stock. We’re holding onto our shares because we believe there are multiple ways to win going forward. The company operates in two disparate businesses, and we believe value could be unlocked if the company divests the animal health business and reinvests in the high-margin dental business. We also believe there is a significant opportunity to improve the company’s earnings power by reducing costs and increasing private-label penetration. With the stock’s valuation at a multi-year low, we think our upside is significant.

Dentsply Sirona (XRAY, Financial) is the leading manufacturer of dental consumables and equipment. The stock sold off due to distribution problems involving fellow Parnassus Fund’s holding Patterson Companies. We believe these issues are temporary, so we used the weakness as an opportunity to add Dentsply Sirona to the portfolio at what we believe is an attractive valuation.

Allergan (AGN, Financial), a pharmaceutical company best known for developing Botox, fell 15.7% from $243.09 to $204.95, reducing the Fund’s return by 55 basis points. The stock dropped after the company announced a deal with the Saint Regis Mohawk Tribe, whereby Allergan transferred patents on its $1.5 billion dry eye drug, Restasis, to the tribe in exchange for an upfront payment and annual royalties. While this deal has the potential to delay generic competition due to the tribe’s sovereign immunity, it has also attracted political scrutiny, which weighed on the stock’s multiple. We trimmed our position to reflect our disappointment with this unusual deal. However, we continue to own the stock because we like the company’s aesthetics franchise and think the stock is significantly undervalued, trading at just 12 times expected 2018 earnings.

Our best performer was Gilead Sciences (GILD, Financial), the biotechnology firm that makes therapies for HIV and hepatitis C. Its stock jumped 14.5% from $70.78 to $81.02, contributing 70 basis points to the Fund’s return. In August, the company acquired Kite Pharma for $12 billion. Kite Pharma is a leader in cellular therapy, a game-changing new cancer treatment that harnesses the body’s own immune system to fight cancer. The acquisition establishes Gilead as a leader in a fast-growing field with huge opportunities.

Shares of Potash Corporation (POT, Financial), the world’s largest fertilizer producer, soared 18.0% from $16.30 to $19.24, adding 51 basis points to the Fund’s return. The stock rose along with fertilizer prices, driven by increasing demand from farmers in Brazil, China and India. The company also provided upbeat commentary on its pending merger with Agrium, which should generate meaningful synergies from the vertical integration of Potash’s fertilizer production with Agrium’s agricultural retail network.

KLA-Tencor (KLAC, Financial), a leading semiconductor equipment manufacturer, boosted the Fund’s return by 44 basis points, as the stock rose 15.8% from $91.51 to $106.00. The company reported better than expected earnings and raised guidance for the upcoming quarter, as shipments and backlog reached record levels. We believe increasing process control intensity in 3D NAND and strong growth from China will push the stock even higher.

Outlook and Strategy

Synchronized global growth was the theme of the third quarter, which helped boost the S&P 500’s year-to-date return by 4.48%. The U.S. economy continues to chug along, and its pace could accelerate if the Trump administration is able to pass tax reform legislation. Growth in the European Union is finally picking up after years of stagnation. The Chinese and Indian economies are Latin America and other emerging markets are rebounding, as commodity prices and foreign exchange rates have stabilized. More than 40% of the S&P 500 companies’ total sales are foreign, so the improving international environment is a big deal for stocks.

We’re not the only ones optimistic about the economy, as widespread investor enthusiasm has pushed the S&P 500 to its eighth consecutive quarterly gain and a new all-time high. The index’s valuation has climbed to 17.7 times forward earnings estimates, its highest level since 2004. As contrarian investors, this recent market strength was a cue to sell some of our biggest winners.

During the quarter, we exited five stocks after each enjoyed a significant rise: John Deere, the world-renowned manufacturer of big green tractors; mortgage insurer Essent Group; memory chip manufacturer Micron Technology; PayPal, the world’s most popular online payment service; and Trimble, a provider of technology solutions for farmers and construction workers. These are all great businesses that have contributed significantly to the Fund’s returns for our shareholders, but they’ve become too pricey for our taste. We also sold credit card issuer Capital One Financial and reinvested the proceeds in its private label competitor Alliance Data Systems, which we believe has more upside due to its faster growth rate. In total, these sales should reduce the Fund’s volatility as we’ve reduced our exposure to businesses in cyclical industries with high expectations.

We were pleased to welcome a diverse group of five new holdings to the Parnassus Fund this quarter. The first addition is C.H. Robinson, the largest domestic truck broker and a name that long-time Parnassus Fund shareholders may remember.

Shippers pay more to access Robinson’s industry-leading network of carriers during dislocations in the truckload market. We believe the recent spike in demand due to rebuilding efforts after the hurricanes, combined with upcoming regulations that will curtail supply, will cause Robinson’s earnings to inflect higher.

Dentsply Sirona is the leading manufacturer of dental consumables and equipment. The stock sold off due to distribution problems involving fellow Parnassus Fund’s holding Patterson Companies. We believe these issues are temporary, so we used the weakness as an opportunity to add Dentsply Sirona to the portfolio at what we believe is an attractive valuation.

Hologic (HOLX, Financial) is a medical technology company focused on improving women’s health through early detection and treatment, including digital mammography and pap testing. In March, the company paid $1.65 billion to acquire Cynosure, a leader in aesthetic laser treatment. While early results from Cynosure have been disappointing, we believe Hologic has the management depth to turn its performance around. Meanwhile, we expect Hologic’s pipeline of innovative new products to widen its lead in women’s health.

New York City-based Signature Bank (SBNYW, Financial) has a unique culture that provides talented and passionate banking professionals with a supportive environment to service their clients. Over the long-term, this has generated outstanding returns for shareholders. We were able to buy this great franchise at a discounted valuation, as investors have overly penalized the bank for losses on taxi loans, which are a small portion of its overall loan book.

The final addition is Starbucks (SBUX, Financial), the largest coffee chain in the world. We believe Starbucks has a long runway for growth, as the company is expanding internationally, penetrating the consumer packaged goods (CPG) market, and launching new food and drink initiatives. At the time of our purchase, the stock was trading at a discount to its historical valuation because earnings growth has slowed. We believe, however, that Starbucks’ robust loyalty program and long-standing focus on innovation will help accelerate growth and lead to strong shareholder returns in the future.

Warren Buffett (Trades, Portfolio) says an investor should be fearful when others are greedy and greedy when others are fearful. Some of the Fund’s stocks have underperformed this year, and we’ve added to most of them at bargain prices. All of our five new positions have trailed the market this year, and that was a deciding factor in why we bought them. These are all socially responsible businesses with sustainable competitive advantages and good prospects that have fallen out of favor with investors due to temporary factors. We don’t know exactly when, but we believe that sooner or later the market will recognize the value we see in our securities.