Jerome Dodson Podcast Interview With GuruFocus Transcript

Transcript of audio interview with Parnassus Funds founder

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Oct 30, 2018
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Holly: Hi. Welcome to the GuruFocus podcast. I'm Holly, I'm the editor of GuruFocus, and today we're very excited to have Jerry Dodson with us. Jerry is the founder of Parnassus Investments, which he started in 1984 with only $300,000 in seed capital, and now it has $27.8 billion in assets under management across its strategies, and he teaches at NYU, as well. So his fund has about 30 holdings, and it's also socially responsible, so that sets him apart, and it's based in San Francisco. It has had an extraordinary performance. So we got an interview with Jerry awhile back, but then the markets decided to be more volatile recently. So we'll get to that later. But right now, we just want to start out with learning about-- how did you get started in investing, Jerry, and how did you know it was the field for you?

Jerry: I had always been interested in investing, but I had a job opportunity after I got out of business school, and the opportunity was to help a group in San Francisco start a new bank. And so one thing led to another, and I became president of the bank. So it was a great opportunity for me, and I was president of Continental Savings in San Francisco for six years. And so I was on, you could say, the fixed income or the lending side of investing, but I was always interested in the stock market. And I had always followed people like Warren Buffett (Trades, Portfolio) and Benjamin Graham, who had a value approach to investing, which made a lot of sense with me. And so I read their books. I read the book by Benjamin Graham called "The Intelligent Investor," and I also read Warren Buffett (Trades, Portfolio)'s annual letter from Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). And so that's what-- they really inspired me to get in. I said, well if I can follow that philosophy of being a value investor and investing when the stocks are trading at low prices, it should be able to produce above-average returns.

So that was at least half the motivation for the Parnassus Fund. The other half was corporate social responsibility. And my thought was that if you invest in companies that treat their employees well, that are good corporate citizens, that practice environmental protection, that are good places to work, they should do well. And I had no proof of that, but it just corresponded with my values, and I thought that made sense, and that's what I wanted to do. So those were the twin principles of the founding of Parnassus Investments.

Holly: Okay, fabulous. And so would you say your biggest influences are the investors that you mentioned, like Warren Buffett (Trades, Portfolio)? Or was there anybody else who had a big impact on you?

Jerry: I would say Warren Buffett (Trades, Portfolio) and Benjamin Graham are the two that had the most impact on me. There are others I would read that are very interesting, but really, in terms of adopting their philosophy, those are the two that I follow.

Holly: Okay. Wonderful. And so moving into your investing criteria, and how you have created your own style. Looking at your Endeavor Fund, it's done extremely well. I think you had a 12.26% return since inception, versus 9.38% in the S&P 500. What would you say is your primary investing criterion that you-- what is the number one thing you look for in a stock?

Jerry: Can I give two instead of just one thing I look for?

Holly: Of course, yes.

Jerry: Okay, one thing I look for is valuation. So I like to buy stocks that are selling at no more than two-thirds of their intrinsic value. So in other words, I look for a one-third off sale. So that's very important. So the ability to calculate intrinsic value, and then knock off a third, that's the valuation. The other half is investing in companies that are socially responsible, that are good places to work, environmentally responsible. That's also a very important part. So between those two, that really sums up the philosophy of the Parnassus Endeavor Fund.

Holly: Okay, and I'm really interested in your ESG-type of investing. Whenever you say you're looking for ethical management, in particular, what does that tell you about a company, and how do you know when you've found it in a company?

Jerry: There are no set benchmarks that we have. It's really an intuitive process. But how I [inaudible] that is that we read over the material that the company puts out, and this can be an annual report, a 10-K, or brochures, or their website, to see if they have the values, treating their employees well, treating the environment well. And so you get a sense of the company from reading the material. Then, when you're interested in a company, we actually talk to management, and we ask them questions. I'll ask them questions like, “Is this a good place to work?” And of course, no one's going to say, “No, this is a bad place to work.” And I've never had anybody say that. But when I ask for specifics, if they can tell me specifics about why it's a good place to work, that convinces me. If it's just a general response, like, “It's a good place to work,” that's not very convincing.

Holly: Great. And so whenever you’re looking at these factors, do you find that this helps you find better companies? Is it restricting that they have to meet these certain criteria? Or does it actually help you pinpoint just better opportunities in general?

Jerry: It definitely helps us find better companies that are good investments. Early on, there were many articles-- not many, but there were some articles written about us. And it would say things like, “Oh, Jerome Dodson (Trades, Portfolio) is a do-gooder, but that's not a good way to find good stocks.” And they said that if you take these social and environmental factors into account, you're probably going to underperform, so it's not a good investment. And I didn't know what to say because I was brand new. And I was starting out, and it didn't seem right. But that's what they said. As it turned out, over the 34 years that I've managed the Parnassus Funds, it has really helped us immensely. So I'd like to go in a little bit about why factors like environment issues help us and make a company a good investment.

Let me start by the environmental aspects. If you invest in a company that takes environmental protection seriously, it's less likely to get sued, less likely to get fined. So it gives you a huge advantage. Also, if they're careful of their resources, it should mean they should actually save costs. So if they are able to reduce the raw material or the other resources that go into it, that should help reduce cost. So it should be a built-in advantage, and it is.

Moving away from the environment to the second important issue is the workplace. It's very important to treat the employees well, and to pay them well, to provide benefits. Earlier on, where people had criticized me, saying, “Well, if you pay people really well, you could raise your costs. You're going to have less profit. It’s not going to be a good investment.” And this turns out not to be true at all. If you treat your employees well, you're much less likely to have high turnover. And high turnover causes all kinds of costs. You have to pay for recruiting; you have to pay for training. And then, if your good, well-trained employees, if they leave -- it's a huge asset.

So you have to pay the employees a little more than the market rate, somewhat more than market. You have to give them good benefits. But most importantly is the spirit in which you treat them, it's very important. So it helps you in many ways. And even though you have to pay them more than the market rate, you don't have to hire as many employees because you're not having this turnover. People are going to work more efficiently. So if they're happy in their job, they're going to work much more productively, and they're going to do a better job. So that's why I think that the workplace and the environment are the two most important issues for us in investing.

Holly: Great. Wow, that is a fascinating perspective. And you certainly prove that it can be done very successfully. So right now, going back to the valuation part of it, it has been a rising market until recently. Have you had trouble finding low-price investments, or investments that are meeting these criteria at the moment?

Jerry: Yes, I have, until about two weeks ago. And as I was putting in trade today, I said, “Boy, there's a lot of cheap stocks around for the first time in a long time.”

So in the meantime, it hurts our performance because the market's going down, and our stocks are going down, too. But there are opportunities that we haven't had in a long time. So hopefully the market will go down, we'll be able to buy, and then hopefully it will come back.

Holly: Right, great. Yes, and I do want to talk about that later, definitely. You bring up a great point. I wanted to talk about, also, the sectors that you have in your portfolio right now. One that is underrepresented in your portfolio is the financial sector. But I'm really interested in it because of rising interest rates right now, so I was wondering your perspective. Is it looking more attractive to you now that interest rates are rising? And also, if mortgage demand is falling, will that offset the widening net interest margins that banks and financial companies might benefit from? And is it a place that you might consider investing, now that interest rates are going up, or should an investor consider it?

Jerry: That's a good question. With the financial institution, especially a bank, the profit is made by the difference between your cost of funds and what you can lend it out for. And quite often they'll call this the spread. And so as the spread widens, you make more money. As it contracts, you make less. Until recently, you could hardly get any interest at all on your savings account. I mean, in my account, I was getting a half a percent on my checking account. But interest rates have been going up; I think the prime rate is now around 5%. But they're still paying very little, and so they're having a really good spread. Now, your question is, what's going to happen as interest rates rise? Well, number one is, they'll be able to charge more for their loans, so that's good. However, I think depositors and savers -- people like me, and hopefully you, and Aida, who's here with me today -- that you ought to get more on the money you have on deposit. And, of course, when that happens, that's good for people like us, that are depositors. But it's not good for the banks.

So the question is, which will rise faster? Will the costs of funds rise faster, or the interest rate that they can lend it out at? And I think what's going to happen is that the spreads are going to probably be constrained a little bit. So I would think that even though there may be possibly more money coming in at a low rate -- it's a mixed blessing, the interest rate increase. And so you’ll say, “Well, interest rates go up, banks are going to make more money.” Well, it’s true, but remember, you have to keep the costs, and if the costs go up even faster, then they won't. So it's a difficult question.

Holly: Interesting. Do you think that it's an area you would consider for those reasons, or are you ruling it out?

Jerry: We definitely would. In fact, until January of this year, we owned a bank. It was Wells Fargo (WFC, Financial) bank, which we really liked because it had a very good lending profile, they made a lot of charitable contributions. It had a lot of good, positive things about the company. What we didn't know at the time is that they were doing things that were highly unethical, such as creating fake accounts. And there was a lot of other abuses. For ESG reasons, we had to sell Wells Fargo in January. So we haven't owned another major bank since then, and we're looking at them, but we haven't found one now. So that's why you see not many financials in the portfolio.

Holly: Okay, great. But you do like the IT sector quite a bit, which is interesting because right now, the FANG stocks, of course -- the IT world, the tech sector seems like such a mixed bag because you have those stocks at the top that are charging everything forward. But then you have semiconductors and other areas that are more volatile right now. So are you still really interested in the tech sector, as it is kind of diverging at this time?

Jerry: Yes. We are. As you indicated, the tech sector has fallen sharply, especially the semiconductors. So there are companies like Micron Technology (MU, Financial), Applied Materials , (AMAT, Financial) they've all come down -- ELAM Research, they’ve come down a lot. I'm talking 20, 30, 40%, so they’re finally beginning at bargain levels. And so as they've come down, we've invested in this sector, in some of those companies I just mentioned.

Holly: And one of those stocks in Qualcomm (QCOM, Financial), right? That's one of your larger investments, I believe, 6.7% of the fund, possibly, at the last available information. And what drew you to that stock, and why do you find it attractive?

Jerry: That stock was down a lot. I think our cost of the stock is just around $50 a share, and they had been up much higher than that, so the one-third off -- I think they'd been trading in the range of $80 plus. And what had happened is that Qualcomm had tried to make some acquisitions. Also, they had a dispute with their largest customer, which you're going to know when I say who the largest customer-- you're going to know it right away because it's Apple Computer, and so the maker of the iPhone. And the Qualcomm chip is the main chip that runs the iPhone. So I suspect you have an iPhone, Holly, is that correct?

Holly: Of course. Yes, [laughter] loyal fan.

Jerry: You’re a loyal fan, all right. So you've got a Qualcomm chip in your pocket right now, with your iPhone.

But Qualcomm was charging a certain percentage, sometimes it was like 10% of the cost of the price of the phone, and Apple (AAPL, Financial) said this wasn't fair. And so there was a huge dispute, and Apple stopped paying Qualcomm. And what happened is that the stock went down to around $50 a share, and we bought a lot of Qualcomm. In the meantime, it's gone back. Now, they haven't settled the dispute yet. But in my opinion, eventually, they’re going to have to settle the dispute because Qualcomm has a patent [inaudible] and that Apple is using it. So at some point, they have to pay the royalty. And I don't know how the settlement will emerge, but somehow, there’s going to be a settlement. And that should make the stock go higher. So that's my investment rationale for Qualcomm.

Holly: Okay, great. And Micron seems to be a similar type of stock because it's also in the semiconductor industry, and it has gone down considerably, year to date. And I also find it interesting because it's David Tepper (Trades, Portfolio)'s largest holding. So it seems like a lot of very recognized investors are interested in this stock, and it has a P/E ratio of only 3.36. So what is going on? And it's also involved in some trade disputes, as well. So where do you see that stock going?

Jerry: The chip that Micron makes is very different than Qualcomm. The chips that Micron Technology makes we would call commodity chips. So one chip is not like another. The chip that Qualcomm makes is definitely not a commodity chip; it's very intricate, it's very specialized, a lot of R&D goes into it. So it's a very different animal than the Micron technology chip.

So it's different, but now Micron is making memory chips. And memory chips are being used more and more. They'll be used for a lot of autonomous driving. If we're going to have these cars that drive themselves, you're going to need a lot of memory chips. And so I think the demand for Micron Technology will go much higher. Traditionally, Micron has been very volatile because what happens is that when the cycle turns, the companies stop buying the chip, and since they are commodity chips, the price goes down, and the stock goes down.

Things have changed because, first of all, there are not as many manufacturers of these DRAMs. They make two chips, dynamic random-access memory chips and NAND chips, but let's just call them memory chips, so I don't have to specify each one. So the demand for these memory chips is very strong, but then sometimes, when the cycle turns, the economy goes down, the demand drops, and, of course, they cut prices. In those days, there was maybe 11, 12 manufacturers, and so it was a very competitive market. Today there are only three major manufacturers. There's Samsung, there's Micron, and there's one other one. So there's basically just three. And so you don't have the same cutthroat competition that you had before. Plus demand has gone up a lot for all the things that we're using today, not only the smartphones, but you talk about the smart houses, the cars coming in, so there's a huge demand. So Micron has really changed the nature, so I think it's a very good investment. And even though it's down because people are concerned about the cycle turning again -- at the current prices, which is down in the $30s now, in the high $30s -- it's a good value. So we're very positive on Micron Technology.

Holly: And then, moving onto Google -- or, I'm sorry, Alphabet. You have a stake in Alphabet, and it has earnings coming out, I believe, on Thursday. And do you have any expectations for what's going to happen on Thursday? Or does the quarter to quarter results -- are those very important to you? Or do you see anything happening to Google in its third-quarter earnings?

Jerry: I'm not sure what's going to happen with Google. The reason we bought it is we liked the business. I mean, it's basically a monopoly. Everybody uses it, I mean, in [inaudible] search. Don't you use Google for search?

Holly: A million times a day. Yes.

Jerry: Okay, exactly, so [crosstalk]. Yeah, so I don't pay much attention to the quarter to quarter earnings, because sometimes they'll have costs in there that are not recurring. So it’s hard to get a -- but we just bought it because it was selling at a very good price. Our average cost is $840 a share; it’s now at $1,100. So this is the kind of stock where you can hold it indefinitely.

And we just think that because they're great engineers, they’ve got a great product -- it's a great place to work, by the way. On a lot of these surveys, when they decide which companies are good places to work, Google (GOOGL, Financial) comes right up at the top. They give free lunches, and they have a lot of other aspects. In fact, some other things I might mention is that they have special benefits for -- when it was bought, it was number one on the 100 best companies to work for in the Fortune article. And both birth and adopted parents now receive 12 full weeks of paid paternity leave, which we like. They offer meals. The first two months of childbirth, they actually will pay for you to order meals in, which I thought was a terrific benefit. Unlimited sick days. Working mothers receive 18 weeks of paid maternity leave, which I like.

And so I just think it's a terrific company, both from its business -- which is mostly the search, but also they're involved in a lot of other new businesses, too -- but as a place to work. So will we hang onto Google? I think we'll probably own Google indefinitely. We haven't been buying since the stock has gone up a lot, but if it ever drops down, we would certainly add to our position.

Holly: Okay. Yes, it does seem like those happy employees would be very productive, with all of those benefits. And are you at all concerned, or do you have any thoughts about the advertising competition that it's facing from Apple and from Amazon right now?

Jerry: Not right now. I mean, the Google -- the way they do it with their words, they come in, and you can pick a word. We’ve used them before, too, by the way. So if someone searches for, say, socially responsible investing, or ESG, terms like that, sometimes we'll buy that word, and so we'll pop up on the Google search. And so there's a lot of people like us that really want to do keywords in the search, and I think that'll continue. And I don't think that the competition will have something similar, and if they do, I don't think it'll be as competitive as Google is. Or Alphabet, whatever we want to call them. I'm like you, I still call it Google, even though they've changed their name to Alphabet.

Holly: I'm sorry, yes. I haven't caught onto the Alphabet thing yet. It's still Google in my head, I'm sorry.

Jerry: I haven't either. It's Google to me, okay?

Holly: Okay, [laughter] for everyone, I've been talking about Alphabet the whole time, not Google. Sorry.

Okay, well, moving onto Starbucks (SBUX, Financial), we’re talking about -- this is the last stock I wanted to bring up of your holdings. But it’s great because we're talking about some of my favorite companies, and Starbucks is one of them. I believe it's up 2.5%, year to date, but it had a decline in June, whenever it announced that it was going to close some stores and slow down the number of licensed store openings it was going to have. But it's recovered, and I'm wondering, are you excited about that stock? And also do you think that Bill Ackman (Trades, Portfolio)’s foray into Starbucks is going to help its prospects?

Jerry: We bought the stock in June, which, as you pointed out, it went down. And we bought it around $49 a share in June, and so we thought that was really a bargain. We think the stock is worth $75 a share, its intrinsic value, and, of course, that's how we get the one third off, buying it at $49. Ackman, of course, he really boosted the stock price when people heard about it. I think he paid a little more than we do. I think he paid $52, $53 share, and when it was announced that he bought it, it went up to $58. Yeah, we think it's going to $75, so we're hanging on.

We think it's a good company. As I say, you use Qualcomm chips, you use the Apple phone, and you also use Starbucks, so you use some of the products and services that are supplied by the companies in our portfolio. It's also, we think, a good corporate citizen. They are working in how they source their coffee, in ethical, environmental aspects, so that's important. We like that. Also, they have a plan to donate 100 million climate resistant coffee trees to farmers by 2025, which I thought was great. And this is certainly going to help the environment. So that's a plus for us. Also, they're trying to build greener stores, so they create the cups using renewable energy. A lot of the things they do -- we think that they're a very socially responsible company. So we like Starbucks.

Holly: Okay. Great. And do you think that there's going to be as strong of growth in China, as Bill Ackman (Trades, Portfolio) is predicting, that it will double in China, or that it will double the U.S.'s presence in China? Do you think that there's as big an opportunity there as people are saying? Or is there a threat from maybe other competitors, maybe that are based in China, that could do the same thing?

Jerry: That's a good question. The real answer, of course, is I don't know. But they've been successful in other foreign countries, so I'm putting in faith that they’ll be able to do it there. But now we're probably on the verge of a trade war with China. So I have no idea how that's going to play out with Starbucks. But I suspect that they’re opening stores in there. Unless the Chinese government takes some kind of action against them, I think they probably would let them expand. And it's a good question. If a Chinese consumer of coffee has a choice of going to Starbucks, or, say, a local competitor, I don't know. Quite often the Chinese think that the westerner products are better, or the services, and I think there may be some mystique about Starbucks. But I think they can be competitive in the Chinese economy.

Holly: Great. And so I also wanted to get your thoughts about the outlook for the market, especially right now. I think interest rates are the biggest concern. Everything just kind of went haywire recently because the S&P, it's dropped 18% in 23 days, we're on our fifth straight week of declines. Do you think that this is being brought about mainly by the rise in interest rates? Or are people just getting scared?

Jerry: I think the interest rates comprise one factor, and a very important factor. The other, even more important, though, is the stock market has been overvalued for a long time. I'm just amazed at how high it has gone. And in fact, I've been having real trouble finding bargains, the bargains I described to you earlier, because the stocks have slung at such a high price. So it's really a difficult situation. So I think, really, it's probably a necessary correction, and the interest rate probably acted like a catalyst that touched off the correction. I would think it might even go down even more.

Traditionally, this is a very weak time of year. If there's going to be a big move down, it usually comes in October and November. And there are various reasons why, but in general, it does tend to be weak, so I would think this is would probably continue for a while. I think we’re going to -- this is the 24th of October, so we’ve got about another week or so left, and then we’ve got another month, in November. By the time December comes around, things change. And this doesn't mean it's going to happen every year just because it's happened in the past. But we do try to look at the previous patterns of the stock market. And going down in the fall and then going up from December till about May has been the pattern. So if past is prologue, I would think it’d probably hit a bottom some time within the next six weeks, but there could be big moves down until then.

Holly: Great. So my guess would be that you're kind of excited about this pullback because it's going to give you an opportunity to maybe buy some stocks you've had your eye on. Do you think this is a good time for value investors to consider buying if they've been on the sidelines?

Jerry: Absolutely. I think it's a wonderful time to buy. It's easier said than done, though, because when stocks go down, people get nervous. And the tendency is to do the wrong thing, namely, to sell during periods of time. But it's really the best time to buy. I must say that it's difficult, psychologically, to do that. Even me, I've been doing this for 34 years, I'm pretty confident, and we’ve been successful. But I get nervous when the market goes down, and I have to force myself to use my head, and not my heart. So I have to say, hey, this is a good value here, and so if the stocks could go down even [inaudible], buy some of these stocks down here, they could go down even further. So you have to be able to have confidence, you have to be able to steel your nerves to buy during this period. But if you're able to do that, it's a great time to invest.

Holly: Great. Yes, I do hear often that you have to have the temperament to be able to remain calm. But every time the market starts going down, I start looking at [laughter] my stocks and seeing how they're doing. Okay, well, to sign off, I was wondering if you have any book recommendations that you're reading recently or just something that's had a big influence on the way that you invest.

Jerry: The book that I would recommend is not new, in fact, it was published maybe 50x, even more, but the [inaudible] version was published in 1957, and it's called "The Intelligent Investor" by Benjamin Graham. And that's one I would recommend. I think it's either in paperback or hardback, and you can probably buy it on Amazon, I would think.

The other one is not even going to cost you any money, it's free, and that is Warren Buffett (Trades, Portfolio)'s annual letter to shareholders. It has a wealth of ideas, and you don't necessarily have to buy the stocks that he recommends, although that's usually a pretty good idea. But just how he approaches investing -- for a new investor, if you do those two things, read The Intelligent Investor by Benjamin Graham, if you go back and read the last few years of annual reports from Berkshire Hathaway, by Warren Buffett (Trades, Portfolio), I think there's a wealth of information there. And I've learned a lot by doing it.

Holly: Great. Yes, those do provide a good education. Well, Jerry, it has been wonderful to speak with you again. This is Jerry Dodson, the founder of Parnassus Investments, and he's been speaking with us today and teaching us about how he invests. So we're really pleased to have you today and appreciate you taking the time to talk with us.

Jerry: Well, thank you, Holly. I appreciate the opportunity to appear on your program. And we really appreciate it; it was a very interesting experience for us.

Holly: Okay. Well, we will talk to you again sometime. Have a good afternoon.

Jerry: All right.

Holly: Okay, bye-bye.

Jerry: Bye now.