Jerome Dodson is the founder and president of Parnassus Investments and the portfolio manager of the Parnassus Fund, the Parnassus Endeavor Fund, and the Parnassus Asia Fund. Parnassus is based in San Francisco, and Dodson's funds have large weightings in the information technology sector. In January of this year, Barron's identified Dodson as one of only four domestic stock fund managers to beat the S&P 500 over the past one-, three-, five-, 10-, and 25- year periods. Wow! Also, his Endeavor Fund, which is rated five stars by Morningstar, is the single best performer of all 346 multi-cap core funds followed by Lipper over the past 10 years. The Parnassus Endeavor Fund has generated 11.96% annualized returns over the past 10 years, beating the S&P 500 by more than 4.5 percentage points per year. Motley Fool analyst John Rotonti interviewed Dodson about ESG investing, valuation, where he tends to find his biggest winners, and more.
John Rotonti: How do you define a high-quality business?
Jerome Dodson: Parnassus Investments defines high-quality companies as those with competitive advantages, quality management, and responsible business practices. I believe a high-quality workplace is one of the indicators of company quality. That's why the Endeavor Fund, which was originally named the Workplace Fund, focuses on investing in good workplaces.
Our standards are quite rigorous; we put all our energies into finding the best 30 or 40 companies for each of the Parnassus Funds. We have a much higher conviction in each company in the portfolio than we would if we held more stocks. If we held 150 companies in the portfolio, it would be hard to have as much knowledge and conviction about each of the companies.
John Rotonti: How do you define a high-quality management team?
Jerome Dodson: High-quality management teams act in the best interest of shareholders. They have a long-term focus, own meaningful amounts of the company stock, and have high integrity. They are good stewards of the firm's capital, allocating in a positive way.
John Rotonti: Can you please explain how and why you include environmental, social, and governance (ESG) factors in your investing process?
Jerome Dodson: Originally, the environmental, social, and governance screens reflected my values, which became the firm's values when it was founded in 1984. At first, I wasn't certain that we would be successful, but we found that responsible investing could be very successful, and at the same time provide a net positive to society. The track record of the Parnassus Funds, such as the Endeavor Fund, shows that.
Integrating ESG research into the fundamental investment process (both negative screens and qualitative assessments of each company) allows us to see risks and opportunities that may be overlooked by other investors. The Parnassus team views good ESG performance as an indicator of company and management quality. Teams that take environmental and workplace factors into account are the kind of teams that have the ability to run a successful business. Firms that treat their employees well will have a more motivated, productive workforce. Companies that take environmental protection seriously are less susceptible to being fined and sued.
John Rotonti: Please explain how you narrow down your investable universe and how large that universe is.
Jerome Dodson: We begin with the largest 1,000 companies in the U.S., and then use some quantitative and qualitative metrics to whittle the universe down to a focus group of about 100 names. Each stock in the focus universe has strong competitive advantages, has strong management and has a positive ESG profile. From there, we're finding the best valuation opportunities -- those good companies trading at temporarily depressed prices -- to include in the portfolio.
John Rotonti: Are there any industries you tend to prefer? Or avoid?
Jerome Dodson: An engaged and motivated workforce can be a competitive advantage, particularly for technology companies that compete on innovation and customer service, so the Endeavor Fund has historically been overweight in the technology sector. The energy sector is underweighted because the Fund does not invest in fossil fuels.
We are always looking for undervalued companies. Sector weights are a byproduct of this bottom-up stock selection process, so sector weights can range from zero to three times the benchmark weight.
John Rotonti: How do you think about valuation? Do you use discounted cash flow analysis? Do you set sell targets? Do you have a preferred valuation ratio such as P/E, P/B, FCF yield? Is FCF yield plus organic growth a good rough estimate of expected annual return?
Jerome Dodson: My investment team builds models to estimate three-year price targets for portfolio companies. As part of estimating a company's value, we look at ratios, for example P/E, P/B, price-to-cash-flow, and price-to-sales.
I started out in the business by looking for bargain stock prices, but I learned that finding opportunities for growth is also helpful, which is why we have developed an investment approach that combines value and growth.
John Rotonti: Do you have a preferred measure for the returns a business is generating? Return on assets? Return on equity? Or return on invested capital?
Jerome Dodson: We look at them all, but the best measure is return on equity.
John Rotonti: I know that no one metric is appropriate for all businesses. But do you have a particular measure of cash flow that you prefer when analyzing most businesses? Operating cash flow less capital expenditures? EBITDA less capital expenditures? Net income plus depreciation and amortization? Owner earnings?
Jerome Dodson: Operating cash flow less capital expenditures.
John Rotonti: How do you evaluate a company's balance sheet? Do you look for a particular coverage or debt ratio?
Jerome Dodson: As long-term investors, a healthy balance sheet is one of our investment criteria. We use both solvency ratios, such as debt to book value, and liquidity ratios, such as current assets to current liabilities, to assess balance-sheet strengths. There is no one-size-fits-all approach, and ratios vary based on the cyclicality and capital requirements of the company's business.
John Rotonti: When should a company pay a dividend or repurchase stock?
Jerome Dodson: Generally speaking, we believe that returning capital to shareholders through dividends demonstrates management's focus on shareholders. However, a company's dividend policy and repurchase timing should be very specific to the business. Since each firm has a different economic cycle and need for cash, the payout ratio of retained earnings will vary by industry and firm. Also, for stock buybacks, it depends on the current price and the need for cash on the books. Buybacks can concentrate earnings into fewer shares, but management can also buy stock at the highest price and take money out of the balance sheet that could be potentially used elsewhere. So, that's also not a one size fits all. In general, if a company can't return well above its cost of capital on new investments, it should return capital to shareholders through dividends or stock buybacks.
John Rotonti: Do you have any performance metrics that you prefer management compensation be based on?
Jerome Dodson: Management compensation should be based on the same metrics that drive long-term stock performance. As a general rule, these metrics include a combination of revenue growth, return on equity, and earnings per share.
John Rotonti: Do you meet with management of the companies you are invested in?
Jerome Dodson: Yes, our analysts meet with company management as often as they can. Doing so is helpful in assessing the integrity of the management team, and in understanding their long-term goals and strategic plans. Many investors and Wall Street analysts focus on short-term metrics, and they get so caught up in quarterly performance that they miss the longer-term trajectory of the business. Management meetings inform our differentiated, long-term point of view.
John Rotonti: What is one question you think investors should ask of each management team?
Jerome Dodson: What can you do to increase the company's return on equity?
John Rotonti: What step(s) should investors take to try avoid value traps?
Jerome Dodson: We invest in companies with good business prospects. While our investments may be going through a difficult period when we first invest, we only invest if we believe the business prospects will eventually improve. We don't invest in companies because their stock is cheap; we invest in ethically run companies with good business prospects, whose stock is undervalued.
John Rotonti: When do you sell? Will you hold a high-quality company that is fairly valued?
Jerome Dodson: If the original investment thesis deteriorates or new information comes to light that changes our viewpoint, we will sell. However, it is more difficult to find compelling value when the overall market valuations are high. Right now, we are holding onto the companies that we think are high-quality companies while we continue to look for great future opportunities. In general, we sell when a stock is fully valued.
John Rotonti: How do you think about position sizing and portfolio diversification?
Jerome Dodson: As an active manager, we want to make sure we earn our fees. We want to be different from the benchmark. The goal of the Parnassus investment process is not to track a benchmark, but to capture more of the market upside than downside. That's why we build focused portfolios of about 30 to 40 stocks that we know very well and feel confident about owning.
John Rotonti: What common characteristics or patterns do you recognize in some of your biggest winners?
Jerome Dodson: Many of our biggest winners have been companies that operate in cyclical industries with secular growth drivers. When their business cycle turns down, investors become overly pessimistic and extrapolate the current negative conditions. They forget the cycle will eventually turn, throw in the towel on the secular growth drivers, and engage in panic selling, pushing the stock to bargain-basement levels. But eventually the cycle turns, and the stock soars higher. It's difficult to have the courage to buy when everyone else is selling, and this has been an important part of our success.
John Rotonti: What lessons did you learn or patterns do you recognize from some of your losers?
Jerome Dodson: In the very early years of Parnassus, I believed that socially responsible companies would necessarily perform better than other companies. I learned the hard way that it's important to always consider both a company's financial prospects and its ESG track record.
John Rotonti: Can you discuss the research process at Parnassus? Are the analysts generalists or specialists? About how many companies does each analyst cover? How often does the investing team meet to discuss new ideas? What is the process for a stock to make it into the portfolio?
Jerome Dodson: The research analysts are generalists, and some team members have specific areas of interests that they cover. In addition, Parnassus also has dedicated ESG analysts. The analysts have broad backgrounds that help them identify general business trends. The team meets weekly to review company research and participates in a semiannual offsite to discuss investment process improvements. We try to get it right most of the time, and we are constantly trying to improve.
I'm the portfolio manager and I make the final call about which stocks are included in the portfolios I manage. These are difficult decisions because, with focused portfolios, each company matters.
John Rotonti: How do the roles and responsibilities of the Director of Research and Chief Investment Officer differ at your firm?
Jerome Dodson: Our Director of Research is focused on the day-to-day implementation of research -- mobilizing the team, organizing and prioritizing research projects. The CIO focuses on longer-term trends, including sources of risk, and serves as a mentor to research team members.
John Rotonti: Which qualities should great analysts have? What about great portfolio managers? Are they different?
Jerome Dodson: Everyone at Parnassus Investments starts out as a research intern and is trained in the Parnassus style. We hire from top schools, and we look for team players, long-term thinkers and clear communicators who are inquisitive.
A portfolio manager needs to be decisive because they make the final decisions on buys and sells, sizing and portfolio construction. The Graham and Dodd approach of investing in undervalued stocks is very easy to understand, but it's very difficult to implement, for both intellectual and emotional reasons. People don't want to buy a stock after it's fallen. You need to have the right temperament to buy a stock when it's down and have the intellectual capability to determine which stocks have gone down due to short-term factors and should be able to bounce back.
John Rotonti: How do you measure the performance of the analysts who work at Parnassus?
Jerome Dodson: We give them rewards if the stocks they pick go up.
John Rotonti: What is your investment thesis on Praxair?
Jerome Dodson: Praxair produces industrial gases, including oxygen, nitrogen and helium, and is the market leader in North America and South America. Industrial gases have low value-to-volume ratios which makes them expensive to transport, so the location of the production facility is very important. As the market leader, PX has the best locations. Industrial gas facilities are expensive to build, so PX signs long-term contracts with its customers, which discourages the construction of competing plants. Being the incumbent with the best locations and long-term contracts provides PX with a wide moat, and the company earns an ROE of about 30%.
Many of Praxair's products bring environmental benefits to its customers. For example, adding oxygen to a high-temperature manufacturing process reduces the amount of energy required, along with the customer's overall expenses.
Since 2000, the company's revenue has grown at a 5% compound annual growth rate (CAGR), while EPS has grown at a 10% CAGR thanks to operating leverage and share buybacks. We believe the company's leadership position, and the increasing importance of its environmental benefits, will drive growth for a long time.
John Rotonti: What is your investment thesis on Apple?
Jerome Dodson: Apple is a leading technology company best known for its iPhones. With a huge installed base of over a billion active devices, Apple is well-positioned to leverage its ecosystem of highly sticky products and services to drive higher earnings ahead. Apple has carved out a strong competitive moat, supported by its customer switching costs, brand equity, and scale advantages, that will enable the company to generate strong returns on capital over the next five years. As customers buy more highly integrated iOS devices such as iPhones, iWatches and iPads and use Apple iOS services such as Apple Pay, we believe Apple's moat will become even more solidified.
The stock price has recently been affected by investor concerns about slowing demand for its highly profitable iPhone products, especially in China. We don't expect iPhone growth rates to come roaring back in the near term, but we think iPhone sales will improve as the company releases iPhones with new features and functionality and users continue to adopt Apple's complementary products and services. We also believe Apple's services business, which includes online storage, music, and applications, will drive meaningful incremental revenue growth over time.
Apple has an extensive global supply chain, distribution networks, and data centers, each of which are energy and resource-intensive, thus exposing the company to high environmental risks. However, with guidance from top management, Apple is adapting its operations to minimize energy use, water consumption, waste production, and toxins in products. Apple is a very desirable place to work, offering a strong benefits package to help lure and retain talent.
John Rotonti: What about American Express?
Jerome Dodson: American Express is the leading credit card issuer to affluent consumers. Affluent consumers use their cards frequently, and often for large transactions, which generates attractive fee income each time the card is used. They're also less likely to carry a balance or to default on their loans, so the credit losses are low.
American Express has built its reputation for customer service and developed its attractive membership benefits over many years. Its 25%-plus ROE is evidence of its wide moat. While competition for affluent cardholders is increasing, and the company recently lost its large co-brand relationship with Costco, we believe American Express' strong brand will allow it to prevail. The company consistently appears on Fortune's 100 Best Companies to Work For list, which provides it with a competitive advantage in hiring and retaining top talent. CEO Ken Chenault has been through cycles before, and we think he'll guide the company in the long-term best interests of shareholders again.
John Rotonti: Some of your funds are receiving investor inflows on the back of exceptionally strong performance. That's wonderful. But would you mind sharing your thoughts on the large publicly traded "active" asset management companies, some of which have historically generated very strong free cash flows and returns on capital but are currently being pressured from poor performance, outflows, lower fees, and the growth of passive strategies and robo-products?
Jerome Dodson: I think investors now realize that most active mutual funds don't beat their indexes. If your fund can't beat its index, you should invest in an index fund. I expect those mutual funds that can't beat the S&P 500 to keep losing assets, while those that perform well will keep growing. Fortunately, we've been able to beat the S&P 500, so our funds should continue growing.
John Rotonti: What are your thoughts on current stock market valuations?
Jerome Dodson: I think the market is currently fully valued. Because of this, it has been challenging to find attractively priced names to add to the portfolio recently. But we continue to search, and we stand ready to invest quickly when new opportunities arise.
John Rotonti: Thank you so very much!
