Back in December of 2016, I had the pleasure of interviewing Jerome Dodson, the founder and chairman of Parnassus Investments. Dodson is an environmental, social, and governance (ESG) investing pioneer with a legendary stock-picking record. In a recent Barron's profile, Dodson was described as "one of a handful of managers to have beaten the S&P 500 index over virtually every time period going back more than 20 years."
Today, I'm interviewing another leader at Parnassus: Ben Allen, its CEO. Allen is also a co-portfolio manager of the Parnassus Core Equity Fund, which has more than $16 billion in AUM. (The other portfolio manager on the Core Equity Fund is Todd Ahlsten, who is also Parnassus's chief investment officer and a member of the Barron's Roundtable.)
Parnassus, which has about $26 billion in assets under management (AUM) spread across four equity funds and one fixed-income fund, employs 51 people, and 16 of those employees are on the investing team. That includes three dedicated ESG analysts.
Allen started at Parnassus as a research intern and worked his way up to senior research analyst, then to director of research and portfolio manager, and eventually to the CEO position. How's that for an example of an awesome workplace culture with opportunities for development?
In this interview, we discuss Parnassus's investment philosophy and process. We also discuss several stocks, including Cadence Design Systems, Adobe, MasterCard, United Parcel Service, 3M, Clorox, and more.
John Rotonti: Can you describe Parnassus's investing philosophy?
Ben Allen: Based on Parnassus's 35 years of investment experience using an ESG integration strategy, we believe that investing in high-quality companies with strong financial prospects and sustainable business practices can both build wealth for our clients and positively impact society.
Rotonti: Does Parnassus use an investing checklist, and if so, would you mind sharing a few of your checks? For example, do you look for a certain level of return on equity (ROE) or return on invested capital (ROIC)? Do you look for a certain growth rate of revenue, EPS, or free cash flow per share? Are there any metrics you tend to focus on more than others?
Allen: The Parnassus investment process is based on getting to know as much about a company as possible before investing. This does include evaluating its fundamentals using traditional ratios such as P/E, P/B, earnings growth, dividend yield, and ROE. However, a distinguishing element of our process is that we also conduct a thorough investigation of each company's unique characteristics, including those that can't be captured by statistics. For example, speaking with board members to learn about the dynamics on the board is part of our investment process. We also seek to understand the dynamics within senior management. This kind of firsthand knowledge about the caliber of a company's leadership team provides invaluable insight into future prospects for the business.
Rotonti: Can you briefly describe the research process? How many companies does each analyst cover? Do you have dedicated ESG analysts and, if so, what is the interaction and work flow like between the generalist analysts and the ESG analysts? Is stock research initiated by the generalist or the dedicated ESG analysts or both? How does a stock make it into a Parnassus portfolio?
Allen: Parnassus Investments has a meticulous, deeply collaborative research culture, and it typically takes between six weeks and six months to get comfortable with a potential investment. When we invest, we invest big and hold companies for a long time. Research analysts and portfolio managers communicate every day and formally meet on a weekly basis to review companies in the investment universe and discuss new investment ideas.
The ESG team, which includes three analysts, is involved at the earliest stages of the process. First, the team determines whether the company passes our exclusionary screens. These screens eliminate companies that derive significant revenue from the manufacture or sale of alcohol, tobacco or weapons, or have significant involvement with nuclear power generation or casino operations.
After these screens are applied, the team begins its bottom-up ESG analyses, including both company performance on and disclosure of a broad range of ESG issues related to the environment, community, customers, workplace and governance. While the Parnassus ESG evaluation process is led by our ESG specialists, they closely collaborate with our fundamental research analysts. Their recommendation is then reviewed by the CIO, who ultimately determines whether the company meets the firm's ESG criteria.
The investment team typically analyzes more than 100 potential new investments per year. Including existing holdings, the total number of stocks analyzed per year may surpass 200.
Rotonti: Does Parnassus supplement its proprietary ESG research with outside sources?
Allen: We use outside databases for discovery of facts and figures; however, we still need to do much of our own fact-finding.
Rotonti: Parnassus places a lot of importance on workplace culture and employee happiness and engagement when looking for investment ideas. So, would you mind briefly describing Parnassus's workplace environment and culture?
Allen: Parnassus is a boutique that operates from a single location. We prefer to bring new members on board as interns, which gives us an opportunity to assess fit, temperament, and ability to work with others as well as investment acumen.
Then we take the skill sets, the personalities and the intellectual strengths that we have and create a system that we believe will best utilize the talent of our investment team in a highly collaborative environment. We value intellectual honesty, accountability, continuous learning, and diversity of opinion.
Rotonti: Companies with strong ESG profiles can both mitigate risk and drive long-term growth through investments into R&D and capex that are sustainable in nature. Does Parnassus look for companies that are committed to finding places to reinvest capital at high rates of return? If so, can you give us a couple examples of companies that excite you based on their opportunities to drive organic growth by reinvesting back into the business?
Allen: In our view, if a company is not investing over a long horizon, it will risk a loss of relevancy in the future. For example, we've seen that a significant portion of the very sizable 2018 corporate tax cuts has been used for share buybacks, one-time bonuses, and M&A. These activities may result in short-term bumps in a company's stock price, but they are not typically sufficient to drive sustainable company success.
On the other hand, the right investments in R&D efforts to develop new products and services can help companies differentiate themselves from competitors and build sustainable moats. Xylem (NYSE:XYL), a leading pure-play water technology provider, has increased its R&D investments as a percentage of sales to accelerate the pace of innovation across its product portfolio. 3M (NYSE:MMM), with its diversified product portfolio and strong focus on innovation, is another example.
Rotonti: Cadence Design Systems (NASDAQ:CDNS) is a company I've been researching, and it's currently one of my high-conviction ideas. I like the company because it has a long-term focused CEO who owns about $100 million in company stock. Cadence also has net cash of $88 million, organic growth driven by the long-term trend toward digitization, improving return on assets (ROA) and return on invested capital (ROIC), and massive free cash flows (FCF) with a five-year average FCF/net income of 1.72 and average FCF margins of 21%. According to S&P Global, in 2018 Cadence generated a ROIC of 15% and used an appropriate amount of debt, which helped boost returns on equity (ROE) to 30%. Importantly, it has a culture of investing in R&D which has led to 20 new product releases in only the last three years. Is there anything else Parnassus likes about Cadence that I'm missing, and can you briefly describe what Parnassus likes from an ESG perspective?
Allen: We think Cadence's relevancy and moat are both strong and that it possesses ESG strengths. Companies like Apple (Nasdaq: APPL), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and Google (NASDAQ:GOOG)(NASDAQ:GOOGL) are now seeking to design more semiconductor chips in-house to further their competitive edge and reduce reliance on outside suppliers. This trend supports the relevancy of Cadence's products because its tools are crucial for designing these complex chips. The company is a clear leader in its segment and, as you pointed out, invests heavily in R&D to maintain its competitive advantage. Finally, Cadence is recognized as a great place to work, with strong social programs geared toward supporting employee volunteering and promoting STEM education.
Rotonti: Cadence claims to have 90% recurring revenue. What is driving that? Is it the contracts with an average term of 2.5 years as well as software maintenance? Or is it something else? And how secure is Cadence's backlog of about $3 billion if we enter an economic downturn?
Allen: Cadence typically signs two- or three-year, non-cancelable contracts, which should reduce volatility during a short-term slowdown. Their customers also would try to recover from a downturn by implementing new technologies, such as autonomous driving, the Internet of Things, hyperscale, and machine learning. Cadence's sales are correlated with their customers' design starts.
Rotonti: Cadence develops system design enablement (SDE) products, including electronic design automation (EDA) software. That's a technical mouthful for a non-techie like myself. Can you explain what these terms mean and what is Cadence's value proposition to its customers? In other words, are its products indispensable, and if so, why?
Allen: SDE products are complicated software programs that help engineers create and test new designs for semiconductors. SDE is analogous to Autodesk and AutoCAD, which are the standard for designing buildings and other manufactured components. Cadence's systems are specific to semiconductors, and there are few competing products.
Rotonti: What is Parnassus's investment thesis on Linde (NYSE:LIN), and can you briefly describe why you like the company from an ESG perspective?
Allen: As a leader in global industrial gas supply, Linde's products and systems are literally designed into manufacturing processes of other companies and are protected by long-term partnerships for supplying gas. In addition, because gases are for manufacturing processes and are relatively low in cost relative to other overhead, customers are more focused on quality and reliability than seeking to cut corners. Some of the company's relevancy is driven by economic growth. Industrial gasses increase efficiency, which can reduce the overall cost of manufacturing.
We invested in Praxair, which is now Linde, because we believe industrial gases will gain share in the economy as we decarbonize, cut energy and water usage, and develop new products using wind and solar energy. Linde offers a great place to work and their push to decarbonize is economically viable. About 30% of the firm's products provide some positive environmental impact, such as being a component of solar manufacturing.
Rotonti: Can you briefly describe the industrial gas industry landscape (or competitive environment) and briefly explain the competitive advantages of industrial gas businesses?
Allen: There are very few players because of the scale required. Density is really the secret to building a competitive advantage in this business. Praxair (now Linde) has always been very focused on building network density in targeted geographies to increase operating efficiency, profitability, cash flow, and return on capital. That's why there tends to be a strong presence in areas of significant industrial density, such as the U.S. Gulf Coast.
Rotonti: What is Parnassus's investment thesis on Adobe (NASDAQ:ADBE), and can you briefly describe why you like it from an ESG perspective?
Allen: Adobe is a best-in-class software business with a wide moat. The company's digital media products have significant switching costs and network effects, and are considered the industry standard for creative professionals. Adobe continues to invest in this ecosystem of professionals, employers, and educational institutions, furthering the company's competitive advantage.
The company's shift into digital marketing dramatically expands its total addressable market and builds on its core advantage in creating, publishing, and managing digital assets. The unabated digitalization of the economy makes Adobe's business increasingly relevant. With its strong management team that has a proven track record, we expect Adobe to provide above-market returns for years to come.
From an ESG perspective, Adobe maintains a great workplace and industry-leading environmental practices. The company is commonly recognized as a best place to work and is committed to 100% renewable energy usage by 2035.
Rotonti: What is Parnassus's investment thesis on Mastercard (NYSE:MA), and can you briefly describe why you like the company from an ESG perspective?
Allen: Mastercard is a high-quality company with a wide moat. The company plays a critical role in the payments ecosystem, and its moat is driven primarily by network effects in its hard-to-replicate payments network. Merchants want to accept payment methods used by the most consumers and issuing banks, while consumers want payment methods accepted by the most merchants and banks. As a significant portion of consumer transactions still occur in cash and the secular shift away from cash continues, Mastercard stands to benefit.
From an ESG perspective, Mastercard is a great workplace, which has been recognized by Working Mother magazine and DiversityInc. The company also has inclusion and diversity initiatives and strong environmental programs, including a European headquarters that is 100% powered by renewables.
Rotonti: Cognizant (NASDAQ:CTSH) recently named a new CEO. Does this change your investment thesis in the company?
Allen: No. Cognizant's consulting and outsourcing model is benefiting from the increasing importance of technology spending and the scarcity of skilled tech labor, which should allow the company to generate high-single-digit revenue growth for many years. Francisco D'Souza has been the CEO since 2007 and was a co-founder of the company in 1994. After a successful tenure, he's ready to retire and we wish him all the best. The board conducted a thorough search process and selected Brian Humphries from Vodafone Business, who will bring a fresh perspective to the company.
Rotonti: The Wall Street Journal recently reported that Amazon is "trying to poach shippers from FedEx Corp. and United Parcel Service Inc. by targeting a common complaint: fuel surcharges and extra fees that drive up the cost of home deliveries." What is Parnassus's investment thesis on United Parcel Service (NYSE:UPS) and does this development change your thesis on UPS?
Allen: I believe it is fair to say that we are watching this development closely, but we believe that the hard-to-replicate networks and logistics expertise help to protect UPS and FedEx from competitive threats. Additionally, it is clear that the relevancy of these companies' services has only grown with online orders and general economic activity. Amazon may actually attempt to supplement, not replace, UPS and FedEx because home deliveries and last-mile deliveries are very costly and difficult.
The UPS investment thesis is that margin contribution from e-commerce volume growth will turn from being decremental to becoming a meaningful incremental contributor as the company focuses on revenue quality, pricing initiatives and network efficiencies.
Scale and density are important in transportation and logistics, and Amazon has neither of these in last-mile delivery. This is why Amazon relies so heavily on the U.S. Postal Service for the majority of its shipments. This is also the reason that surcharges are necessary despite the economies of scale that come with massive global networks. Disclosures from Amazon are limited, which tends to allow fear to outweigh fundamentals, and as a result the Amazon hype often becomes sensationalized. Until Amazon details how much capital it is investing, it is easy to draw the wrong conclusion with respect to realistic implications for UPS.
More fundamentally, even if Amazon were to offer free shipping on its own network, large retailers compete directly with Amazon. These large retailers would not want Amazon to gain access to their company's sale trends, customer data, etc., which Amazon could use to its advantage. In contrast to Amazon, UPS is not competing with the retailers that ship on its network. This is probably the biggest hurdle that Amazon will encounter as it seeks to lure customers into its shipping network. Some success is more likely with small customers, just as some small businesses are already selling on the Amazon marketplace.
Rotonti: Bloomberg recently published an article titled "Cancer-Linked Chemicals Manufactured by 3M Are Turning Up in Drinking Water." What is Parnassus's investment thesis on 3M (NYSE:MMM), and does this change your thesis on the company?
Allen: The durability of 3M's growth over the past 15 years is due to its innovation engine, portfolio breadth, and pristine balance sheet. 3M has paid dividends to its shareholders without interruption for more than 100 years and increased the annual dividend for 60 consecutive years —all of which reflect the stability and long-term health of its business.
We are closely monitoring and engaging with the company regarding its ongoing chemical-related controversies. We recognize the potential financial, operational, and reputational risks associated with this legacy issue, but at the same time give credit to the company for pursuing rigorous enterprisewide environmental goals.
Rotonti: According to S&P Global, over the past five years 3M grew revenue at about a 1% compound annual growth rate (CAGR) and EPS at a 6% CAGR. Are you satisfied with this level of growth, and at what rate (roughly speaking) do you expect 3M to grow revenue and EPS over the next three years?
Allen: No, we're not satisfied by that level of growth. However, the 1% revenue CAGR was weighed down by foreign currency translation and some divestitures. The company's organic growth rate over the past five years has been closer to 3%. Over the next five years, the company expects 3% to 5% organic revenue growth and 8% to 11% EPS growth. We believe those targets are achievable.
Rotonti: What is your investment thesis on Starbucks (NASDAQ:SBUX), and can you briefly describe why you like it from an ESG perspective?
Allen: Starbucks is a very high-quality business, with a strong brand and competitive position in the retail coffee market. Customers are loyal, and their innovative loyalty program is a valuable tool for increasing sales capacity and for driving customers to stores. We expect long-term growth to continue as more consumers move from discount to premium coffee.
Parnassus bought the stock at a depressed valuation. Its same-store sales comps had been low for several months. We thought the company's innovations with beverages could improve same-store sales and increase Starbucks's relevancy.
Starbucks was one of the first companies in its industry to prioritize both profitability and socially responsible principles and is consistently recognized as a good place to work. Notable examples include health insurance for employees and financial assistance for higher education. The company also promotes sustainable coffee farming in developing countries.
Rotonti: In December 2018, Starbucks lowered its long-term guidance for the second time in about a one-year span. Starbucks now expects global comps growth of 3% to 4%, revenue growth of 7% to 9%, and non-GAAP EPS growth of at least 10%. Are these reasonable expectations?
Allen: We think these expectations are reasonable.
Rotonti: Starbucks built its brand as the "third place" where people can spend their time away from home or work and enjoy a daily delight. But it seems as though some of its new growth initiatives, including drive-through stores, delivery, and a virtual store in China, are moving the company at least partially in a new direction. This is probably inevitable given the growth of the digital economy/e-commerce, but do you think this changes the Starbucks story in either a positive or negative way?
Allen: These developments speak to the company's increasing relevancy. For some customers, Starbucks is a place to sit down with other people over coffee. Other customers value the convenience of an efficient grab-and-go approach, and so prefer Starbucks' mobile order system and the other innovations you've listed.
Rotonti: It seems as though the competitive advantages of many CPG companies are under attack because the digital economy (e-commerce and social media) has increased price transparency and decreased the amount of capital needed to start and scale a new business, and it also seems like millennials are less brand-loyal (or at least more willing to experiment with newer brands). Is Clorox's (NYSE:CLX) competitive advantage intact, and what is your overall investment thesis in Clorox?
Allen: Despite these trends, we like Clorox a lot. Clorox maintains a strong moat due to its category-leading brands. These brands dominate their categories by maintaining either the highest or second-highest market share. This scale demonstrates Clorox's ability to grow and preserve pricing power. Clorox has furthered the relevancy of its brands through R&D. The company allocates a significant research budget to improve the health and wellness, sustainability, and affordability profile of its products. This innovation drives demand for existing products, and also allows the company to uncover adjacencies. Further, Clorox's management team has made wise decisions historically to invest capital into the company to support growth. These decisions have led to product innovations that have bolstered sales over time. Additionally, senior leaders at Clorox have made well-aligned acquisitions and prudently deployed capital.
We think many millennials appreciate that Clorox is a top ESG performer. The company embeds environmental and social sustainability into its corporate strategy and publishes integrated financial and ESG reports. The company also strives to reduce its operational waste (energy, water, and manufacturing waste) and improve the sustainability of its products. Finally, Clorox prioritizes workplace safety and diversity, and the company's board of directors includes women and minorities.
Rotonti: How do you decide to sell a stock and how often is the sell decision based on ESG reasons?
Allen: We're long-term, high-conviction investors, so the turnover rate in the Parnassus Funds is typically low. Many positions are sold due to valuation and may be purchased again at a future date. Others are sold due to deterioration of the investment thesis, either fundamental or ESG— or as a result of both deteriorating fundamental and ESG characteristics.
Rotonti: Has Parnassus ever considered creating an actively managed ESG exchange-traded fund (ETF)?
Rotonti: Is there anything else you would like our readers to know about Parnassus's investing philosophy, strategy, or process? Or are there any other stocks you'd like to highlight?
Allen: Parnassus is the largest pure-play ESG fund company in the United States. Every strategy offered by our firm since its inception in 1984 has been managed using both fundamental and ESG criteria. The investment team's expertise is in valuing intangible attributes of a company, such as long-term relevancy of the business model and sustainable competitive advantages. We also believe that the firm's long-term investment horizon is a competitive advantage, because the portfolio managers can take advantage of material stock price drops that result from short-term issues. Finally, the firm's consideration of ESG factors allows the team to see risks and opportunities that the firm's competitors often overlook.