Parnassus Digest - April 2010
Print Version 
Senior Research Analyst Insight
The future is unpredictable but, by investing in high-quality
companies, Parnassus Investments believes it can outperform
the market over the long-term. Our analysts look for companies
that have "economic moats," a term that was coined by Warren
Buffett, perhaps the greatest investor alive. Ryan Wilsey, Senior
Research Analyst, offers insight into how the investment team
identifies and incorporates moats in our investment process.
An economic moat is a long-term competitive advantage that allows a
company to earn returns on capital well in excess of its cost of capital.
Typically when a company earns outsized returns, new competitors
enter, and the average return on capital for the industry falls to the
marginal cost to produce the product. However, economic moats help
prevent competitors from entering, and allow our portfolio companies to
enjoy outsized returns over the course of our expected holding period.
Unfortunately, all too often investors mistake a temporary advantage or
even a fad as a moat, and end up paying too much for a company. At
Parnassus Investments, we have a strict process for analyzing moats,
which fall into one of the following six categories: Brand, Customer
Switching Costs, Low-Cost Producer, Network Effects, Patents, and
Regulatory License. Following are six examples of current Parnassus
Investments portfolio companies that best
demonstrate these moats.
Brand: Nike’s (NKE) brand is unmatched
in sportswear, which causes customers to
choose Nike products over its competitors'
products. This allows Nike to charge more
for its products than if it had no moat. We find brand moats the most challenging to identify because most
brands can only generate high returns on capital temporarily and,
therefore, do not have moats. The investing landscape is littered with
formerly high-flying brands that turned out not to have a moat such as
Krispy Kreme doughnuts and Crocs shoes. Investors should proceed with
caution when searching for brand moats!
Customer Switching Costs: With over 1,200 branches, Royal Bank
of Canada (RY) has the largest branch network in Canada. These
branches make it very easy for new customers to open an account.
Once customers deposit money at the Royal Bank of Canada, they are
unlikely to go through the hassle of switching to a competing bank, even
if it offers a better interest rate. The reason is that switching banks
requires a customer to fi ll out time-consuming forms and go through the
hassle of changing all of his or her direct-deposit and automatic bill-pay
relationships.
Low-Cost Producer: Compass Minerals’ (CMP) salt mine has the
cheapest extraction cost in the country because its salt vein is 3-4x
thicker than its competitors. This natural advantage allows Compass to
use a cheaper mining technique, which is not feasible for its competitors.
Because Compass has the lowest costs, it can either price cheaper than
its competitors to gain market share or price the same as its competitors
and earn a larger profi t margin.
Network Effects: eBay (EBAY) exhibits strong network effects. As more
sellers list products for sale on eBay, the value to new buyers increases
because they are more likely to find the product they are looking for.
Similarly, as more buyers come to the site, the value to sellers increases
because they are able to sell their products at higher auction prices.
Patents: Qualcomm’s (QCOM) more than 10,000 patents on Code Division
Multiple Access (CDMA) technology make it virtually impossible for a
competitor to develop a wireless standard based on its technology. Since
CDMA is currently the only technology available for today’s high-speed 3rd generation wireless networks, Qualcomm benefits tremendously
from the increasing adoption of data-intensive smart-phone users.
Regulatory License: The government has granted VeriSign (VRSN)
the exclusive rights to manage the domain registry for .com and .net
websites. The government requires a domain registry provider with the
competence to ensure that web-users reach the appropriate website
when they enter a domain name into their web browsers. VeriSign has
earned the government’s trust through over ten years of operation with
zero domain registry downtime.
Hopefully, you now have a better idea of how and why Parnassus
Investments seeks to identify companies that have economic moats.
Analyzing moats is at the core of our fundamental investment process.
We think it has helped us generate strong long-term returns in the past,
and we expect it to continue to generate value for our shareholders in
the future. If you would like to learn more about moats, I recommend
reading The Little Book that Builds Wealth by Pat Dorsey. It is a quick
read, provides numerous real-life examples and is well worth your time.
Ryan Wilsey
Senior Research Analyst
Percentage of Parnassus Funds represented by the companies in this
article, as of March 31, 2010: NKE is 3.0% and 1.8%, of PRBLX and
PARWX, respectively; RY is 2.0% of PRBLX; CMP is 1.8% of PARSX; EBAY
is 0.7% and 4.3%, of PARNX and PARWX, respectively; QCOM is 5.0%,
5.7% and 7.2%, of PARNX, PRBLX and PARWX, respectively; VRSN is
3.5%, 1.3% and 3.1%, of PARNX, PRBLX and PARSX, respectively.
The views are subject to change at any time in response to changing
circumstances in the market and are not intended to predict or guarantee
the future performance of any individual security, market sector or the
markets generally, or the Parnassus Funds®. Any specific securities
discussed may or may not be current or future holdings of the Fund.
Inside Parnassus
Parnassus Investments is honored to be recognized as
the #1 Equity Fund Group in the Small Group category
by the US Lipper Fund Awards 2010. This is Parnassus
Investments’ first time receiving the Lipper award; the
firm ranked 1st out of 162 companies, based on threeyear
history. The Parnassus Workplace Fund, which invests
in companies that have favorable work environments,
received the award for best U.S. multi-cap core fund; it
ranked 1st out of 658 U.S. multi-cap core funds.
In calculating the awards, Lipper considered all open-end
funds registered for sale in the United States in qualifying
classifications. Awards were given to funds with a 3-, 5- and
10-year history as of the end of the evaluation year Lipper
U.S. Classifications with at least 10 distinct portfolios.
Both group and fund awards were calculated using Lipper’s
consistent return score.
1All returns greater than one year are annualized.
2The inception date for the Parnassus Fund is December 31, 1984.
The inception date for the Parnassus Equity Income Fund and Parnassus Fixed-Income
Fund is August 31, 1992. The inception date for the Parnassus Mid-Cap Fund, Parnassus
Small-Cap Fund and Parnassus Workplace Fund is April 29, 2005. The inception date for the
Institutional Shares of the Parnassus Equity Income Fund is April 28, 2006.
3 As described in Fund’s current prospectus dated May 1, 2009, Parnassus
Investments has contractually agreed to limit the total operating expenses (exclusive
of acquired fund fees and expenses) to 0.99%, 0.99%, 0.78%, 1.20%, 1.20%, 1.20%
and 0.87% of the net assets of the Parnassus Fund, the Parnassus Equity Income Fund–Investor
Shares, the Parnassus Equity Income Fund–Institutional Shares, the Parnassus Mid-Cap
Fund, the Parnassus Small-Cap Fund, the Parnassus Workplace Fund, and the Parnassus
Fixed-Income Fund, respectively.
Performance shown for the Parnassus Equity Income Fund – Institutional Shares prior
to the inception date of April 28, 2006 reflects the performance of the Parnassus
Equity Income Fund- Investor Shares and includes expenses that are not applicable
to and are higher than those of the Institutional Shares.
Performance data quoted represent past performance and are no guarantee of future
returns. Current performance may be lower or higher than the performance data quoted,
and the most recent month-end performance is available on the Parnassus Investments
website (www.parnassus.com). Investment return and principal will fluctuate, so
that an investor’s shares, when redeemed, may be worth more or less than their original
principal cost. The S&P 500 Index, the Russell Midcap Index, and the Russell 2000
Index are widely recognized indexes of common stock prices. The Barclays Capital
U.S. Government/Credit Bond Index is a widely recognized index of fixed-income security
prices. An individual cannot invest directly in an index. An index reflects no deductions
for fees, expenses or taxes. Returns shown for the Funds do not reflect the declaration
of taxes a shareholder would pay on the fund distributions or the redemption of
fund shares. Prior to March 31, 1998, the Parnassus Equity Income Fund was a balanced
fund. Prior to May 1, 2004, the Parnassus Fund charged a sales load of a maximum
of 3.5%, which is not reflected in the total return figures.
Common stock prices fluctuate based on changes to a company’s financial condition
and on overall market and economic conditions. Small- and mid-cap companies can
be particularly sensitive to changing economic conditions and have fewer fi nancial
resources than large-cap companies. Investments in fixed-income securities are subject
to interest rate risk, credit risk and market risk, each of which could have a negative
impact on the value of the Fund’s holdings.
Before investing, an investor should carefully consider the investment objectives,
risks, charges and expenses of the fund and should carefully read the prospectus,
which contains this information. A prospectus can be obtained on the website, www.parnassus.com,
or by calling (800) 999-3505.