Parnassus Digest - July 2014
Parnassus Small Cap Fund Insight – Q&A with Ryan S. Wilsey
The Parnassus Small Cap Fund was launched in 2005 by Jerome L. Dodson. Ryan S. Wilsey joined Parnassus Investments in 2009 as a Senior Research Analyst and in 2011 was promoted to manage the Fund alongside Mr. Dodson. On July 1, 2014, Mr. Wilsey became sole Portfolio Manager of the Parnassus Small Cap Fund. In this issue of the Parnassus Digest, Mr. Wilsey reviews the Fund’s investment strategy and answers questions he has recently received from investors.
At Parnassus, the equity team, which covers large-, mid-, and small- cap stocks, evaluates investments through four lenses:
1. Relevancy: Is the business becoming more relevant over time?
2. Moat: Does the company have a sustainable competitive advantage?
3. Management: Has management made good capital allocation decisions and are its incentives aligned with ours?
4. Valuation: Does the company trade at a meaningful discount to our estimate of its intrinsic value?
If a company rates highly on the first three criteria, it screens as a good business, and I will add it to the watch list. I have approximately 300 companies on the watch list for the Parnassus Small Cap Fund and the team is constantly evaluating new companies to expand this list. When one of the companies on the watch list trades meaningfully below our estimate of intrinsic value, we conduct deep-dive research on the company. This includes a comprehensive, company-specific investment analysis process to determine the intrinsic value of the company based on three criteria: relevancy of the company’s products or services, moats and management. If everything checks out, we add the company to our portfolio. Our intention is to hold our investments for at least three years, in order to benefit from both the valuation moving towards our estimate of intrinsic value, as well as the business’s increasing intrinsic value as it reinvests its cash flows.
“Our intention is to hold our investments for at least three years, in order to benefit from both the valuation moving towards our estimate of intrinsic value, as well as the business’s increasing intrinsic value as it reinvests its cash flows.”
I have recently received some questions that I thought would be of interest to our broader investor base:
Q: What changes do you intend to make to the portfolio?
A: I will continue to execute the Parnassus Small Cap Fund through the four lenses discussed earlier because I believe it is the best approach to outperform the market through a full economic cycle. The most significant change to the way the Fund will be managed is that the bar has been raised regarding moats – I require that every company in the portfolio has a moat, regardless of how cheap the opportunity looks. This change is in-line with how my associates Todd C. Ahlsten and Benjamin E. Allen mange our Parnassus Core Equity Fund, which has been a very successful strategy since Todd took it over in 2001. I view the Fund as the small cap equivalent of the Parnassus Core Equity Fund.
Q: How do you identify moats for smaller companies?
A: As I discussed in the April 2010 Parnassus Digest (a copy can be found at www.parnassus.com/our-firm/highlight/75), we have identified six different types of moats: brand, customer switching costs, low-cost producer, network effects, patents and regulatory license. Typically, a company with a moat will have a large market share and a limited number of competitors. As you can see in the chart below, our portfolio companies, Gentex, Blount International and First American Financial, combined with each of their largest competitor, dominate their markets. Although MRC Global and Thermon Group are less dominant, when we dig a little deeper, we learn that their second largest competitor each only has 8% and 4% market share, respectively. High market share is a key signal for our team to conduct deep research into whether or not the company has a sustainable competitive advantage.
Q: What is your competitive advantage?
A: Equity investing is a competitive industry where your key resources go home each night. Therefore, successfully hiring and retaining our investment team is critical. Mr. Dodson started the Parnassus internship program over 25 years ago and in that time we have had more than 200 interns. This program allows us to get to know candidates for three months, as they research in depth and pitch two different investment ideas to the entire investment team. Additionally, it helps the candidates to understand our firm’s culture and investment philosophy, which in turn helps them to make an informed decision on whether Parnassus is the right firm for them. Amazingly, everyone on our equity team has been hired through our internship program (I interned way back in 1998!), and this has led to very low turnover in our team. Since our knowledge and learning lessons compound over time, retaining our team and maintaining consistency within our investment process are strong competitive advantages.
“Since our knowledge and learning lessons compound over time, retaining our team and maintaining consistency within our investment process are strong competitive advantages.”
Q: What themes are you investing in right now?
I purchased Gentex, a manufacturer of auto-dimming car mirrors, in 2012 because it has a dominant market position and we expect auto-dimming mirrors to penetrate down-market into midsize and economy cars.
While researching Gentex’s rear camera display product, we learned that consumers prefer displays in the center console. This led us to research Harman International, the leading manufacturer of automotive infotainment systems. I purchased Harman in 2013 because we expect infotainment penetration to increase and margins to expand, thanks to the company’s shift from customized to standardized systems.
While covering Harman International, we noticed that U.S. automotive sales kept exceeding expectations. We researched the automotive value chain and identified that large dealerships have a competitive advantage versus independent dealerships and mechanics. Last February, I purchased Group 1 Automotive, which owns over 150 automotive dealerships, because we expect the strong growth in new car sales will eventually lead to very profitable parts and services revenue.
A: I do not invest in themes; each stock purchased is based on bottom-up research conducted on the company and its industry. However, our research often generates new ideas from companies we already own. Let me give you an example:
Q: What is your outlook?
A: For the second quarter in a row, the Russell 2000 increased modestly. While the index’s price-to-earnings ratio remains near a decade-high level at 20.4x, I do not expect broad valuation multiple or profit margin expansion. Therefore, I prefer out-of-favor companies not currently trading at peak valuation multiples, which also have competitive advantages that allow them to increase prices through the economic cycle.
I hope this helps you better understand how the Parnassus Small Cap Fund is managed.
Ryan S. Wilsey
Gentex represented 3.9% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014. Harman International represented 1.6% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014. Blount International represented 5.4% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014.
First American Financial represented 4.4% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014. MRC Global represented 5.1% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014. Thermon Group represented 3.0% of the portfolio of the Parnassus Small Cap Fund as of June 30, 2014.
The fund invests in the stocks of smaller companies, which are generally riskier than larger companies, and the fund’s share price may be more volatile than funds that invest in larger companies.
The views expressed in this Parnassus Digest are subject to change at any time in response to changing circumstances in the markets 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. Investment return and principal value will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Any specific securities discussed may or may not be current or future holdings of the Funds.
The Parnassus Funds are underwritten and distributed by Parnassus Funds Distributor, a subsidiary of Parnassus Investments and FINRA member.
Before investing, an investor should carefully consider the investment objectives, risks, charges and expenses of the Funds and should carefully read the prospectus or summary prospectus, which contains this information. A prospectus or summary prospectus can be obtained on the website, www.parnassus.com, or by calling (800) 999-3505.