A Focus on Quality Companies

Sponsored by Parnassus Investments

When you buy a car or a home appliance, you will likely look for indicators of quality, because when you make a major purchase, you hope it will last a long time. Only after identifying a quality product will you consider price. The Parnassus Investments team believes this type of focus on quality purchased at a good price is also a great way to invest for the long term.

What is a quality product? As a consumer, you know it when you see it. A careful consumer will look very closely to ascertain the quality of a potential purchase. But quality can be hard to define. Although there are some features typically associated with quality merchandise, such as superior materials, top-notch design and durability, many elements of quality are product-specific, making a comprehensive definition elusive. The same is true for quality investments.

Investment Quality

Quality has no universally agreed-upon definition in finance, so it’s important to understand the unique contours of each quality-focused investment strategy. Many investment managers rely on financial data to identify quality attributes of stocks. For example, they may consider a stock’s return on equity (ROE), debt-to-equity ratio, accruals ratio and earnings variability when determining its quality. These types of measures are also used to construct the S&P 500^® Quality Index and the MSCI Quality Index.

Parnassus Investments’ evaluation of quality includes looking at statistics, but it also goes much deeper. Parnassus undertakes an intensive, holistic examination of each company under consideration for investment. For example, our investment team often meets with management and may even tour production facilities to learn as much as we can about the level of quality of a company before we invest and after we become shareholders. We view shareholders as company owners, and we only buy when we have developed a high level of confidence in the company and plan to hold their stock for a long period of time.

Stability and Profitability

Over time, the price of a stock is driven by the profits of the underlying company: companies with consistently healthy profitability will generate healthy returns and companies with below-average profits will find their stocks lagging. Solid financials, such as stable and growing revenues, dividends, earnings and cash flows, along with low levels of debt, are important indicators of past profitability. However, it is exceedingly difficult to estimate a company’s future profitability from their reported financials alone.   

Parnassus considers company financials as only one aspect of a multi-faceted approach to gauging the value of a company. Much of our attention is focused on meticulously evaluating the unique combination of features of each business to form a more complete view of its strengths and weaknesses in the context of its competitors, customers and the broader society.

This deep research ranges from developing a robust understanding of the company’s competitive advantages to considering how their operations may fare as the planet’s climate changes. We evaluate intangible attributes of a company, such as the long-term relevancy of its business model. We query management about their dividend payment plans, capital allocation strategies and earnings consistency. We also apply an ESG (environmental, social and governance) lens to obtain a more comprehensive view of the company. In addition to revealing investment opportunities, this ESG analysis helps us avoid risks related to a wide range of issues, such as natural resource depletion, customer boycotts, lawsuits and employee retention.

Three Pillars of Quality: Relevancy, Moat and Management

The Parnassus investment approach is organized around three pillars—relevancy, moat and management. This structure helps our team focus on the most important company attributes.

Relevancy

Our investment team determines whether a business is gaining or losing market share to help gauge its potential future relevance to customers. Our assessment of relevancy includes the following components:

• Industry growth rates
• Current market saturation
• Product substitution risks, including disruptive technology
• Secular trends that may affect sales over time
• Relationships with customers and the community

Moat

A quality company should be able to ward off competitors. We seek to understand the strength and persistence of each potential investment’s moat¹ to determine how likely it is to ward off competitors for an extended time by looking for characteristics such as:

• A high level of return on invested capital
• A strong network effect, such as a suite of compatible products
• Patents and regulatory licenses
• High customer switching costs
• An effective, well-known brand
• Low production costs relative to competitors

Management

We evaluate company management to determine whether executives and board members are good stewards of investor capital and are incentivized to prioritize long-term success. Ideally, a company will have low management turnover and a record of effective governance across economic environments. Some attributes of effective management include:

• Exhibiting strong business ethics, high integrity and transparency
• Prioritizing strategic investments in marketing and innovation
• Owning meaningful amounts of company stock
• Making thoughtful, effective capital allocation decisions
• Promoting efficient operations and appropriate investments in technology
• Maintaining positive records on ESG issues, such as fostering a good workplace culture
• Having a history of taking advantage of opportunities, managing risks and delivering on goals

Sample Profiles of High-Quality Companies

Instead of using a general formula to measure quality across all the companies in the investment universe, we closely evaluate each company’s unique set of attributes and how they relate to its relevancy, moat and management. As the following table illustrates, the most noteworthy features of quality may vary significantly from company to company.

Quality at a Good Price

Like the shopper who will look for the best price for a quality product, Parnassus will only buy a quality company if the price is right. High-quality companies are often expensive, because investors are prepared to pay more for their securities than for lower-quality alternatives. If a company we are considering is too expensive, we will patiently wait for the price to become more attractive. However, we are careful to avoid value traps, because we know some companies are cheap for a reason and likely won’t bounce back.

To determine whether a high-quality company is currently a good buy, Parnassus calculates an expected three-year rate of return for the stock based on low, high and base cases. When evaluating this range of outcomes, we look for companies that we expect will have a greater potential upside than downside. Our analysis gives equal importance to the range of possible outcomes as to the base case, allowing the investment team to evaluate the risk of permanent loss of capital. This risk may be relevant for companies in mature industries, for example.

Quality Strategies in Up and Down Markets

It is not a coincidence that quality-driven investment strategies gained credence in the aftermath of the dot com bubble collapse. Healthy businesses with the financial flexibility to sail through tough times help clients maintain confidence and stay invested in equities even when the market is rocky.

Like quality consumer goods, quality investments are designed for the long term. The distinctive advantage of high-quality strategies is that they can strongly outperform in falling markets and also continue to generate wealth when the market is rising. This pattern reflects the attributes of quality companies that maintain a consistent focus on earnings stability across the market cycle and leading positions in the marketplace.

A Confidence-Inspiring Approach

A thorough evaluation of quality requires more than tracking company data. In our experience, careful assessment of a company’s relevancy, moat and management is an effective way to identify high-quality companies. By thoroughly understanding a company’s level of quality and its expected range of valuation outcomes, we at Parnassus believe that we are positioned to pick winning stocks. This depth of research also creates a high level of conviction in each of our holdings, which results in a strategy that is designed to stay firmly on course regardless of market conditions.

Benjamin E. Allen, Parnassus Investments CEO and Parnassus Core Equity Fund Portfolio Manager

To learn more, visit www.parnassus.com or call (800) 999-3505.

¹ Warren Buffett uses the term economic moat, which evokes the image of a castle moat, to mean how well a business can protect its market share from competitors.

The views expressed in “A Focus on Quality Companies” 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. Mutual fund investing involves risk, and loss of principal is possible. The Parnassus Funds are underwritten and distributed by Parnassus Funds Distributor, LLC. 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.

The Parnassus Funds are underwritten and distributed by Parnassus Funds Distributor, LLC.