Sponsored by Parnassus Investments
Parnassus is keenly focused on downside risks, and closely considers how the companies in our portfolios may hold up during a market downturn. We believe that managing downside risks is particularly important because if investors’ strategies remain aligned with their risk profiles across the market cycle, they should be more likely to maintain the course they have set for their portfolios.
Investments for the Full Market Cycle
For more than a decade, the stock market has experienced strong and steady growth, benefiting from the bull market that began in 2009. While speculation is rising that we are in the latter innings of this bull market, Parnassus does not attempt to predict when the market will turn. We expect, however, that a bear market will emerge at some point.
Our investment team carefully assesses companies to find those businesses that we believe are likely to maintain a high level of quality, regardless of whether markets are rising or falling. These types of companies have features that may help them capture a larger percentage of market gains on the upside than losses when the market tumbles, enabling them to potentially outperform over the full market cycle.
The Search for High-Quality Investments
Definitions of quality vary widely—as does the performance of quality strategies. Parnassus identifies high-quality companies by measuring the strength and durability of their moats (sustainable competitive advantages), evaluating their long-term relevancy, scrutinizing the effectiveness of their management teams and developing an understanding of their ESG risks and opportunities. Once our investment team has gained confidence that a company meets our quality criteria, we also consider valuation.
Wide Moats
We look for aspects of a company’s moat that we believe will enable it to successfully defend its market position and potentially gain market share when markets fall. Wide-moat companies with highly differentiated, dominant market positions may secure better pricing and profits for their products. These types of companies may also be able to continue to gain market share when the market moves downward, because they are supported by sustainable competitive advantages such as:
- High switching costs that make it very difficult for customers to move to a competitor
- Intangible assets, such as brands, patents and regulatory licenses
- Low cost advantages and the power to price more competitively than their peers
- The ability to scale effectively, which increases operational efficiency and makes it difficult for new entrants to compete for market share
- A sizeable network effect, increasing the value of the firm's products and services as its user base expands
Moats in Action
Cerner provides software, hardware and services to medical facilities that increase efficiency, reduce operational expenses and reduce costly errors.
We believe that this company can continue to compound earnings when the market is down, because it operates in an industry that depends on a unified system of electronic medical records. Cerner’s wide moat is supported by a strong network effect and high switching costs. Its software is deeply integrated into hospital operations, which locks clients into extended relationships given the significant costs and difficulty of revamping back-office IT infrastructure.
Republic Services is the second-largest waste management company and one of the largest recycling companies in the US, with sustainable earnings growth opportunities in our view. The company provides essential services that we believe are recession resilient. Its wide moat is supported by high switching costs, regulatory barriers and efficient scale.
Increasing Relevancy
If a company is positioned to be more relevant three to five years into the future than it is today, we believe it is likely to deliver sustainable earnings growth over time. Our team gauges a company’s potential future relevance to its customers by evaluating:
- The company's addressable market, including its size and projected growth, as well as industry growth rates
- Opportunities to sell the business's products and services to a larger portion of that addressable market
- Secular trends that impact sales over time, including the threat of disruption by new technologies
- The extent of which the company's offerings are mission critical for its customers, which may include its ability to secure long-term customer contracts
- The risk of substitution for other products and services
- The company's success with innovation to develop new products that are likely to be relevant in the future
Relevancy in Action
Synopsys is one of the largest global electronic design automation (EDA) players, offering innovative tools to develop complex semiconductor chips that we believe will be needed regardless of the market environment. Its mission-critical EDA software enables its customers to create and optimize the design of customized chips. The company benefits from cutting-edge innovation and a strong balance sheet with minimal debt. As chips become more complex, advanced EDA tools will be required by customers who seek to lower their design cost, improve chip performance, reduce their time to market and identify defects before chips are released.
Fortive, a diversified industrial growth company that was spun off from Danaher Corporation in 2016, provides mission-critical automation equipment and software applications. The company’s products, such as its Tektronix test and measurement equipment, are gaining relevancy as manufacturers rely on its technology to test a variety of renewable-energy applications, including electric vehicles, wind and solar energy, and batteries. The company has carved out dominant positions with its leading products that support its pricing power. Fortive also benefits from a seasoned management team that uses business systems to drive accountability, efficiency and innovation throughout the organization— attributes that should help bolster the company during a downturn.
Management with a Long-Term Vision
Another key feature of high-quality companies is an effective, strategic leadership team. Good stewards of investor capital are incentivized to prioritize the long-term success of the companies they lead, and preparing for hard times is a critical aspect of management’s responsibilities. Some of the features of successful management teams that may benefit a business when markets are volatile include:
- Thoughtful, effective capital allocation decisions that support sustainable growth
- Consistent dividends, which may offer some cushion when the market falls
- A good workplace, including an emphasis on talent development, retention, diversity and inclusion, and succession planning
- An independent board with appropriate structure, composition and board-member engagement
- An incentive-compensation structure aligned with the interests of the long-term shareholders and meaningful stock ownership requirements, creating 'skin in the game' for management
- A high level of transparency and clear goals for ESG performance to help avoid hidden risks and capture ESG-related opportunities
- Appropriate investments in efficiency, technology and innovation
Solid ESG Profiles
We believe high-quality companies with leading environmental, social and governance practices are likely to have fewer major controversies and a narrower range of adverse outcomes than their peers. Integrating ESG principles into core firm policies can widen a company’s competitive advantage and potentially increase its relevancy in the future. Examples of socially responsible practices that may support company resilience during adverse economic conditions include:
- Development of a highly engaged, diverse workplace with a dynamic, inclusive culture from the board level down to the shop floor
- Maintenance of a strong safety record for employees, suppliers, partners and contractors
- An emphasis on attracting, retaining and developing talent to support R&D, as well as a pipeline of new and innovative products and services
- Consistent disclosure of material ESG-related information and establishment of time-bound, measurable goals for ongoing improvements
- Robust data security and privacy protocols, as well as ethical sales and marketing practices to protect customers and the community
- Initiatives to assess climate risks to the company and reduce the company's carbon footprint, with goals for reduction of emissions that are aligned to science-based targets
- Programs to reduce the use of resources, such as water and energy, that help protect the environment while also reducing costs and increasing profits
ESG Integration in Action
Xylem sells energy-efficient pumps, water treatment products and filtration systems. The company holds a strong market position as a pure-play water technology company supported by long-term secular trends. The need to replace aging water infrastructure and use water more efficiently drives the company’s relevance. The company is focused on delivering sustainable growth across the market cycle and has set corporate goals to increase its speed of innovation.
Clorox is a global manufacturer of consumer and professional products with premium-priced brands like Brita Water and essentials that in our view will be recession resistant, including a wide array of household cleaning products. The company views diversity and employee engagement as a core part of its corporate strategy to drive innovation, productivity and safety. Clorox’s employee engagement rate is very high relative to its peers and its innovation, including its program to gather ideas from employees through crowd-sourcing innovation competitions, is expected to boost revenue growth annually in future years.1
Financial Indicators of Quality
In addition to our deep dive into the qualitative characteristics of each business, Parnassus evaluates each company’s financials to help determine its level of quality. Two important aspects of this research include evaluating the level of debt and determining how effectively the company puts capital to work over time.
Pristine balance sheets and lower leverage are particularly valuable assets for companies during downturns, when their lower-quality peers may be highly levered. Companies with significant leverage may struggle to cover their debt obligations during periods of economic declines and are at higher risk for bankruptcy.
In contrast, companies whose leaders are thinking multiple years into the future are likely to construct a strategy that aims to deliver substantial organic growth, even during hard times. These companies may have modest amounts of debt, but it’s matched with resilient earnings and durable cash-flow streams to support interest payments.
Return on invested capital (ROIC) is another indicator of companies with defensible positions in their respective marketplaces. ROIC measures a company’s level of efficiency in generating income.
If the company is able to consistently generate a high level of income from the capital that it deploys relative to the cost of that capital, it likely has a wide moat and should be able to generate attractive returns for shareholders across a full economic cycle.
The Staying Power of Quality
Our investment team carefully assesses all of these aspects of quality to construct a holistic picture of each business that reveals its unique attributes. This comprehensive analysis allows our team to make investment decisions with a high level of conviction that the selected companies will remain competitive and relevant across the market cycle— and prove their mettle most compellingly during market downturns.
Lori Keith
Parnassus Investments Portfolio Manager
Parnassus Mid Cap Equity Fund
To learn more, visit www.parnassus.com or call (800) 999-3505.
Issue published January 2020.
1 Clorox 2019 Analyst Day (October 1 2019) and 2019 Integrated Annual Report.
Important Information
For the current holdings of the Parnassus Fund, the Parnassus Core Equity Fund, the Parnassus Endeavor Fund, the Parnassus Mid Cap Fund and the Parnassus Fixed Income Fund, please visit each fund’s individual holdings web page. Current and future portfolio holdings are subject to change.
As of 12/31/19, Cerner (CERN) represented 2.0% of the TNA of the Parnassus Core Equity Fund, 3.4% of the TNA of the Parnassus Mid Cap Fund and 3.2% of the TNA of the Parnassus Fund. Holdings are subject to change.
As of 12/31/19, Republic Services (RSG) represented 3.3% of the TNA of the Parnassus Mid Cap Fund. Holdings are subject to change.
As of 12/31/19, Synopsys (SNPS) represented 2.0% of the TNA of the Parnassus Core Equity Fund and 2.2% of the TNA of the Parnassus Mid Cap Fund. Holdings are subject to change.
As of 12/31/19, Xylem (XYL) represented 1.8% of the TNA of the Parnassus Core Equity Fund, 3.0% of the TNA of the Parnassus Mid Cap Fund and 1.1% of the TNA of the Parnassus Fixed Income Fund. Holdings are subject to change.
As of 12/31/19, Clorox (CLX) represented 3.2% of the TNA of the Parnassus Core Equity Fund, 2.3% of the TNA of the Parnassus Mid Cap Fund and 1.2% of the TNA of the Parnassus Fixed Income Fund. Holdings are subject to change.
As of 12/31/19, Fortive Corp. (FTV) represented 2.7% of the TNA of the Parnassus Mid Cap Fund and 1.3% of the TNA of the Parnassus Fixed Income Fund. Holdings are subject to change.
Past performance does not guarantee future performance or results. Mutual fund investing involves risks, and loss of principal is possible. There are no guarantees any investment strategy, including a socially responsible (ESG) investment strategy, will be successful in any market environment.
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.
