Wednesday, March 1, in New York City, I interviewed Master Investor Jerome Dodson, CEO and founder of The Parnassus Funds. The Parnassus Funds under the leadership of Jerry Dodson have built one of the most impressive performance records in the investment business, generating superior returns over the last one, three, five, ten and twenty-five years. According to Barron’s, the Parnassus Endeavor Fund is one of only four domestic stock funds to accomplish superior returns with such consistency. The fund has a five-year annual return of 17.8% versus 14.1% for the S&P 500.
The Parnassus funds have accomplished these returns following simple investment principles: invest in companies with exceptional long term profitability during periods of temporary adversity, or when the market is negative about the prospects of an entire sector, and focus on companies that are socially responsible, in particular that are good places to work, that treat their employees well. In part, this approach evolved out of studies of the investment performance of Fortune’s list of the best 100 companies in the country to work for — they outperformed the market by one to two percent, on average, consistently, over long periods. In our interview, I explored the investment principles behind the Endeavor Fund, as well as the individual holdings in the fund — what positions Jerry feels best about, and which ones concern him.
Rod MacIver: What do you look for in potential investments?
Jerry Dodson: There are two crucial considerations. One, we look for companies that are out of favor, that are selling at low prices compared to their five-year historic average price to earnings, price to sales, price to cash flow, price to book value. The second thing we look for are companies that are good corporate citizens and that have good environmental policies. We look at charitable contributions. Most importantly, we look at how a company treats its employees. We try to invest in undervalued companies that we think are good citizens and that are socially responsible.
Rod MacIver: Average price earnings, price sale, price book over the last, what period of time?
Jerry Dodson: Five years. If the average five-year PE ratio is 15, and now the stock is selling at 14 or below, it’s a candidate. If the average PE is 21, and now it is trading at 19, it is cheap on a relative basis.
Rod MacIver: I see. If it falls further … let’s say it falls 50% from where you buy it. You have been investing long enough that that must have happened at least a few times.
Jerry Dodson: Unfortunately, it has. Just because it is out-of-favor and trading at five year lows, doesn’t mean it can’t go lower. We look at it again to see if the fundamentals are still intact. We look at the qualitative; what Warren Buffett calls “moat”. Of course, we exclude certain areas: tobacco, alcohol, gambling, and, in my fund, fossil fuels.
Rod MacIver: How about military suppliers?
Jerry Dodson: There’s a good question. Because we don’t want to give the idea that we’re anti-military. The military keeps America …
Rod MacIver: You like living in America.
Jerry Dodson: Exactly! Safe and free! We don’t want to invest in weapons manufacturers, which have a lot of different problems. If they’re making, say, uniforms for the military, or they’re selling canned foods or something like that, that’s fine.
Rod MacIver: Yes. Okay, so if it falls, you look at it again, review it, and if the fundamentals appear reasonable and it’s now down 50%, you buy more, and if it’s not, you sell it, and move onto the next thing.
Jerry Dodson: Exactly.
Rod MacIver: Holding period, on average?
Jerry Dodson: The average is about three years, but of course it varies from time to time. Sometimes, it’ll go up in a year and we sell it. Sometimes, we should have sold sooner and we didn’t. For instance, Whole Foods. We bought in the low $30s. It promptly went to $60, but we’d held it less than a year so to take a capital gains tax, not an ordinary tax, we held on. Was that a mistake. It promptly plunged back, below where we originally bought it. That was within a year. Typically, you don’t have that happen.
Rod MacIver: Would you ever hold a stock for decades?
Jerry Dodson: Not that long. We sell when a stock reaches what we calculate as intrinsic value. It’s rare that we hold more than three or four years.
Rod MacIver: Yes, and it appears from what you’ve said, that you won’t pay a premium for growth unless it’s reflected in the historic five-year average PE, price book, price to sales, etc. Right? You wouldn’t for instance, apply the Benjamin Graham valuation formula for growth stocks as outlined in the 1962 edition of Security Analysis, which proposes appropriate PE ratios for companies based on historic growth rates. They range from nine to 48.4 basically. He’s looking at historic growth rates, but not looking at historic PE ratios. Your approach is fascinating to me. That’s why I’m re-exploring it. Of course, the most standard, widely used, difficult to use well ratio, is the PEG ratio. Price earnings to growth, so if a company is growing at 10%, the PEG ratio is ten times. If it’s growing at 50%, then the appropriate PE ratio is 50, according to the theory. That doesn’t enter into your analysis, correct?
You can read the entire interview [HERE].
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