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July 19, 2006
Parnassus Small Cap Fund Identifies Unique Sustainability Characteristics to Outperform Russell 2000
    by Bill Baue

While the introduction of the Parnassus Workplace Fund a year ago piqued interest, the Parnassus Small Cap Fund unveiled at the same time is turning heads with strong financial performance.


A little over a year ago, Parnassus Investments launched three new funds: the Parnassus Small Cap Fund (ticker: PARSX), the Parnassus Mid-Cap Fund (PARMX), and the Parnassus Workplace Fund (PARWX). From a socially responsible investing (SRI) perspective, the workplace fund is novel and unique in screening primarily according to corporate treatment of their workforces, but looking at one-year financial tells a different story.

"The workplace fund is by far the most interesting of the three--it is the only fund I know of that focuses on workforce issues explicitly," said Jerry Dodson, founding president and chief investment officer of Parnassus. "Performance-wise, however, the only one that's really exceeded expectations is the small-cap fund."

The small-cap fund, which invests in companies at the larger end of the small-cap universe (under $3 billion), has generated one-year returns of 17.38 percent as of June 30, according to data provided by Thomson Financial Network. This places the fund in the 17th percentile, meaning that it outperformed 83 percent of its same-category peers (both SRI and non-SRI). Looking at year-to-date performance through the first two quarters, the fund places even higher--in the fifth percentile with returns of 11.80 percent.

Mr. Dodson places this performance in comparative context to its benchmark, the Russell 2000, which rose 8.21 percent year-to-date and 14.58 percent over the past year, for the period ended June 30.

"The Russell 2000 performance this year has been strong, but it's really been a tale of two quarters," Mr. Dodson told SocialFunds.com. "The first quarter, the Russell 2000 shot right up with very strong performance, and it stayed strong until May 10 when the Fed raised the interest rates, and then it really plunged a lot."

"Our returns in the first quarter were about the same as the Russell 2000, but in the second quarter when the Russell plummeted, we essentially stayed pretty flat," Mr. Dodson continued. In the second quarter, the Russell 2000 fell 5.02 percent. "So the main reason we're outperforming the Russell 2000 and other small-cap funds is because we kept up with them on the upside and we didn't take the plunge on the downside."

Mr. Dodson attributes this success more to intuition than intent.

"One reason for the fund's strong performance is that we look for companies that have some unique characteristic distinguishing them from competitors--I think this ended up giving the fund some stability and it also represents a more sustainable business model," said Mr. Dodson. "To tell you the truth, I wasn't smart enough to think of this strategy in my original conception of the fund--it was almost an existential phenomenon."

"I'm hoping this strategy will help us going forward if in fact the run of small companies comes to an end," he added, referring to recent suggestions from market analysts that large-cap funds may be replacing small caps as top performers.

Companies contributing most to this recent success include j2 Global Communications (JCOM), best known for its eFax product that transforms faxes into emails, which rose 32.9 percent during the second quarter, from $23.50 to $31.22.

"The stock was trading at depressed levels at the beginning of the quarter because of a possible Federal Communications Commission tax on phone lines J2 uses to turn faxes into emails," Mr. Dodson pointed out, referring to the FCC's Universal Service Fund (USF). "We went down and visited the company in San Diego and decided it was well managed and its employees were highly motivated, so we felt it meets our social criteria."

"Both sales and earnings increased substantially during the quarter, but really the FCC decision not to impose this special tax was probably the most important piece of the stock climbing higher," he explained. The USF is certainly a worthy program to support, as it advances the availability of quality telecommunications services to all consumers, including those in low income, rural, and insular areas. However, the FCC decided to levy the tax on Internet-based phone companies and by raising the current contribution level of cell-phone companies instead of applying a flat tax measure.

Another contributor to strong second quarter performance was Applied Films (AFCO), which makes equipment for producing architectural glass that turns the sun's heat into electricity. The company’s product clearly fills the fund's criterion that its holdings have a positive environmental impact. The stock rose 45 percent during the second quarter--from $19.43 to $28.32, when Parnassus sold it.

"The reason they climbed so high is they got a buyout offer from Applied Materials--so there was definitely luck involved there," said Mr. Dodson. The buyout went through on July 7.

Tower Group (TWGP), an insurance company that specializes in underwriting policies for small businesses (especially restaurants), rose 31 percent in the second quarter from $23.10 to $30.25.

"We invested in Tower Group because of its expertise in insurance for small businesses, which we regard as an underserved market," said Mr. Dodson. "Our thought was that the large insurance companies could not easily enter this market, as they did not have the knowledge or desire to do so--this of course represents the unique characteristic that provides stability to Tower's business."

JM Smucker (SJM), the familiar maker of jams and jellies, also had a strong run, rising 12.6 percent for the quarter from $39.70 to $44.70.

"They've been on the Fortune 100 Best Workplaces list for years and years," Mr. Dodson points out, marking an overlap between the Small Cap and Workplace Fund portfolios.

The Workplace Fund is up 2.32 percent year-to-date, placing it in the 43rd percentile. Over a one-year period ending June 3rd it is up 5.37 percent, placing it in the 74th percentile and underperforming the S&P 500 by more than three percentage points.

"We had higher hopes for the Workplace Fund, because when the people at Russell did an analysis for Milton Moskowitz, the Fortune list did better than the S&P 500 pretty consistently, year after year," said Mr. Dodson. "We do stock-picking within the Fortune 100 list--there are probably about seven or eight companies with strong workplace practices that we identified through our own research to put in our portfolio."

"We've been slightly outperforming the Fortune 100 Best list, which has been lagging the S&P 500," he added. "I'm still optimistic--it's still pretty early in the game."

 

 
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