As of June 30, 2019, the net asset value (“NAV”) of the Parnassus Endeavor Fund (Trades, Portfolio) – Investor Shares was $34.16, so the total return for the quarter was a slight loss of 0.09%. This compares to a 4.30% gain for the S&P 500 and 3.67% for the Lipper Multi-Cap Core Funds Average, which represents the average return of the multi-cap core funds followed by Lipper (“Lipper average”). For the first half of the year, the Parnassus Endeavor Fund (Trades, Portfolio) – Investor Shares was up 18.32% compared to a gain of 18.54% for the S&P 500 and 17.26% for the Lipper average. After a terrific start to the year in the first quarter, we slumped in the second quarter, but for the year-to-date, we remain ahead of Lipper and we’re essentially tied with the S&P 500.
Below you will find a table comparing the returns of the Fund with the S&P 500 and the Lipper average for the one-, three-, five- and ten-year periods. Because of our loss last year, we’re behind both indices for the one-year period, and we’re behind the S&P 500, but ahead of the Lipper for the three-year period. We’re ahead of both measures for the five- and ten-year periods, so we still have strong long-term performance.
Right now, a very large number of the stocks in the portfolio are trading far below their intrinsic value. Quite often, when this has happened in the past, the Fund has moved sharply higher. There is, of course, no guarantee that this will happen in the near future, but we remain positive for our portfolio, given the difference between our estimate of its intrinsic value and current market quotations.
Second Quarter Review
There were six stocks that each reduced the Fund’s return by 35 basis points or more. (A basis point is 1/100th of one percent.) Three stocks increased the Fund’s return by that amount.
Our worst performer was Regeneron Pharmaceuticals (REGN, Financial), a biotechnology company that makes treatments for eye and heart diseases, cancer and inflammation. Regeneron cut 108 basis points from the Fund’s return, as its stock plunged 23.8% from $410.62 to $313.00. (For this report, we will quote total return to the portfolio, which includes price change and dividends.) Investors feared the company’s blockbuster drug Eyelea would lose market share after the FDA prioritized approval for a competing drug developed by Novartis. Higher contract manufacturing and R&D costs, as well as lower reimbursements from Sanofi, Regeneron’s development partner, also pushed the stock lower. The company’s own pipeline progress is encouraging, however. The FDA approved two of Regeneron’s medications—Dupixent, for adolescent atopic dermatitis, and Praluent, which reduces the chance of heart attack and stroke in at-risk adult patients.
Alliance Data Systems (ADS, Financial), the leading private-label credit card issuer, subtracted 64 basis points from the Fund’s return, as the stock sank 19.6% from $174.98 to $140.13. The shares fell after the company sold its marketing segment, Epsilon, for net proceeds of $3.5 billion, which was below investors’ expectations. The stock fell again later in the quarter after the company’s long-time CEO, Ed Heffernan, retired abruptly. We’re excited that Melisa Miller has been promoted to CEO, and we believe she can reinvigorate the company. We expect the stock to move significantly higher as Alliance Data repurchases stock with proceeds from the Epsilon sale and its loan growth accelerates, thanks to recent partnership wins with Sephora, Burlington Stores and IKEA.
Clothing and accessories retailer GAP (GPS, Financial) slashed 59 basis points from the Fund’s return, as its stock fell 10.8% from our average cost of $20.14 to $17.97. Sales at GAP’s comparable stores experienced their biggest declines in three years, due to cold and wet weather and poor merchandising decisions. A dramatic restructuring of the business is underway, as management plans to close hundreds of underperforming stores and spin off Old Navy into an independent company to unlock shareholder value.
Toy manufacturer Mattel (MAT, Financial) sliced 45 basis points from the Fund’s return, as its stock slid 7.7% from $13.00 to our selling price of $12.00. In April, the company recalled all models of its Fisher-Price Rock n’ Play sleepers, after the product was linked to over 30 infant deaths. This safety failure exposed key lapses in the company’s enterprise risk management systems and their tragic, real-world consequences. Given the risks of further reputational damage to the company’s brands amid ongoing product liability lawsuits, we sold all our shares.
NVIDIA (NVDA, Financial) subtracted 36 basis points from the Fund’s return, as its stock fell 8.4% from $179.56 to $164.23. The company makes graphics processing units (GPUs), which are customized chips central to gaming, machine learning and autonomous driving applications. The stock fell after sales to data centers disappointed for the third consecutive quarter. Management also withdrew its financial targets, dampening expectations that a demand recovery was imminent. We see upside to the stock, as demand recovers and NVIDIA integrates its March purchase of computer networking company Mellanox Technologies.
Micron Technology (MU, Financial) cut 35 basis points from the Fund’s return, as its stock fell 6.6% from $41.33 to $38.59. Prices for Micron’s dynamic random-access memory chips (DRAMs) continued to decline, indicating that the memory market is oversupplied. The trade war with China and export ban on Chinese technology company Huawei also pressured the stock, since Huawei is a big customer of Micron’s. We believe the impact of the ban will be fleeting, as global supply chains have already begun to adjust. Long-term, demand from data centers and the Internet of Things (IoT) should drive sales of Micron’s vital chips for years to come.
Our biggest winner this quarter was Qualcomm (QCOM, Financial), the leading manufacturer of mobile phone chips. It contributed 110 basis points to the Fund’s return, as the stock soared from $57.03 to $76.07 for a total return of 34.6%. The stock saw its biggest one-day jump in nearly 20 years after Qualcomm reached an agreement with Apple to settle all litigation between the two companies worldwide. The years-long dispute centered around what royalties Apple should pay for the chip that powers the Apple iPhone. Ultimately, Apple paid Qualcomm for the chips it received, and further agreed to long-term license and supply agreements. Though Qualcomm’s victory was later tempered by antitrust rulings in the U.S. and EU, we applaud management’s commitment to R&D, and believe the stock has more upside in the years ahead.
Applied Materials (AMAT, Financial) increased the Fund’s return by 93 basis points, as its stock soared from $39.66 to $44.91, for a total return of 13.8%. Applied is the world’s leading supplier of manufacturing equipment, software and services for the semiconductor industry. Sales and profits came in better than feared, suggesting a stabilization in industry demand drivers such as high-performance computing, artificial intelligence and big data. Last month, Applied bought Japanese semiconductor manufacturing company Kokusai Electric to strengthen its position in the memory market in Asia. The deal’s sound strategic and financial merits also sent the stock higher.
Cummins (CMI, Financial), a leading maker of diesel engines for trucks, added 42 basis points to the Fund’s return. Its stock rose from $157.87 to $171.34, for a total return of 9.3%. Although total orders for Class 8 trucks fell during the first half of the year, the company’s profits grew due to an increase in off-highway sales and lower warranty charges. Profits were also less impacted by President Trump’s tariffs than initially feared, since the company had diversified some of its alternator production away from China.
Outlook and Strategy
Most of the short-term movements in the U.S. stock market over the past year have been caused by changes in U.S.-China economic relations. When relations appear to be improving, stocks move higher. When relations are deteriorating, stocks move lower, as happened in the fourth quarter of last year. Right now, relations are reasonably good, so the stock market is at an all-time high. The two sides are talking to each other, but there are significant fundamental differences that will be difficult to bridge. The U.S. wants a firm, written agreement that will allow Americans free access to the China market for manufactured goods, financial services and agricultural products. Xi Jinping is saying, “We’ll do all that, but we don’t need to write it all down. Just trust us.” The Americans are justifiably skeptical, pointing to the $400 billion-dollar trade deficit and all the restrictions that China places on American goods and services.
There are strong pressures on both leaders. The United States is a major market for Chinese products and an enormous percentage of the Chinese workforce is engaged in making products to send to America. The already-weakening Chinese economy could be thrown into a depression if America sharply decreases its imports from China. Although the U.S. could not manufacture most of the goods at the reasonable prices that we receive on Chinese imports, there are other countries that would love to fill the void—most notably Vietnam. The Vietnamese have developed the technology and the workforce to manufacture most of the items that America now imports from China. Xi Jinping realizes this and wants to settle the dispute, but he can’t appear weak or look like he’s capitulating to the Americans.
On the other hand, the American President faces pressures of his own. The Chinese have reduced the amount of U.S. agricultural products they import from the U.S.—most notably soy beans, which are an important part of the Chinese diet. American farmers are feeling the pressure, and farm group representatives are talking to the Chinese right now to induce them to buy more American farm products. Most of the states in the U.S. farm belt are swing states. If conditions don’t improve, they would probably vote against Trump in the next election, and he is well aware of this.
Also, American industrial and financial firms want support to expand in China, and if Trump is unable to help them, he will lose their support. Right now, the Chinese have stacked the deck against American businesses, prohibiting entry into certain sectors and forcing technology transfers in advanced manufacturing. If Trump can’t wring significant concessions from the Chinese, the business community will most likely turn against him. Given this situation, both sides are highly motivated to make a deal.
How does all this relate to the stock market and the Parnassus Endeavor Fund (Trades, Portfolio)? The U.S. stock market is trading at an all-time high, but the Parnassus Endeavor Fund (Trades, Portfolio) is not. In our view, our stocks are trading far below their intrinsic value. For example, the price/ earnings (P/E) ratio* of the S&P 500 is 20.5 times based on earnings for the last 12 months, while the P/E ratio for the stocks in the Parnassus Endeavor Fund (Trades, Portfolio) are trading at only 11.9 times last year’s earnings. This is an enormous difference, so it’s one indication that our stocks may outperform the market going forward, or at least it’s an indication that our stocks are selling at bargain prices compared to the market as a whole.
Right now, the American economy is very strong. Unemployment has been below 4% for more than a year now, and at 3.7%, it’s close to a historic low. Job growth is strong, with 224,000 new jobs created in June. Household income and spending are up, while consumer confidence is strong. Business investment has slowed down, but I suspect that’s because of the trade tensions with China and the stock market sell-off late last year.
For all the reasons we’ve outlined here, we expect the U.S. and China to reach agreement. This should help to keep the economy moving along quite well, and it should help the stocks in the Parnassus portfolio.
Yours truly,
Jerome L. Dodson Billy Hwan
Lead Portfolio Manager Portfolio Manager
