October 28, 1996
Dear Shareholder:
As of September 30, 1996, the net asset value per share (NAV) of the
Parnassus Fund was $30.92 so the return for the third quarter was a loss of
3.83%. This compares to a gain of 3.09% for the S&P 500 and 2.90% for the
average growth fund according to Lipper Analytical Services. We underperformed
both the S&P and the average growth fund for the quarter. Below you will find a
table summarizing our average annual returns as of September 30, 1996 for the
one, five and ten-year periods and for the life of the Fund. The overall return
figures give investment performance only while the total return figures are
reduced by the amount of the maximum sales charge.
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Average Annual Average Annual
Total Return Overall Return
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One Year ........................ (16.34%) (13.30%)
Five Years ...................... 13.53% 14.34%
Ten Years ....................... 10.58% 10.98%
Since Inception on 12/31/84 ..... 10.82% 11.15%
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COMPANIES MAKING AN IMPACT ON THE PORTFOLIO
The reason we had a loss for the quarter was because nine of our
companies had stock market declines of 10% or more. Although we had a number of
stocks that did quite well in the quarter, declining issues overwhelmed the
gainers. Of the nine that had substantial losses, three were technology issues
and the others came from the following industries: retail, medical, airlines,
specialized chemical and oil.
Our biggest disappointment during the quarter was Mentor Graphics which
lost an incredible 45.4% during the quarter as its stock went from $16.25 to
$8.88. Mentor is a company with positive social characteristics including an
award from Working Mother magazine for its family-friendly policies. From a
business standpoint, the company also has some excellent products: software for
use in designing electronic circuits. For example, the independent research
firm, Dataquest, named Mentor as the world's leading supplier of design-for-test
software.
On September 26, the company announced that its earnings and revenue
would be weaker than expected and below the quarter of a year ago. This caused a
sharp decline in the value of the stock. As of this writing, Mentor has not
released its complete financial results, but we feel the company's recent
acquisition have depressed earnings. More often than not, problems develop when
one corporation acquires another; unexpected expenses pop up and sales are not
as strong as they first appeared. We are now in the process of evaluating our
position in Mentor.
Genus, the maker of semiconductor production equipment, dropped 32.5%
during the quarter as its stock went from $9.63 to $6.50 per share. At the
present time, there is overcapacity in the semiconductor chip industry and
prices have dropped by huge margins. Semiconductor companies are losing money
and, consequently, they are purchasing less equipment from companies like Genus.
Although sales are weak, Genus still has excellent technology.
Wellman, the nation's largest recycler of plastic, saw its stock
decline 25.1% as it went from $23.38 to $17.50. Wellman's main product is
textile fiber and worldwide demand for fiber has declined sharply with Europe
being especially weak. At $17.50 a share, the stock is an absolute bargain and
we expect a recovery of this well-managed company as demand for fiber improves.
The Sun Company's shares decreased 24.3% during the quarter as the
stock went from $30.38 to $23.00. Of all the oil companies, Sun has shown the
most respect for the environment as evidenced by its signing the CERES
Principles of environmental conduct. Sun does not produce oil, but instead
refines and markets petroleum products. As the spread between the cost of crude
oil and the price of refined gasoline declined during the quarter, Sun's
earnings have been hurt. Refining margins have dropped to a very low $3 per
barrel. Over the next six months, we expect margins to improve. Sun's stock
should rise in value.
Calgon Carbon, the producer of activated carbon for use in purifying
food and water, had a 23.2% decline in its share price. Weakness in its European
markets as well as an increase in natural gas prices (its principal fuel) hurt
earnings. If the European economy picks up as I expect and if Calgon is able to
increase its prices somewhat, the stock should be able to rebound.
Southwest Airlines, one of the best managed airlines, had a 21.5% drop
in its share price for the quarter. Rising fuel prices and the reinstatement of
the airline ticket excise tax hurt the company's earnings. During the quarter,
maintenance costs increased as the company overhauled a large number of its
aircraft engines. Another interesting twist was Southwest's 25th anniversary
celebration where the company offered deeply-discounted fares. Because of this
promotion, the company's phone lines were so jammed up that many regular
customers could not get through and revenue suffered.
Sunrise Medical's stock dropped 17.5% during the quarter, going from
$19.25 to $15.88. Tandem Computers saw its share price decline 13.1% as it
dropped from $12.38 to $10.75. Finally, The Limited had an 11.1% decline as its
stock went from $21.50 to $19.13.
SIX WINNERS
Fortunately, not all the news was bad during the quarter. Six of the
companies did extremely well. Three of the companies were tied to the current
positive phase of the construction cycle: an office furniture company, a
residential furniture company and a building products company.
Herman Miller's stock increased 32.2%, going from $30.63 to $40.50. The
company now has its costs under control and its international divisions are
performing better. New designs for office furniture have gained consumer
acceptance and revenue is increasing at a substantial pace.
Ethan Allen, the residential furniture company, saw an increase of
25.8% in its stock price as it went from $24.75 to $31.13. The company has
remodeled most of its stores and it has also developed new furniture styles that
appeal to younger buyers.
Quantum Corporation had a 20.1% increase in its stock price as it went
from $14.63 to $17.56. The company makes disk drives and other computer storage
products. Its high-end storage products are selling quite well and the strong
demand for personal computers means more demand for disk drives.
Morgan Products went up 17.7% in the quarter as its stock rose from
$6.38 to $7.50. Demand for Morgan's doors, windows and other products was strong
during the quarter, but much of its improved earnings came from cost control.
The company sold a plant in Kentucky and consolidated its manufacturing
operations in one efficient plant in Oshkosh, Wisconsin.
Sullivan Dental Products increased 9.9%, going from $10.13 a share to
$11.13. Increasing demand for its products and a better sales force helped
Sullivan. Advanced Micro Devices saw its stock increase 8.3% as investors
anticipated a seasonally strong fourth quarter, pushing up the stock from $13.63
to $14.75.
CONFESSIONS OF A CONTRARIAN
For the five years ending on June 30, 1995, the Parnassus Fund was one
of the top-performing mutual funds in the country, far outdistancing the S&P 500
by averaging over 19% per year. For the first half of 1995, the Parnassus Fund
was up about 15%. During the second half of 1995, though, the roof caved in and
we lost almost all that we made. While the average growth fund was earning
around 30% for the year, the Parnassus Fund gained only 1%. For the year-to-date
in 1996, things are not much better as we're down 2.7% while the average fund is
up around 13%.
What caused this surprising and shocking turn of events? The quarterly
reports have given you a blow-by-blow and a company-by-company description, but
I would also like to take a somewhat more philosophical turn and write about
something that can best be called "Confessions of a Contrarian."
Parnassus is a contrarian fund so we buy stocks that are out of favor
with Wall Street. Essentially, we're bargain-hunters. Because the stock market
is always going to extremes---first overvaluing and then undervaluing a
company---we hope to buy stocks when they're undervalued and sell them when
they're fully valued or overvalued. Our aim is to achieve above average
performance.
For most of the Fund's history, the strategy worked quite well. We were
long-term investors. We did a great job of identifying undervalued companies.
Each year, enough of those companies bounced back into favor so that the Fund
chalked up excellent returns. We didn't have a lot of turnover---only around 30%
per year compared to the growth fund average of 100%---and this helped save on
expenses.
One thing that I haven't emphasized in these quarterly reports before
is that it only takes spectacular performance by a few companies to achieve
excellent overall returns. Each year, most of the portfolio companies were stuck
in the mud while a relatively few companies made the portfolio soar.
At this point, you may be saying to yourself, "Why is that such a
secret? Most good portfolio returns are built on the backs of just a few stocks.
That's true of most mutual funds. Besides, it's no secret to shareholders since
each quarterly report discusses the best-performing companies and it's clear
from these reports that just a few stocks moved the portfolio."
That's all true, but that's not the confession. The "confession" is
that most of the portfolio's stocks were pretty mediocre performing companies
and we stuck with them too long. These were certainly undervalued companies, but
they stayed undervalued---usually for a very long time.
I assumed they would come back into favor, but they never did. Those
stocks stayed undervalued year after year after year. Because these stocks were
stuck in the mud, other issues had to do all the heavy lifting. Although I was
dimly aware of this, I never made it a priority to weed out these companies
since they were not overvalued. Because these companies were not overvalued and
because our fund was long-term oriented, I figured that there was no reason to
hurry and sell them off since our performance was fine.
By the middle of 1995, though, these companies comprised a very
substantial portion of the portfolio---over 50%. While we sold off our winners
as they appreciated, we held on to those that were stuck in the mud.
This abundance of mediocre performers, though, would not have hurt us
that much had not two other things happened. First, we didn't have as many
winners as we normally had during late 1995 and early 1996. The other
significant thing was that we had a number of disasters during this most recent
period---far more than we have ever had before.
I don't want to recount all the disasters we've had, but an example
would be Mentor Graphics in the current quarter. Another would be Sunrise
Medical when it dropped 48.9% from January 1, 1995 to October 27, 1995. On
October 26, the CEO announced that the company had discovered one of its
divisions had inflated assets and earnings for several years. Fraudulent
accounting induced panic selling.
Apple Computer would be another example. In the summer of 1995, sales
of its new Power Macintosh were strong and the company was doing well. Then
because of poor management, the company failed to control costs, produced too
many low-end Macintoshes and not enough high-end ones so that the company had
simultaneous shortages and inventory gluts---a remarkable feat.
Finally, there was the case of CML, the parent of Nordic Track, the
Nature Company and Smith & Hawken. CML had traded as high as $32 per share in
1993, hit a high of $22.50 in 1994 and had dropped to $10 a share when Parnassus
first considered the stock. Our average cost in the stock was $8.00 a share, but
we lost 36% when it dropped to $5.13 a share before we sold. These examples will
give you a flavor of some of the things that happened over the past 15 months.
A reasonable way to explain our recent performance is to cite these
disasters and the unusual absence of big winners. However, there's no guarantee
that we won't have more disasters in the future. It's unlikely that they will
ever be as concentrated as they've been over the past 15 months, but we're
certain to have some again in the future. No matter how careful one is, it's
impossible to avoid them completely.
The same thing applies to our winners. We'll continue to pick our share
of top-performing companies, but there will undoubtedly be stretches again in
the future when we'll have few real winners.
Given this reality, we have to get better performance out of the rest
of our portfolio. We can't afford to hold onto these mediocre performers year
after year. Although we still hope to have relatively low turnover and we still
consider ourselves long-term investors, we have to start looking at our
companies in a different light.
As of this year, we've adopted a policy of not investing in a company
unless we see a catalyst that will improve earning in the next 12 months. If we
think it will take longer than 12 months, we'll postpone our investment. If a
current holding reports poor results and we don't feel earnings will rebound
within a year, we'll sell the stock.
This is a substantial departure from our previous policy of prior
years. Before, we would apply our ratios, determine if a stock were undervalued,
check the social criteria, then invest. We didn't pay enough attention to the
immediate outlook.
We've started implementing this policy in the first part of 1996. This
policy doesn't mean that all our stocks will go up within 12 months. Far from
it. Some will go down and some will stay the same. Our plan is to determine if
some catalyst will emerge in the ensuing 12 months to improve performance. This
policy should help to prevent us from holding the same mediocre performers for
years.
COMPANY NOTES
The Sun Company reports that its environmental efforts are bearing fruit.
For 1995, highlights included:
---a reduction of more than 50% in toxic emissions under the EPA's
voluntary 33/50 program
---a 41% reduction in oil spills of ten barrels or more
---a 16% reduction in Sun's OSHA recordable incident rate
---a 45% reduction in the number of times Sun facilities exceeded the
permitted level of air emissions
---a 51% reduction in waste water permit exceedences
---a 90% reduction in fire losses.
Toys "R" Us has joined the American Academy of Pediatrics and Allstate
Insurance Company to promote child passenger safety in vehicles. Allstate will
distribute "$5 off" coupons for child safety seats and Toys "R" Us will honor
the coupons.
FALL INTERNS
Jane Liou is a senior in business administration at the University of
California at Berkeley. She has served as vice president and treasurer of the
Undergraduate Finance Association. Previous experience includes work as a hedge
fund intern at Cannell Capital Management in San Francisco and research work
with Litman/Gregory in Orinda, California. She has also served as a volunteer
tutor for elementary school students in Oakland.
Howard Ting is also a senior in business administration at the
University of California at Berkeley where he is a member of Pi Alpha Phi
fraternity and a member of Cal Team Tennis. His experience includes work as a
research assistant to Professor Miguel Cantillo on the German economy and the
banking industry as well as work in comparative economic development for the
United States, Great Britain and Germany. He has also worked as an electronic
brokerage intern for Charles Schwab and as an audiovisual technician for Photo &
Sound Company in San Francisco.
Heidi Chu is majoring in molecular and cell biology at the University
of California at Berkeley where she is a senior. At UC, she is a member of the
Korean Students Association and the Molecular and Cell Biology Undergraduate
Student Association. Her work experience includes a stint as a research
assistant in a laboratory doing DNA work as well as working as a swimming
instructor at UC Medical School and as a salesclerk at the Cannery Kid in San
Francisco.
GOOD STEWARDSHIP
Finally, I would like to say that I realize that improvements have to
be made in the stewardship of your money. We are working hard to improve our
management skills. I appreciate your understanding during this difficult period
and we'll do our best to improve the Fund's performance.
Yours truly,
Jerome L. Dodson
President
THE PARNASSUS FUND: Portfolio as of September 30, 1996
Number
of Shares Issuer Market Value Per Share
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310,000 ATC Environmental, Inc. $ 3,991,250 $12.88
71,900 Acme Metals, Inc. 1,231,287 17.13
750,000 Advanced Micro Devices, Inc. 11,062,500 14.75
5,000 Aetna, Inc. 351,875 70.38
340,000 Apple Computer, Inc 7,543,750 22.19
180,000 Calgon Carbon Corporation 1,867,500 10.38
800,000 Cypress Semiconductor Corporation 10,000,000 12.50
600,000 Electro Scientific Industries 10,950,000 18.25
260,000 Ethan Allen Interiors, Inc. 8,092,500 31.13
902,500 Genus, Inc. 5,866,250 6.50
381,000 H.B. Fuller Company 14,573,250 38.25
150,000 Herman Miller, Inc. 6,075,000 40.50
80,000 Hewlett-Packard Company 3,900,000 48.75
80,000 Houghton Mifflin Company 3,770,000 47.13
400,000 Inland Steel Industries, Inc. 7,150,000 17.88
700,000 Integrated Device Technology, Inc. 6,956,250 9.94
530,000 The Limited, Inc. 10,136,250 19.13
450,000 Liz Claiborne, Inc. 16,762,500 37.25
620,000 Mentor Graphics Corporation 5,502,500 8.88
97,500 Merix Corporation 1,876,875 19.25
940,000 Morgan Products, Ltd. 7,050,000 7.50
615,000 Quantum Corporation 10,800,938 17.56
200,000 Ryerson Tull, Inc. 2,775,000 13.88
880,000 Sequent Computer Systems, Inc. 11,440,000 13.00
160,000 Southwest Airlines Company 3,660,000 22.88
600,000 Sullivan Dental Products, Inc. 6,675,000 11.13
154,700 Sun Company, Inc. 3,558,100 23.00
160,000 Sunrise Medical, Inc. 2,540,000 15.88
492,000 T. J. International, Inc. 8,979,000 18.25
850,000 Tandem Computers 9,137,500 10.75
520,000 Toys "R" Us, Inc. 15,145,000 29.13
125,000 United Healthcare Corporation 5,203,125 41.63
430,000 Wellman, Inc. 7,525,000 17.50
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Total Portfolio $232,148,200
Short Term Investments and
Other Assets 12,286,179
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Total Net Assets $244,434,379
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The Net Asset Value as of
Septermber 30, 1996 $ 30.92
