THE PARNASSUS FUND
QUARTERLY REPORT
SEPTEMBER 30, 1997
October 30, 1997
Dear Shareholder:
As of September 30, 1997, the net asset value per share (NAV) of the
Parnassus Fund was $51.43 so the overall return for the quarter was 21.87%. This
compares to a return of 7.48% for the S&P 500+ and a return of 10.61% for the
average growth fund according to Lipper Analytical Services. For the fourth
consecutive quarter, we've outperformed both the S&P and the average growth
fund. During the quarter, we earned double the return of the average growth fund
and almost triple the return of the S&P. For the year-to-date, we're up 49.55%
compared to 30.96% for the S&P and 26.65% for the average growth fund.
Our most significant milestone, however, is our performance over the past
12 months where we've gained 71.61% compared to 40.44% for the S&P and 33.52%
for the average growth fund. Over the past 12 months, the Parnassus Fund has
outperformed the average growth fund by an astonishing 38.1 percentage points
which for the past year makes us the nation's no. 1 growth fund out of the 784
growth funds followed by Lipper Analytical Services*.
Below you will find a table summarizing our average annual returns as of
September 30, 1997.
<TABLE>
- --------------------------------------------------------------------------------
<CAPTION>
Average Annual Average Annual
Total Return Overall Return
- --------------------------------------------------------------------------------
<S> <C> <C>
One Year 65.60% 71.61%
Five Years 21.47% 22.34%
Ten Years 12.87% 13.27%
Since Inception 12/31/84 14.68% 15.00%
- --------------------------------------------------------------------------------
<FN>
The overall return figures give investment performance only while the total
return figures are reduced by the amount of the maximum sales charge (3.5%).
Past performance is no guarantee of future returns. Investment return and
principal value will fluctuate and an investor's shares, when redeemed, may be
worth more or less than their original cost.
* The Parnassus Fund charges a maximum sales charge of 3.5% and Lipper
rankings based on total return do not take the sales charge into account
although the total return figures quoted in this report do. For the five years
ending 9/30/97, the Parnassus Fund placed 48th out of 298 growth funds and for
the ten-year period, it placed 92nd out of 179 growth funds.
+ The Standard & Poor's 500 is an unmanaged index of the common stocks of
500 companies and it is not possible to invest directly in an index.
</FN>
</TABLE>
THREE NEW INVESTMENT TECHNIQUES
As most of you will remember, the Fund experienced a difficult period of
poor performance during the 15 months ending on September 30, 1996. That
experience caused us to do a lot of soul-searching and we came up with three new
investment techniques in an effort to improve our performance.
The first one - the 12-month catalyst - we've already reported to you.
After determining that a company is undervalued, we ask ourselves if there is a
catalyst emerging within the following 12 months that will cause earnings to
increase substantially. If there is no visible catalyst, we don't invest in the
company. This doesn't mean that we'll always be right on every company we invest
in, but we think it does give us an advantage in making investment decisions.
Prior to 1996 when we developed this technique, we didn't do a very good
job in assessing the prospects for future earnings. Since earnings estimates
were notoriously unreliable, we concluded that there was no reason to spend time
thinking about a company's immediate prospects for higher earnings. This proved
to be a mistake. While we still think that quarterly earnings forecasts are not
very reliable, we do think that we can make a reasonable assessment of a
company's prospects for earnings improvement over the next 12 months.
We developed this analysis during the Fund's difficult period because so
many of the undervalued companies in the portfolio stayed undervalued for long
periods of time. While the stock market raced ahead in late 1995 and early 1996,
the price of most of our companies stayed pretty flat, causing the Fund to
underperform.
Our second new investment technique - a quarterly free cash flow analysis -
developed in response to so many of the "disasters" we had during our difficult
period. While we called an undervalued company that stayed undervalued "stuck in
the mud", a "disaster" is a company that actually declines in value by a
substantial amount. While there is no way to eliminate disasters entirely, we
think we can reduce their number to an absolute minimum and, hopefully, never
again have as many as we did during our difficult period.
To try to identify companies that may be having problems in the future, we
now perform a free cash flow analysis on each company every time a firm reports
quarterly earnings. Sometimes, a company's earnings will look fine because of
accounting entries, but they will not be making money on a cash basis. When we
discover a company like this in our portfolio, we now give it close scrutiny.
We take a company's quarterly earnings and add in non-cash expenses like
depreciation and amortization to get cash flow. Then we subtract an amount for
capital expenditures that we think is necessary for the company to operate. The
remainder is what we call free cash flow or "owner's earnings."
If the amount is negative or small in relation to reported earnings, we
take a closer look at the company. We won't necessarily sell the stock if
there's no free cash flow, but there had better be a good reason for it and it
better be a temporary situation.
A third new technique that we're using involves re-evaluating a company in
the portfolio as it reaches its initial "sell" target. Whenever we invest in a
company, we determine what we feel is its intrinsic value and that becomes the
price at which we intend to sell. Historically, we have usually sold our stocks
at the predetermined target price.
What we discovered is that we often left money on the table. Our stocks
would rise quite a bit after we sold them. What seemed to be happening was that
the intrinsic value of many of our companies increased substantially during the
holding period. Our analytical techniques did not focus closely enough on this
increase in value. Many times, we sold on the basis of a target price that had
grown out of date. For the last year or so, we have been focusing more on making
a revaluation of a company's intrinsic worth before selling it. Naturally,
there's always the danger that during this extra holding period the stock can go
down as well as up, but on balance, this third new investment technique has
helped us quite a bit as you will see later in the section where we discuss
individual companies.
In my view, much of the Fund's improved performance over the past 12 months
can be attributed to these three new investment techniques. Of course, much of
the performance can also be attributed to investment techniques we've been using
since the Fund began, and quite candidly, some of the last year's stellar
performance can be attributed to plain luck. In any case, 12 months is not
enough time to determine if the new techniques will make a permanent difference
in the Fund's return. We need at least three years of performance to make a
well-reasoned decision. So while the final returns are not yet in, I can say
that the early results look great.
PERFORMANCE OF INDIVIDUAL COMPANIES
During the quarter, some of our companies dropped in value, but none of
those that declined had a substantial impact on the Fund. On the other hand, we
had a dozen companies that increased more than 30% during the period and four of
them gained more than 50%. The star performer for the third quarter was Tandem
Computers which went from $20.25 to $34.90 at the time it was bought out by
Compaq. This resulted in a gain of 72% on top of the 71% it gained in the second
quarter. Once our Tandem shares converted to Compaq stock, they rose an
additional 14%, going from $65.50 to $74.94.
Our average cost for Tandem was $11.77 a share and our average holding
period was almost four years so we had owned the company for a long time.
Earlier this year, the stock was selling for $14 a share right before the
takeover announcement and it jumped to a little over $20 a share after the news
became public.
Our target price for Tandem was $18 a share so we considered selling Tandem
after the announcement. Since Compaq intended to pay for Tandem with its own
shares, we would in effect be owning Compaq instead of Tandem. Our research
director, David Pogran, did a good job of analyzing Compaq and recommended that
we hang onto our shares. As it turned out, it was the right decision because
Tandem's shares moved up another $14 between the time after the announcement and
the time that the merger was consummated. In other words, we made more than
double the amount during the post-announcement period than we did when the stock
first jumped on the news.
This is a good example of our third new investment technique of holding
beyond our initial target price and revaluing a company before selling its
stock. In this case, the new valuation was of Compaq (or the joint Tandem/Compaq
entity). David Pogran's good work helped the Fund's performance quite a bit.
The second best performer during the period was Nellcor Puritan Bennett, a
maker of medical products based in the San Francisco Bay Area. The company went
from $18.13 to $28.50 a share for a gain of 57%. Like Tandem, Nellcor was bought
out by another company - this time for cash.
Genus, the Silicon Valley-based maker of semiconductor production
equipment, rose 53%, going from $4.50 to $6.88. The company's prospects are
improving as demand for its equipment grows.
The stock of Mylan Labs went up 52% during the quarter, climbing from
$14.75 to $22.44. Investors have recognized the value in this maker of generic
drugs. Patrick McVeigh of Franklin Research & Development was responsible for
bringing this company to our attention and pointing out both its financial and
social merits.
Protocol Systems, another maker of medical equipment, gained 47% during the
quarter as its stock increased from $8.00 to $11.75. Portland-based Protocol
makes patient monitoring equipment that is more portable and more durable than
competitive products.
Electro Scientific Industries (ESI) saw its stock increase 46% as it went
from $41.88 to $61.00. This was on top of the 66% increase of the second
quarter. The company is based in Portland, Oregon and makes laser-based products
for use in the semiconductor industry. ESI offers another illustration in the
value of reassessing a company's value rather than selling at a predetermined
target price. Our cost was $21.47 per ESI share and our initial price target was
$35. Once the company's stock hit $35, I asked Todd Ahlsten, one of our
analysts, if we should think about selling. Todd conducted an analysis that
showed the company's value to have increased substantially since we first
purchased its stock. Our new target became $51 a share. When it hit that price,
I again asked Todd if it was time to sell. Because of important acquisitions in
related areas, the company was able to expand the use of its laser products into
new industries. This increased the value of the company and we held on. The
stock is now trading at $61 a share, but Todd says that it's still undervalued
and we should continue to own this company.
Intuit, whose products include Quicken (personal finance software),
TurboTax (tax preparation software) and small business accounting systems, went
up 40% as its stock climbed from $22.94 to $32.00. Investors recognized the
value of the company's excellent products.
Broderbund, the company that provides computer games and educational
software, had a 38% increase in its stock as it went from $24.69 to $34.00.
Broderbund provides a good example of what we mean when we talk about a 12-month
catalyst. Early this year, the company's stock dropped below $20 a share because
of lower earnings and weakness in the consumer software market. However, we knew
that Broderbund was going to bring out a sequel to Myst, the best-selling
computer game of all time. We felt that this new game would sell well and make a
substantial impact on the company's earnings. Although the company's situation
was difficult at the time we bought the stock, the introduction of Riven (the
sequel to Myst) in the fall was the catalyst we were looking for.
Adobe, the maker of software for graphics and printing, had a 37% increase
in its stock as it rose from $36.83 to $50.38. The company makes Page-Maker for
desktop publishing and Postscript for formatting laser and inkjet printers.
Centigram, a manufacturer of voice mail equipment, gained 37% as its stock
went from $12.94 to $17.75. Wellman, the nation's largest recycler of plastic,
had a 33% increase in its stock price, going from $17.38 to $23.19; price
increases for bottle resin gave a boost in revenue to the company. FEI, maker of
electron microscopes and semiconductor inspection equipment, had a 32% increase
in its stock price as it went from $15.75 to $20.75.
COMPANY NOTES
Sequent Computer Systems has been rated one of the top family-friendly
companies in the country according to a special report in the September 15 issue
of Business Week. Sequent was also rated among the best companies for families
by Working Mother magazine. Oregon Business also rated the company highly in
this regard.
Delta Air Lines took 300 members of Atlanta's Boys and Girls Club to a
special viewing of the Atlanta Ballet's production of Peter Pan. This is part of
Delta's plan to help the Ballet with its outreach program to underprivileged
youth.
Aetna U.S. Healthcare is the first national health benefits company to make
a commitment to the American Diabetes Association's new guidelines. The company
will support and cover screening for diabetes beginning at age 45 for its HMO
members as well as regular testing when necessary.
A September television documentary on PBS entitled "The Excellence File"
recognized Whole Foods Market for its progressive, team-building management
practices. We have also done very well financially on our investment in the
stock.
OUTLOOK AND STRATEGY
In our last quarterly report, we talked about how the biggest companies had
performed much better than the small and medium-sized companies and what this
meant for the market indices. Well, that has changed and the smaller and
medium-sized companies are now doing better than the larger companies. In our
third quarter performance discussion at the beginning of this report, you will
notice that the average growth fund did much better than the S&P 500. Since
growth funds have a broad range of companies in their portfolios and the S&P 500
represents primarily the very large companies, this means that the smaller
companies are catching up.
The Parnassus Fund has some very large companies as well as some smaller
companies, but overall, we are in the mid-cap range. This means that if current
trends continue and medium-sized companies do better than the big-cap companies,
the Parnassus Fund should continue to beat the S&P 500. (This is not a
guarantee, but an attempt to analyze current trends.) For this reason, we
continue to remain as fully-invested as possible.
In my view, the big-cap companies are fully-valued and maybe even somewhat
overvalued. However, the small and mid-cap companies for the most part are not.
As long as interest rates do not move up sharply, there is more room for these
companies to move higher.
ANNUAL DIVIDEND
The Fund will pay a dividend to all shareholders of record as of December
18, 1997 (record date). The dividend is payable to everyone who owns shares on
that day even if the shares were purchased only a few days before. Since the
dividend is taxable, a shareholder investing just before the record date would
end up paying taxes on a non-existent gain. This is especially significant this
year because the dividend is likely to be quite large given our excellent
performance.
For example, if the NAV were to be $52.00 on December 18 and if the
dividend were to be $8.00, then the NAV would drop by $8.00 that day to $44.00
per share. There would be no economic loss since the $8.00 dividend would make
up for the $8.00 drop in the NAV, but the $8.00 dividend is taxed even though it
would not be a true gain to a shareholder purchasing just before the record
date.
Each shareholder has to make his or her own decision, but my recommendation
would be not to make any additional investments in late November or early
December until after the dividend is paid (the ex-dividend date). This year, the
ex-dividend date will be December 19 so it is safe to make investments on or
after December 19. You can also send in a check now for an additional investment
and ask the staff to hold the investment until the ex-dividend date.
There are only two exceptions to my recommendation. First, if you have an
IRA or another retirement account, you can make additional investments at any
time since retirement accounts are not taxable. The second exception is PAIP
accounts. There is no reason to skip an automatic PAIP investment since it is
done every month and represents a relatively small investment compared to your
entire investment program and the tax effect should not be significant. (I'm
making my regular PAIP investment in November and December.) With the exception
of PAIP and IRA accounts, I would defer new investments until the ex-dividend
date (December 19).
SEC MATTER
The hearing on the SEC matter was held in San Francisco from September 22
through September 26. The hearings produced some interesting changes in the tone
of the SEC's comments. At the time the charges were announced and in the
prehearing brief, they stated that I artificially inflated the value of Margaux
stock and that I had also misused soft dollar credits from brokerage
transactions for my personal benefit. By the time the SEC attorney made his
opening statement at the hearing, he conceded that there was no dishonesty and
there was "no larceny" involved in this case. Instead, they maintained that the
Trustees and I had not used proper procedures to price Margaux after it was
delisted by the NASDAQ National Market System. My view, however, is that we did
price Margaux correctly and that we will ultimately be successful on all of the
issues.
This past June, we sent a letter to all shareholders outlining the SEC's
charges and our response. If you don't have a copy of this letter or you would
like another one, you can call our office to obtain a copy.
All evidence and all testimony were presented at the San Francisco hearing
except for the experts' testimony which is scheduled for Washington, D.C. from
December 1-4. Our experts will say we priced Margaux properly and their experts
will say we didn't price it properly so I imagine it will be a standoff.
The complete hearing record probably won't be ready until January and the
attorneys will need some time to prepare post-hearing briefs. Then, the judge
will have to review the record and decide points of fact and law. So, it will
probably be late next spring before a decision is reached.
FALL INTERNS
Bryant Cherry is a graduate of Stanford University and holds an M.S. in
accounting from San Jose State University. His previous experience includes work
in fund-raising at Stanford Business School, experience as a senior accountant
at Frank, Rimerman & Co. in Menlo Park and service as a financial consultant at
Merrill Lynch & Co.
Paul Schulten is a graduate of Vassar College in English literature and
also holds an MBA from Vanderbilt University's Owen Graduate School of
Management. His previous experience includes work in risk management with
Prudential Securities and in public finance with Fitch Investors Service.
Gee Leung is a senior at the Haas School of Business at the University of
California at Berkeley. Prior to attending Berkeley, he was student body
president at the College of Marin and he worked as a teller at Wells Fargo Bank.
He has also done consulting with small businesses for an economic development
project in Oakland, California.
Finally, I would like to thank all of you for investing in the Parnassus
Fund. I am delighted that we were able to give you such good returns this year
as a reward you for your support.
Yours truly,
Jerome L. Dodson
President
<TABLE>
<CAPTION>
THE PARNASSUS FUND PORTFOLIO: SEPTEMBER 30, 1997*
# of Shares Issuer Market Value Per Share
<S> <C> <C> <C>
- --------------------------------------------------------------------------------
600,000 ATC Group Services, Inc. $6,337,500 $10.56
100,000 Acme Metals, Inc. 1,600,000 16.00
280,000 Adobe Systems Incorporated 14,105,000 50.38
500,000 Advanced Micro Devices, Inc. 16,281,250 32.56
160,000 Aetna, Inc. 13,030,000 81.44
100,000 Amgen, Inc. 4,793,750 47.94
900,000 AnnTaylor Stores Corporation 13,387,500 14.88
439,100 Broderbund Software, Inc. 14,929,400 34.00
315,000 Building Materials Holding
Corporation 4,114,688 13.06
100,000 Burlington Coat Factory 2,112,500 21.13
39,500 Cannondale Corporation 888,750 22.50
535,000 Centigram Communications 9,496,250 17.75
400,000 Compaq Computer Corporation 29,975,000 74.94
70,000 Corporate Express, Inc. 1,478,750 21.13
800,000 Cypress Semiconductor 12,400,000 15.50
60,000 Delta Air Lines, Inc. 5,651,250 94.19
500,000 Electro Scientific Industries, Inc. 30,500,000 61.00
300,000 FEI Company 6,225,000 20.75
450,000 First Data Corporation 16,903,125 37.56
700,000 Genus, Inc. 4,812,500 6.88
80,000 Hewlett-Packard Company 5,565,000 69.56
120,000 Houghton Mifflin Company 4,530,000 37.75
575,000 In Focus Systems 12,865,625 22.38
500,000 Intuit, Inc. 16,000,000 32.00
148,000 Invacare Corporation 3,478,000 23.50
200,000 Mentor Graphics Corporation 2,425,000 12.13
1,000,000 Morgan Products, Ltd. 6,687,500 6.69
900,000 Mylan Laboratories, Inc. 20,193,750 22.44
245,000 Planar Systems 2,771,563 11.31
785,000 Protocol Systems, Inc. 9,223,750 11.75
200,000 Ryerson Tull, Inc. 3,237,500 16.19
750,000 Sequent Computer Systems, Inc. 18,609,375 24.81
265,000 The Wet Seal, Inc. 6,194,375 23.38
500,000 Toys "R" Us, Inc. 17,718,750 35.44
375,000 Wellman, Inc. 8,695,312 23.19
50,000 West Marine, Inc. 1,143,750 22.88
400,000 Whole Foods Market, Inc. 15,450,000 38.63
------------
Total Portfolio $363,811,463
Short Term Investments
and Other Assets $ 27,910,661
------------
TOTAL NET ASSETS $391,722,124
============
THE NET ASSET VALUE
AS OF SEPTEMBER 30, 1997 $ 51.43
<FN>
*Portfolio is current at time of printing, but composition is subject to change.
</FN>
</TABLE>
- --------------------------------------------------------------------------------
THE PARNASSUS FUND
Distributed by Parnassus Investments
One Market-Steuart Tower #1600
San Francisco, California 94105
415-778-0200
800-999-3505
www.parnassus.com
This quarterly report must be preceded or accompanied by a current prospectus.
