The Parnassus Fund
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Quarterly Report
March 31, 1999
April 26, 1999
Dear Shareholder:
As of March 31, 1999, the net asset value per share (NAV) of The Parnassus
Fund was $36.38 so the overall return for the quarter was 0.39%. This compares
to a return of 4.99% for the S&P 500 and 4.36% for the average growth fund
according to Lipper Analytical Services. Although the S&P 500 had a good gain,
most stocks did not do as well. The increase in the S&P came only because of the
upward movement of a few very large companies. Broader indices either increased
quite modestly or even fell. For example, the average diversified U.S. stock
fund gained only 0.93% while the average mid-cap stock fund fell 0.35%. The
average small-cap fund fell 5.69% and the small-cap, value-oriented funds fell
an average of 9.50%.
The strong gains in most stock market averages over the past quarter (and, in
fact, over the past few years) have been due to a relatively small number of
stocks while the broader market averages have not done nearly as well. Because
the S&P 500 is weighted by market capitalization (i.e., a company's number of
shares outstanding times their market price), the fifty largest stocks count for
more than half the movement in the index. So it's possible for 450 companies in
the index to have little or no gain and the biggest companies to have a large
gain and the index will still show a substantial movement upward.
Generally speaking, companies are divided into three size categories: large
capitalization companies ("large-cap"), mid-cap and small-cap. Definitions vary,
but a small-cap company is usually defined as having a market capitalization
less than $1 billion, a mid-cap company having a capitalization between $1
billion and $15 billion and a large-cap company over $15 billion. The Parnassus
Fund doesn't define its investment strategy in terms of any specific size, but
in practice, most of our companies fall in the lower end of the mid-cap range.
Because of this, our returns tend to move more with the small-cap and mid-cap
results. For the last few years, though, large-cap companies have done much
better than small and mid-cap ones.
As of the end of March, the average market cap of our portfolio companies was
$11 billion which is at the high end of mid-cap. This average, however, is
distorted by three of our companies that have enormous market capitalizations:
Intel at $191 billion, Hewlett- Packard at $56 billion and Compaq at $52
billion. Excluding these companies, the Fund's average market capitalization is
only $2.2 billion or at the small end of the mid-cap range.
What all this means is that the market is valuing large-cap companies at a
much higher level than small and mid-cap companies. To put this into
perspective, consider relative price/earnings ratios. The P/E ratio is the price
a stock is selling for divided by its earnings. For example, if a company earns
$1 per share per year and it's selling at $15 per share, then the P/E ratio is
15. Historically, companies in the S&P 500 have sold for about 14 times earnings
while today they're selling for 26 times earnings. At the present time, the 100
largest companies are selling at an average P/E ratio of 32 while the smallest
100 companies are selling at a P/E ratio of 19. So two companies can be earning
the same amount of money, say $1 a share, but the large company would sell for
$32 and the smaller company would sell for $19 a share -- an astonishing
discrepancy.
The average large company P/E ratio of 32, though, hides some of the more
extreme examples of rich valuations. For instance, as I write this report, Cisco
Systems sells for 77 times 1999 earnings, Microsoft sells for 74 times earnings
and Dell Computer sells for 76 times 1999 earnings. Needless to say, we don't
own any of these issues.
Why do companies sell at P/E ratios that are so different? The primary reason
is different expectations for growth in earnings. It's reasonable for a company
whose earnings are growing at 20% per year to sell at a higher P/E ratio than
one whose earnings are growing at 5% per year. One rule of thumb is that a
company's P/E ratio should be about the same as its annual rate of growth in
earnings. For example, a company whose earnings are growing about 20% per year
should have a P/E ratio of 20.
Recent increases in valuations of large companies, though, have pushed up P/E
ratios far above their growth rates. Although the 100 largest companies in the
S&P 500 are selling at 32 times earnings, they're definitely not growing 32% per
year. While Cisco Systems sells at a P/E ratio of 77, its growth rate is only
around 30% per year. Microsoft's P/E ratio of 74 contrasts with its growth rate
of around 24%. Wal-Mart sells at 48 times earnings while its growth rate is
about 14%. Lucent Technologies sells at 94 times earnings while its growth rate
is around 21%. While these are wonderful companies and they should sell at above
average P/E ratios because of their high expected growth rates, their current
prices are completely unjustified. Corporations like these push the S&P 500
higher while most companies have much more modest valuations.
At some point, a correction should set in, but it's hard to know when that
will happen. I had thought it would have happened by now, but investors keep
pushing the large growth companies to higher and higher levels. There are a
number of factors that keep this phenomenon going.
First is the indexing phenomenon. As the S&P 500 keeps outperforming the
average stock and the average mutual fund, investors put more money into index
funds. Since index funds are heavily weighted toward the large growth companies,
these funds put even more money into these large-cap issues which, in turn,
pushes the price of those stocks ever higher.
A second factor is foreign investments. Foreigners see the U.S. stock market
continuing to go higher and they decide they want in on the action. Since they
only know the familiar names, overseas investors put most of their money into
the large-cap issues.
A third factor is that institutional and individual investors buy these same
large-cap stocks because they are the ones that have been performing the best.
They reason that it's best to stick with what's happened in the past and more
money chasing large-cap stocks means their prices go even higher.
The most likely end to this scenario is when a number of the large-cap
companies stop growing or at least see their growth rates decline substantially.
Investors will no longer pay high multiples for these large-cap companies and
prices will go down. As prices go down, fewer investors will put money into
these issues and the mechanism will work in reverse. For that reason, we are
avoiding large-cap companies that have very high multiples. Although this makes
our performance compare unfavorably with the S&P 500 at the present time, we
should make up for it in the future.
We do have some large-cap companies in the portfolio, but they are not
selling at 70 times earnings. Intel has a P/E ratio of 34, Hewlett-Packard has a
ratio of 25 and Compaq sells at 18 times annual earnings.
One concession that we are making to size, however, is increasing the average
market capitalization of the portfolio as we make new investments. At the end of
March, there were 31 companies in the portfolio: 15 below $1 billion in
capitalization, 12 from $1 to $15 billion and four over $15 billion. In the
future, we should have fewer companies below $1 billion. Smaller companies will
have to have exceptional prospects to be included in the portfolio. I expect to
have more mid-cap companies in the Fund, especially those at the higher end of
the mid-cap range. We'll also continue to have some good large-cap companies as
long as their valuation levels are reasonable.
Below you will find a table summarizing our average annual returns as of
March 31, 1999 for the one, five and ten-year periods as well as 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
(3.5%).
<TABLE>
<CAPTION>
Average Annual Average Annual
Total Return Overall Return
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<S> <C> <C>
One Year (8.00%) (4.66%)
Five Years 9.11% 9.89%
Ten Years 11.50% 11.89%
Since Inception 12/31/84 12.06% 12.34%
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<FN>
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.
</FN>
</TABLE>
WINNERS AND LOSERS
There were some strong gains in the portfolio during the quarter, but
unfortunately, they were balanced out by some sharp losses. Six companies lost
more than 24% during the quarter. Four of them were technology companies, one
was a supermarket chain and one was a medical equipment company. We expect five
of the six to bounce back in the near future and we sold one of the companies
because of deteriorating fundamentals.
Read-Rite dropped 55.4% during the quarter as the stock went to $6.59. The
company makes the heads that read and write data onto the hard disk drives that
store digital information. Weakness in the disk drive industry hurt the company.
Read-Rite's technology has also fallen behind its competitors. For this reason,
we have sold the stock.
Western Digital, a disk drive manufacturer, dropped 47.3% during the quarter
as its stock went to $7.94. The same weakness in the drive industry that hurt
Read-Rite also hurt Western Digital. Unlike Read-Rite, though, Western Digital
has advanced technology and its sales should show strong growth over the next
year. We're holding on to the stock. We expect Western Digital to make a strong
comeback before the year is out.
Advanced Micro Devices (AMD) posted a loss of 46.6% as its stock sank to
$15.50 by the end of the quarter. AMD has done an excellent job of competing
with Intel in the microprocessor industry. In fact, its share of microprocessors
sold in personal computers through retail stores actually rose above that of
Intel at one point in the first quarter. Unfortunately, the company had
manufacturing problems and earnings dropped off sharply. Because of its strong
position in microprocessors, we're hanging onto the stock in hopes that the
company can improve its manufacturing efficiency.
ADAC Laboratories, a medical equipment company, had a 31.8% decline in its
stock price during the quarter as it went to $13.63. The company had to restate
earnings which rattled investors. Historically, the company has booked earnings
when it delivers its equipment, but there have been long periods between the
time equipment is delivered and when it's installed. ADAC now has to book its
sales when the equipment is installed rather than when it's delivered. This will
cause a delay in recognizing revenue, but otherwise the company's fundamentals
are sound and the products are of high quality.
Whole Foods Market, the nation's largest natural foods retailer, saw its
stock decline 28.9% during the quarter as it closed at $34.38. Sales have been
strong at the stores, but expenses took an unexpected turn upward. The situation
appears to be improving at the present time which should boost earnings.
Compaq Computers dropped 24.3% to $31.75 a share due to reduced demand for
personal computers. We continue to hold the stock since the company is trading
at a relatively modest valuation and we think business will get stronger as the
year goes on.
Six companies in the portfolio gained more than 20% during the quarter. Four
were hardware technology companies, one was a software company and the big
winner was a telecommunications company.
Xylan, a firm that makes sophisticated switches for use with data networks in
telecommunications, gained 109.6% during the quarter. Alcatel, the French
telecommunications giant, bought Xylan for $37.00 a share.
LSI Logic, a Silicon Valley manufacturer of specialized semiconductors
(ASICs), gained 93.4% during the quarter as its stock climbed to $31.19 a share.
Stronger demand for specialized semiconductors and better pricing helped grow
revenue and earnings at LSI.
The stock of Lam Research climbed 62.8% during the quarter as it reached $29
a share. A maker of semiconductor capital equipment, Lam benefited from
increased worldwide demand for new machines.
Applied Materials, the world's largest producer of semiconductor capital
equipment, benefited from the same phenomenon. The stock moved up 44.5% to
$61.69 a share as orders surged from Korea and Taiwan as well as from North
America.
Adaptec makes chips for use in connecting hard disk drives and other
peripheral equipment to the central processing unit of computers. Its share
price went up 30.3% to $22.88 because of increased demand and better cost
control.
Adobe is a well-known maker of graphics software products like "PageMaker"
and "Photoshop." Historically, the company has not had good cost controls, but
management seems to be more disciplined and expenses are now reasonable. A
number of new high quality products are contributing to revenue and earnings.
The stock appreciated 21.4% as it moved to $56.75 a share.
SOCIAL NOTES
A number of shareholders have written to us asking about the issue of foreign
sourcing of products. We have nothing against foreign sourcing per se and, in
fact, American investment and production in less developed countries is a great
help to their economic development. What we do object to are companies with
contractors who do not treat their workers fairly. If a company has a
substantial amount of production in third world countries, we require that
company to have a code of conduct for labor to make an investment. Obviously, no
company is perfect, but we think you can make meaningful distinctions between
corporations in the same industry.
For example, we prefer Reebok to Nike in terms of social factors. Although
Nike seems to have made some progress of late, we still don't think they have as
good a social record as Reebok. (Reebok is in our portfolio, but not Nike.) Last
year, the Council on Economic Priorities did a study of codes of conduct for
working conditions and found that Reebok was one of five companies to have the
best code of conduct.
For 11 years, Reebok has sponsored Human Rights Awards to focus international
attention on specific human rights issues. Each recipient receives a $25,000
grant and access to a support network called Forefront that campaigns for the
release of political prisoners, helps protect members under attack for human
rights activities, provides technical assistance and serves as a forum for
discussing issues. The four recipients for 1999 include a former slave from
Ghana fighting to free other young women, a lawyer fighting unjust application
of the death penalty in the United States, an activist fighting abuse against
ethnic minorities in Burma and a student leader fighting for democratic reforms
in Kenya.
On March 30, 1999, Reebok announced a program to help stop domestic violence.
From April 5 through May 15, Lady Foot Locker and Reebok will donate $5.00 from
the sale of every pair of the new Leader DMX 2X shoes at Lady Foot Locker stores
to the Family Violence Prevention Fund. The Fund, a non-profit organization
founded in 1980, is a national innovator in developing new ways to stop domestic
violence through strategies in public education, child welfare, immigration,
public health and criminal justice.
One program that social investors don't talk about too much, but which we
regard as important is paid sabbatical programs. A sabbatical is a way for a
company to invest in an employee by allowing time to be spent away from the
daily routine of a job while still developing valuable skills. Three of our
companies have notable sabbatical programs: Adaptec, Intel and LSI Logic.
Adaptec offers six-week paid sabbaticals after only five years of service. Intel
offers eight weeks of paid sabbatical leave after every seven years.
SHAREHOLDER LETTER
Dear Mr. Dodson:
As always, I enjoyed reading your annual report on the Parnassus Fund. Not,
of course, that I was particularly thrilled by the Fund's severe
underperformance last year, but I've been around long enough to know that
volatility is inherent in investing. I put a little bit into the Fund near the
bottom late last summer, and of course now wish I'd done more!
I was a bit surprised, though, by the "dog that didn't bark." For the first
time I can remember, the Portfolio of Investments shows a huge amount of
short-term investments, plus credit amounts "payable upon return of securities
loaned." I know that the reports have stated in the past that the Fund lends out
securities, but I've never seen it displayed this way, and I'm surprised you
didn't mention anything about it. Is this a new accounting requirement, or a new
way the loans are being handled? How much income does the Fund derive from
securities loans? I presume it must be part of the interest income shown in the
statement of operations. Should we understand the real cash position of the Fund
to be 2.8% of net assets (since 97.2% of net assets are in stocks)?
It would also have been of interest to have a little more explanation of
the "Other Income," which came to about 12 cents a share. Who was sued and why?
I always appreciate the time you take to explain what's happening in the
reports. I realize you can't talk at length about every detail, but it would be
helpful to hear explanations for out-of-the-ordinary events.
Sincerely,
Kelvin Smith
Stamford, Connecticut
Dear Mr. Smith:
I always appreciate receiving letters from you because of your sharp eyes and
inquiring mind. The reason you haven't seen the accounting entries before is
because we just started lending out securities last year. After a thorough
analysis, the Trustees approved the program and things have gone smoothly.
Howard Fong, Vice President of the Fund, handles the program in conjunction with
Union Bank of California. The Bank does most of the work including monitoring
the collateral that borrowers put up to borrow our securities. The risk of
losing money is very slight as the cash collateral is equal to 102% of the
market value of the stocks borrowed. The Fund has been earning about $27,000 a
month in income. It appears on the Fund's income statement under the "interest"
category.
With regard to the "Other Income" of $1,096,868, it was the Fund's part of a
settlement of a class action suit against Sunrise Medical. We bought stock in
the company a few years ago and afterward there was a discovery of accounting
fraud. Income was overstated which caused an inflated stock price.
Yours truly,
Jerome L. Dodson
PERSONNEL MATTER
Finally, I would like to announce that at their last meeting, the Trustees
elected Susan Loughridge as Vice President of The Parnassus Fund. Susan has been
with us for six years and she manages the Shareholder Service Department. Those
of you who have talked with Susan about your account know that she does a great
job.
Yours truly,
Jerome L. Dodson
President
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<TABLE>
<CAPTION>
THE PARNASSUS FUND PORTFOLIO: MARCH 31, 1999*
# of Shares Issuer Market Value Per Share
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<S> <C> <C> <C>
370,000 ADAC Laboratories $ 5,041,250 $13.63
400,000 Adaptec, Inc. 9,150,000 22.88
150,000 Adobe Systems, Inc. 8,512,500 56.75
600,000 Advanced Micro Devices, Inc. 9,300,000 15.50
30,000 Apex PC Solutions, Inc. 418,125 13.94
200,000 Applied Materials, Inc. 12,337,500 61.69
365,000 Building Materials
Holding Corp. 3,695,625 10.13
700,000 Cognex Corporation 16,581,250 23.69
450,000 Compaq Computer Corp. 14,287,500 31.75
10,000 Consolidated Stores Corp. 303,125 30.31
600,000 Electro Scientific Industries, Inc. 27,900,000 46.50
465,000 FEI Company 3,894,375 8.38
600,000 Helix Technology Corporation 9,225,000 15.38
140,000 Herman Miller, Inc. 2,555,000 18.25
170,000 Hewlett-Packard Company 11,528,125 67.81
200,000 Intel Corporation 23,825,000 119.13
10,000 Invacare Corporation 243,125 24.31
400,000 Just For Feet, Inc. 5,000,000 12.50
400,000 Lam Research Corporation 11,600,000 29.00
300,000 LSI Logic Corporation 9,356,250 31.19
275,000 Mattel, Inc. 6,840,625 24.88
160,000 Micrion Corporation 1,350,000 8.44
790,300 Morgan Products, Ltd. 2,815,444 3.56
590,000 Oxford Health Plans, Inc. 9,218,750 15.63
525,000 Quantum Corporation 9,450,000 18.00
50,000 Read-Rite Corporation 329,687 6.59
350,000 Reebok International Ltd. 5,556,250 15.88
325,000 St. John Knits, Inc. 8,571,875 26.38
150,000 Symantec Corporation 2,540,625 16.94
270,000 Wellman, Inc. 2,396,250 8.88
1,050,000 Western Digital Corporation 8,334,375 7.94
300,000 Whole Foods Market, Inc. 10,312,500 34.38
400,000 Xylan Corporation 14,725,000 36.81
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Total Portfolio $267,195,131
Short Term Investments
and Other Assets $ 13,802,924
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Total Net Assets $280,998,055
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The Net Asset Value
as of March 31, 1999 $ 36.38
<FN>
Portfolio is current at time of printing, but composition is subject to change.
</FN>
</TABLE>
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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.
