One of the top fund managers of the decade is holding triple his normal cash position

Published Thu, Oct 20 20162:38 PM EDT

Jerry Dodson, founder and lead portfolio manager of Parnassus Investments, an independent investment management firm with about $20 billion under management, believes market participants may be running out of investment options due to high valuations. "Right now the cash holdings of the Parnassus Endeavor Fund are 15 percent. Usually we like to have maybe 5 percent. But what's happening is, we are not able to find undervalued companies," said Dodson. "And the difficulty we think is that the market is fully valued." The Parnassus Endeavor Fund is the top-performing large cap growth fund over the last three, five and 10 years, according to Morningstar. The fund is up 11 percent this year alone. In this wide-ranging conversation with CNBC's Mike Santoli , Dodson shares his investment approach, and also discusses: How there are still some values out there. Three of his favorite long-term holdings. Socially responsible investing. His favorite investing lessons. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Jerry Dodson is the founder and president of Parnassus Investments, an independent investment management firm with about $20 billion under management, where he's the lead portfolio manager of The Parnassus Fund, a five star rated mutual fund that's been ranked in the top 20% of Morningstar's large company growth category for over a decade. He also oversees the Parnassus Endeavor Fund, another top-ranked mutual fund that's outperformed the market by an average of six percentage points since 2012. Prior to founding Parnassus in 1984, Jerry served as president and chief executive officer of Continental Savings of America from 1976 to '82. He holds an MBA degree from Harvard Business School, and he joins us now at the NASDAQ to discuss his investment approach and outlook for the markets. And Jerry, thank you very much for being here. JEROME DODSON: Thank you. Good to be here. MIKE SANTOLI: Appreciate that. So your firm, for more than 30 years now, interesting kind of strands of your investment process, which is, you know, you are kind of a growth manager looking for high quality companies, but with a value contrarian discipline. Being very careful about what prices you pay, I guess, for stocks. And also using a social screen, basically, about how the company does its business. How do all those things kinda work together? JEROME DODSON: We think that actually considering social and environmental factors really helps us in terms of financial performance. The reason is, is that companies that have enlightened management also have good environmental policies and social policies in the sense of being a good place to work. So we think that those really help us. Now, why is that true? Why do the environmental help from a financial standpoint? It's mostly on cost savings. So if you use less water, if you use less energy, it's really gonna help, in the bottom line, help your costs. Also, if you are environmentally responsible, it means you probably won't get fined or sued by the Environmental Protection Agency or the neighborhood where you operate. So we think they work well together. MIKE SANTOLI: So you don't obviously feel as if there's any kind of, sort of, tradeoff necessarily, between focusing on those companies with kind of good environmental and social policies, or getting investment returns, obviously. JEROME DODSON: I don't. But early on, say, when we first started the fund, which had been 30 years ago, there were a lotta critics that said, "Hey, if you have to be environmentally responsible, it's gonna cost you money. You have to, you know, do certain things." But they really didn't think it through, seeing how being environmentally responsible could actually save you money. And I think that's the big difference. Because today, or in 2016, it's pretty clear that the environmental responsibility saves you money, whereas 30 years ago it was not clear. MIKE SANTOLI: And about the, kind of, being a good place to work. So essentially having policies that are good for employees. How does that build value for a company? JEROME DODSON: Primarily because it can make you much more efficient. So number one, you're gonna have much less turnover if you're a good place to work. So you're not paying money to recruiters. You're not training people all the time. You've got people that are staying around, and they're building. Also, there are literally dozens of ways an employee could sabotage a business, either by being unproductive or doing things that are not in the company's interest. And if you're a bad place to work, a lot of that probably would go on. If you're a good place to work, it's probably not true. So I would say the productivity is really the key element. When you get people working hard, focusing, being efficient, that doesn't mean you have to work a lot longer. But you just have to work smarter. MIKE SANTOLI: And does that come-- and how do you actually determine whether in fact it seems a good place to work? Does that just come through the productivity and efficiency numbers? Or do you look at surveys or other metrics? JEROME DODSON: One way we do it is we read the annual survey by Fortune magazine called "The 100 Best Places to Work in America." There's also Working Mother magazine has a survey. And there's a lot of other surveys around. But Fortune is that one that's best known. So we do that. But we also go beyond that. And we usually ask companies if this is a good place to work. Now, naturally no company's gonna say no, we're not a good place. They're all say they're going to be a good place to work. That's true. However, I think that if a company actually is a good place to work, they answer the questions differently. They're very specific. They'll talk about benefits. They'll talk about training programs. They'll talk about, you know, the attitude. And you can get a feeling. If we think they're pretty general, they don't give us a lot, if we don't believe their story, then they're probably not true. So I think by talking to the companies, doing these surveys, also reading the general media, the press, I think that's really what gives us an idea on the companies. Sometimes you can talk to the individual employees, if we know that. Of course, if they're not-- no company's gonna let me go into their plant or into their office and walk around interviewing employees. They're just not gonna do that. So I can't do that on site. But you can do that if you know them and refer 'em. So that's generally how we determine. MIKE SANTOLI: All right, so let's get to the financial criteria. So when you're looking at investment opportunities, looking at companies, you try to find high quality companies, but that are trading maybe at a temporary discount or they've had some kind of setback, and therefore trying to go against whatever that short term movement has been. Try to talk about that process in terms of evaluating companies that are undergoing some kind of challenge. JEROME DODSON: It's really a difficult exercise at times. Because when we buy a company, something has happened to knock down the price. What we try to do is we try to determine the intrinsic value of a company. And we try to knock off a third. And that's our buy point. So for example, if a company has an intrinsic value of $100, as we calculate it, we won't pay more than $67 for that. So something's happened to make that stock fall from $100 to $67. and usually it's something bad, naturally. So you have to decide, is this permanent? Or is this temporary? Something (UNINTEL) come back? And there's no easy answer how to do that. It's just common sense or it's experience. 'Cause it'd be something like a raw material cost. It could be, like, a marketing mistake. There are just so many things that could happen. And we say, "Well, is this temporary or is this permanent?" And that's really how we do it. MIKE SANTOLI: Well, let's get to one of those companies undergoing one of these short-term challenges. Maybe it's short-term. Wells Fargo company. That you own. Always has been a company that was really respected for how it ran the business, and in fact, how it treated employees. But obviously, with the latest scandal and the replacement of the CEO, that's somewhat been called into question. So what's your basic take now on Wells Fargo right now? JEROME DODSON: Naturally, we're disappointed what happened. That is opening those accounts that were not authorized. So if I came in and you-- I'm the Wells Fargo banker. You came in to see me. I open account in your name. Put Mr. Santoli account. And you don't know that I opened account for you. That's not good business, right? (CLEARS THROAT) So that has really happened. And that's really what's forced the stock price down. Regulators have jumped on them. The senator and congressman. We still like the company. MIKE SANTOLI: So you owned it before this? JEROME DODSON: We owned it before. So we-- yeah, we've suffered a loss. Fortunately it's not a huge loss, but yeah, we'd owned it. The reason we own it is we still think it's socially responsible. For example, 50% of their officers and managers are women. They have very good diversity program. They're supportive of the LGBT issue. They're environmental. They take that into account. They have a lot of renewable energy they're using. So-- oh, they're the number three charitable contributor in the country. Number three of all the firms. So these things we really like. We don't like opening up fake accounts. But in the final analysis, there wasn't that much damage done. I think they charged about $25 per account on these fake accounts. And they-- or they paid this back. But it wasn't a lotta money. There's not permanent damage done to people, even though, you know, I don't like the idea of someone opening an account in my name and I didn't authorize it. But it's not a huge-- it's not as much to do as you would think by listening to the senators or the congressman or the other people. The regulators. So we still like the company, and we think it's-- they have too many other good things about 'em. So yeah, we still like Wells Fargo. MIKE SANTOLI: What's interesting is that one of the responses by some of those senators and congress people to this whole issue has been that Wells Fargo operated, really, kind of an unfriendly workplace, at least in this one division, in forcing these salespeople to perhaps meet unreasonable goals. So it's interesting that it kind of turned into an issue about how employees were treated. So obviously that's not something you think was endemic to the company? JEROME DODSON: Not overall. But you make a good point. And that is if you put to much pressure on some of the bankers in the branch network to come up with a quota, like you have to open, you know, I don't know, 20 accounts a day, that's not good. So there is no such thing as a permanent is-- excuse me. There's no such thing as a perfect company. But in Wells Fargo's case, we think they're more good. And we didn't-- we objected to what they were doing, the pressure. And I don't think they'll be doing that again. I think they've learned their lesson. And so we're hopeful they'll-- the stock will come back. They've been very profitable. They have a very good return on equity. About 13% now. And as interest rates go up higher, we think they'll exceed 15%. So they have a good return on equity, more than other-- any major bank. So we like the company. Disappointed. But we think there's an opportunity here with Wells Fargo stock. MIKE SANTOLI: All right. Let's move on to another one. Also a high quality company that's actually doing great things with its products. Gilead Sciences. Everyone kind of agrees this kind of lead drug for treatment of hepatitis is tremendous success. But yet the stock trades at unusually low valuation for a company that's a profitable as it is. How do you explain that? And where's the opportunity there? JEROME DODSON: Well, you make a good point because the P-E ratio is less than seven, if you believe that. It's 6.7. Very low. And the reason it's so low is some of the earnings they've had in the past, primarily from the hepatitis C-- the two drugs they have. Those medicines are-- people are using them less because people are being cured. (LAUGH) Which is a good thing. You wanna do that-- MIKE SANTOLI: Absolutely. JEROME DODSON: But if you have less sales, it's a dichotomy. So their other one, their HIV drug, medicine, they're doing fine. But it's the hepatitis C. So why do I think the earnings will come back? Well, you never know for sure. But they have a very good laboratory. Their researchers, really smart people. And we think they're gonna come up with something new. We don't know for sure. We have no inside information. And we may be wrong. But we're just thinking that its stock is down so low. It probably doesn't have much downside risk. But if they do bring a new product to market, and it's a good one, which we expect, their earnings will come back, and it'll have a lot of appreciation in the stock. So that's our thoughts on Gilead Sciences. MIKE SANTOLI: It's interesting. A lot of the commentary among investors has been looking at that low valuation and saying, "Well, clearly the market has decided that those earnings can't really be easily replaced by anything that Gilead might come up with." Which you're saying they very well might have something to replace it. But they say, "Well, Gilead should be going out and becoming an acquirer, and just kinda buying up, perhaps, new products and smaller biotech companies." Is that something that would make sense or is necessary? JEROME DODSON: I think it might make sense. (CLEARS THROAT) Gilead has made a lotta money on both the Hepatitis C and the HIV drugs. So they have huge cash. So if-- they might discover something themselves. Or if they find a promising new product, promising new drug in a small company, it might make sense to buy that company. So that's really two ways I think that Gilead could bounce back. MIKE SANTOLI: Gotcha. And let's move on to another controversial name which is actually fun to talk about too, is Whole Foods. JEROME DODSON: (LAUGH) Right. MIKE SANTOLI: I guess, talk about it just from a perspective of what the franchise means. I mean, obviously they kind of introduced a lot of the country to, you know, kind of organic food and being thoughtful about where food comes from, things like that. Is that part of the kind of social aspect of the investment? Or is it really about how the company is run? JEROME DODSON: No, that's a factor. The natural organic food that you mentioned, though, that's important to us. Also, being a good place to work is important to us. They have a good philosophy, because there in the company, they-- if a certain store has savings, they pass it on to the employees, which is good. And they give good medical plan, good benefits. They treat their employees well. So we like 'em from that standpoint as well. What's happened in the last two years is that other people are selling natural organic foods as well. Especially Kroger and Trader Joe's, two very important ones. But even some you don't think about, like Walmart, of all people-- MIKE SANTOLI: Sure. JEROME DODSON: --(LAUGH) selling natural organic foods. So it's no longer a unique market to them. They don't have that same market niche. So they're gonna have to do something to get back. What they're doing now is they have a new brand. I think it's called 365. And they're opening stores that are not as high priced. And I think there's a good market for that. If this concept does well, then I think they'll be able to snap back and get growth again. Because growth used to be 6%, 7%, 8%, sometimes double digit. Now it grew, I think, 1% in the last quarter. So we're talking about really slow growth. So they need to get going again. And if this new concept, the lower price concept, I think that should do it. MIKE SANTOLI: Yeah. So in terms of the, kind of, the macro backdrop and how the market is generalist (?) position, does that filter in to what you look at in terms of how you're gonna deploy money? Or is it just kind of a company by company process? JEROME DODSON: It's mostly a company by company process. But it indirectly affects us. For example, right now the cash holdings of the Parnassus Endeavor Fund are 15 percent. Usually we like to have maybe 5 percent. But what's happening is we're not able to find undervalued companies. MIKE SANTOLI: Interesting. JEROME DODSON: And the difficulty, we think, is that the market is fully valued. And if you look at certain ratios, it does look like it's fully valued. So that means that there's not as much opportunity out there if it's fully valued. In terms of the economy, the economy looks, like, okay. It could be better. But there's nothing looks bad in the offing. But you never know what's gonna happen. And so you really can't use the macro view too much, because it'll turn around and change. So for example, years ago, 15, 20 years ago, we would try to time the market. So if the market looked fully valued, we'd go in cash, and vice versa. If it looked undervalued, we'd invest. And every time we would sell and take a lot of cash, sometimes 30 percent and 40 percent cash, the market would still going up, even though it was fully valued. So we've stopped doing that, and it's been much better for us. Just focus on the individual company. MIKE SANTOLI: And so right now, when you mention the Endeavor Fund has had that cash position built up to a relatively high level, that's simply no-- it's not really a market call. It's just about not finding enough fresh opportunities? JEROME DODSON: Exactly. It's just that we can't put the cash to work, and we've had so much cash coming into the fund because of our good performance that we just can't deploy it. And we've been looking. And hopefully we'll find some. But in the current market, most companies, especially socially responsible companies, look pretty fully valued. MIKE SANTOLI: Interesting. I guess another kind of outgrowth of the whole process is the sector breakdown of your funds, right? I mean, obviously you don't own energy explicitly. Energy companies. But then in terms of very high, relatively high technology weighting. So in other words, is that all just kind of a byproduct of the types of companies that you insist on owning? It's not about saying, "Hey, I really liked technology this year"? JEROME DODSON: No, it's really because a lotta technology companies are socially responsible. And because of that, we tend to focus on that aspect. As you pointed out, we don't invest in any fossil fuels. That eliminates energy. But if a company is, unless it's, like, something that hurts the environment, we're pretty much open to any kind of company. But it just, that's the way that the individual companies add up in our portfolio and mean the heavy technology weight. MIKE SANTOLI: What about companies that are, I guess, by their product and by their kind of stated mission, are about renewable energy or other areas where it's very specifically an environmental focus? Is that a special focus of the funds? Or is that just, you know, just one other company that might be okay? Like solar power or something like that. JEROME DODSON: Well, you'd think we would invest a lot in solar power, you know, given our philosophy. Because as a society, and for the environment, solar power is great. We don't own any, unfortunately, because they tend to be overvalued. They tend to have certain aspects that we don't think are sustainable, such as the subsidy. There now there's subsidies. You get tax subsidies. And we're worried that by legislative fiat, you could do away with those subsidies. And so the fact they're (?) being fully valued if not overvalued, having the problem of the subsidies, we haven't invested in solar power. So a citizen, I think it's great. But as an investor, it doesn't make sense. MIKE SANTOLI: Interesting. And your end investors, right, so the people who have money with you, are they for the most part specifically looking for that kind of social play as well as the investment return? I mean, is that kind of how the funds tend to be positioned out in the market? JEROME DODSON: We used to know that answer to the question. We started out, it was mostly people that liked the social and environmental factors. Now, we have so many shareholders. We have 350,000 people that own shares in our funds. And we tried to do a survey, but we did not get a statically valid sample. People (?) wouldn't fill in the surveys. (LAUGH) So we really don't know. And we've talked about it ourselves. And some people think that well, in terms of the social, environmental investors, they only amount to maybe, like, 20 percent, 30 percent. It's really people that like the return. I wish I knew the answer to that. And I think it's both. But I suspect that really, a lot of that money that's come in, pushing up to $20 billion, is really people that look at it, and hey, it's-- this is a good place to make money. There is a hard core, though, that like the social aspects of it. But we haven't been able to-- we've tried survey. We really can't answer the. MIKE SANTOLI: Interesting. One thing we like to ask, actually, is any lessons or general principles that you've come across in all your years of investing. And you mentioned, maybe, that the hazards of explicitly trying to time the market, at least from your fund's perspective. But are there other things you feel like you always like to try to emphasize or come back to when it comes to, you know, those lessons or principles? JEROME DODSON: Well, type of market, we've already talked about that one, which is an important one. I think one of the major problems in investing is that when things look good, the stock is up high. And that's the worst time to invest. And when the stock goes down, it's the best time to invest. But there's something that happened that makes people nervous. And so it's really a psychological problem more than anything. If you're able to train yourself to go in after a stock goes down with the confidence, you're gonna do much better. But if you keep buying stocks at the top, you're doomed to poor performance, in my opinion. So I think the psychology is probably one of the most important aspects. MIKE SANTOLI: So when it feels most uncomfortable, perhaps, to look to buy is often the right time to do it-- JEROME DODSON: Absolutely. You have to be able to use rationality. To use your mind to think beyond short-term aspects of what came down, and say, "Okay, is this company gonna go out of business, or is it gonna not grow again, or terrible things happen to it? Or is it gonna change? Is it gonna go back to being a good company?" If you're able to think that through, I think that you solved a lotta the problems, that you're on your way to getting better performance. MIKE SANTOLI: And then I guess there have to be times when, you know, your faith that it's only temporary is not redeemed, right? When it turns out that things were perhaps worse, or it's more of a permanent destruction of value at the company. How do you know when to abandon one? JEROME DODSON: Well, that's a really good question. I have an issue right now. An example would be IBM. We own IBM because it's selling at a very low price. And we think it should be turning around. The problem is that its hardware that it's selling is-- has very low margins. Its software and services have high margins. So they're trying to go from being a hardware company to a software and services company. So they're trying to do that. But it's been much slower than I thought. They haven't been able to convert it into the software and services company. And so is that mean it's gonna be forever down here? So we're holding on. But that's one that sometimes I wonder, maybe I made-- so we're not perfect by any means. There's some times we'll have these ones, and they just don't come back. But in most of the cases, we're correct. But IBM, the jury is still out. I hope they're able to come back. But it's been much longer than I ever anticipated. MIKE SANTOLI: Well, the company did start with adding machines, it's-- JEROME DODSON: (LAUGH) Sure. MIKE SANTOLI: --reinvented itself before. Or timestamp machines, actually, I think, right? JEROME DODSON: Is that where it was? Where it was-- MIKE SANTOLI: Yeah, so. JEROME DODSON: --a time clock would come in? (LAUGH) MIKE SANTOLI: Maybe there's a record for them coming back. We'll see. JEROME DODSON: Good. MIKE SANTOLI: Jerry, thank you very much for being here. Appreciate that. JEROME DODSON: Thank you. I have enjoyed being on the program. MIKE SANTOLI: Thanks. For CNBC PRO Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

"Right now the cash holdings of the Parnassus Endeavor Fund are 15 percent. Usually we like to have maybe 5 percent. But what's happening is, we are not able to find undervalued companies," said Dodson. "And the difficulty we think is that the market is fully valued."

The Parnassus Endeavor Fund is the top-performing large cap growth fund over the last three, five and 10 years, according to Morningstar. The fund is up 11 percent this year alone.

In this wide-ranging conversation with CNBC's Mike Santoli, Dodson shares his investment approach, and also discusses:

How there are still some values out there.
Three of his favorite long-term holdings.
Socially responsible investing.
His favorite investing lessons.

PRO subscribers can also read the entire transcript of the exclusive interview below.

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