Small-company stocks have been hot of late, but Parnassus Small-Cap Fund (symbol PARSX) has been even hotter. Over the past five years through November 19, Parnassus returned an annualized 8.9%, beating the Russell 2000 index of small-company stocks by an average of 6.0 percentage points per year and its category (stocks of small companies with a blend of growth and value attributes) by an average of 6.4 points per year. Veteran manager Jerome Dodson has done so by investing in small but strong companies that sell at value prices and meet his social screens.
Dodson begins by trying to determine the business value of a company, or what the business is worth regardless of the stock price. If the stock’s market capitalization (price times shares outstanding) is one-third or more below his estimate of the company’s value, he’ll consider adding it to the fund.
But a cheap stock isn’t a value unless the company’s businesses are strong. So Dodson looks for firms that have sustainable competitive advantages and strong balance sheets, with low debt and a lot of cash. Strength also comes from being socially responsible, he believes. He says that if a company respects the environment and its employees, it’s less likely to be fined, face lawsuits or practice fraudulent accounting.
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Although small-company stocks have historically delivered higher returns than their large-company brethren, they tend to be more volatile. Thanks to his conservative strategy, Dodson has a history of limiting losses during bear markets (Small-Cap lost 25% in 2008, compared with a 34% loss for the Russell 2000 index) but lagging during strong markets.
The fund, however, has performed admirably over the past year, a time of generally strong performance for stocks. Over that period, it returned 27.8%, beating the Russell 2000 index by 2.5 percentage points and the average small-blend fund by 4.0 points.
The performance of small-company stocks doesn’t line up precisely with that of large-company shares. Small-capitalization stocks usually outperform large caps at the start of a bull market. As the bull market ages, small caps begin to lag. Since the stock market bottomed on March 9, 2009, the Russell 2000 has surged a whopping 111%, while Standard & Poor’s 500-stock index, which is oriented toward large companies, has returned a not-unimpressive 84%. In Dodson’s view, the small-cap party isn’t over yet. He says he expects small caps to outpace the shares of large companies for at least another 12 to 18 months.
Dodson says he’s particularly upbeat about the telecommunications sector. Because of the continued growth in the use of the Internet and the proliferation of smart phones and other mobile devices, carriers are experiencing exponential increases in traffic, which is placing huge demands on their networks.
As a result, Dodson says, telecom-services providers need to invest in equipment to meet the increasingly large volume of data coursing over their networks. Among companies likely to benefit, says Dodson, are makers of optical networking products, such as Ciena (CIEN), Tellabs (TLAB) and, in particular, Finisar (FNSR). Finisar has a new product, called roadm, that enables telecom companies to reconfigure their networks depending upon the amount of power being used or the kind of data that’s being transmitted.
Dodson also likes an obscure Israeli company called Ceragon Networks (CRNT). It manufactures equipment that allows wireless-services providers to transfer cell-phone calls from individual towers back to the core network. Sales to emerging markets represent a huge opportunity for Ceragon, says Dodson. He also favors ClickSoftware Technologies (CKSW), which makes workforce-management software. It, too, is based in Israel.
And although most investors are avoiding homebuilders, Dodson thinks the stocks are too cheap to pass up. His favorite is Toll Brothers (TOL), a maker of high-end homes.
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