Jerome Dodson, the legendary guru of environmental, social and governance (ESG) investing, has a lot to cheer about these days. A strong stock market, growing consumer confidence and solid economic indicators are all good signs for investors and for his firm, San Francisco-based Parnassus Investments.
The promise of the new Donald Trump administration to lower corporate taxes and improve aging infrastructure seems to be moving the stock market forward, despite valuations that are high based on historic averages.

Things have also been going well closer to home as Parnassus’s stable of six mutual funds continue to churn out some impressive performance numbers. The $3.3 billion Parnassus Endeavor Fund, which the 73-year-old Dodson has managed since its inception in 2005, delivered nearly twice the return of the S&P 500 last year and has beaten the market over the long term. Parnassus Investments, which he started in 1984 with $300,000 in initial seed capital from friends and family, now manages over $21.6 billion.

Yet lurking in the shadows is a creeping anxiety Dodson and others feel about promises from the new administration to roll back financial and environmental regulations, among other things.
Earlier this year, he wrote on the firm’s website that “while relaxing the rules could make for short-term economic boosts, the long-term implications could be far-reaching, particularly on issues related to ESG investing.”

He worries that the administration will reverse many regulations designed to protect current and future generations. These include the Dodd-Frank rules, curbs on the production of coal and other fossil fuels and transparency requirements for companies reporting financial results. Since he penned those words, the new administration has pushed to limit overseas manufacturing, invoke tariffs on foreign goods and abolish the Affordable Care Act.

The shake-up has left Dodson wondering where the notoriously unpredictable Trump will go from here. “The bad news is that he has threatened a trade war with other countries with a focus on China and Mexico,” he says. “If he actually carries out those threats, it will be a disaster, and we’ll be plunged into a deep recession. The same is true of his threat to build a wall between the United States and Mexico.”

Parnassus has good reasons for concern. Many of its funds are overweight in technology companies that manufacture many of their parts in foreign countries. Hefty tariffs on these parts could raise consumer prices and slow sales. Health care, another big sector in some of the firm’s funds, could also suffer if the Affordable Care Act is repealed without a suitable replacement.

At the same time, he sees reason for optimism about the president’s desire to lower corporate taxes and expand infrastructure investments. Both moves, he believes, would help increase corporate earnings and stimulate economic growth. “If the Donald can forget about building a wall next to Mexico, drop his ideas of starting a trade war with China and others, and focus on tax reform and infrastructure investment, it would be a winning strategy,” Dodson maintains.

As the drama unfolds, Dodson continues his long tradition of zeroing in on stock picks that most would classify as contrarian. To find them, he sifts through companies that are suffering what he considers temporary misfortunes such as missed earnings numbers or falling sales, but that otherwise have enough long-term stamina to eventually recover. They must be selling at a steep discount relative to their five-year historic averages (according to their price/earnings ratios and other metrics). Once he buys them, he’s willing to wait several years for his investment thesis to pan out.

American Express, which he started buying back in February 2015, exemplifies his approach. Investors have punished the stock because of the increased competition the company faces from prestige cards and the loss of a longtime partnership with Costco.

Dodson believes that the company can turn things around, however, because it has innovative management and its cardholders spend more. The company is also known as a great workplace for employees, which falls under Parnassus Investments’ good governance banner. Amex’s price-to-earnings ratio is well below both the market average and its historic range, so the stock is also a bargain.

Dodson’s willingness to hang on to a company for the long term is apparent in his long history with IBM. He began buying the stock in 2013 when it dropped on disappointing earnings news, and earnings growth since then has been modest because of declining hardware sales. Still, the company’s software sales have been on the rise and at some point, he believes, those rising sales will more than compensate for hardware sales declines. In the meantime, the stock is selling at an extraordinarily low price-to-earnings ratio and yielding an attractive 3.15% to boot.

Parnassus Investments’ mutual funds couple bargain hunting and faithful tenacity with screens that weed out companies in alcohol, tobacco, weapons manufacturing, gambling and other “sin” industries. The funds also avoid companies involved with the exploration or production of fossil fuels, while pursuing companies that meet environmental, governance and social criteria in a broad swath of sectors.

In Parnassus Endeavor, once called Parnassus Workplace, the most important criteria for companies are their corporate policies toward and treatment of employees. Among the attributes Dodson likes are generous profit sharing and bonus plans for employees, companies’ open communications with shareholders, and corporate boards of directors with more independent members. He tries to suss out that kind of information through publicly available documents, as well as by speaking with employees and managers. “A good workplace environment is crucial to a company’s success because satisfied employees work harder to make a company more profitable,” he says.

Critics of ESG investing, also called sustainable investing, believe that people shouldn’t have to select stocks with their hands tied by constraints. They also argue that it’s difficult to weed out good corporate citizens from bad ones, since in many cases things don’t get put down on paper. This investment style also involves making judgment calls, since there isn’t a precise definition of what constitutes a strong environmental, social or governance practice.

Nonetheless sustainable investing, which was once mainly pursued by institutional investors and public pension funds, has been gaining traction among individuals. According to a survey done in 2015 by Morgan Stanley’s Institute for Sustainable Investing, 84% of millennials (those born between 1980 and 2002) indicated an interest in it. A 2016 survey by U.S. Trust reveals that interest in ESG investing is increasing, especially among high-net-worth women, millennials, Gen Xers and those with at least $10 million in investable assets.

Morningstar’s introduction of fund sustainability ratings provided another signal of growing its popularity.

While some ESG funds have middling performance records, that doesn’t apply to Parnassus offerings. Over the 10 years ending December 31, 2016, the Parnassus Fund delivered annualized returns of 9.68%, while Parnassus Endeavor returned 12.27% and Parnassus Core Equity returned 9.69%. The S&P 500 returned 6.93% for the same period.

The firm’s record of public investment performance traces back to 1984 when Dodson started the Parnassus Fund, one of the first mutual funds to engage in sustainable investing. In the fund’s early years, he occasionally moved large amounts into cash when he felt stocks were overvalued, and jumped back into the market after a correction. That practice ended about 15 years ago after some ill-timed moves took the fund out of the markets as they kept climbing. “I learned expensive markets can get even more expensive,” he says.

Which is pretty much what he thinks is going on now. Promises by the new Trump administration to cut taxes and expand infrastructure appear to be providing a tailwind to a seven-year-old bull market, and prices are becoming more and more expensive.
The price/earnings ratio of S&P 500 companies based on the last 12 months’ earnings is around 20, when the historical range is about 15 to 16. While the p/e of companies in Endeavor’s portfolio is much lower than the market average, they won’t be immune to a market correction.

“In my opinion, the stock market is now fully priced,” Dodson says. “It’s getting harder to find good companies that are undervalued.”

Nonetheless, he believes market misperception and investor overreaction to bad news will continue to provide fodder for bargain hunting. Last year, Qualcomm, the leading provider of software and semiconductors used in mobile devices, was one of the fund’s best performers. But earlier this year the stock suffered a setback when the company became embroiled in a legal battle with Apple over licensing agreements and licensing fees. Dodson took advantage of the downturn and bought more of the stock. “The fight will eventually be resolved because Apple and Qualcomm need each other,” he says.

Parnassus also invests in the stock of biotechnology holding Gilead, which makes therapies for HIV and hepatitis C. Because the company’s therapy drug for the latter disease cured so many people, demand for the drug is shrinking. This has caused an earnings decline. The share price sank nearly 30% last year and trades at around seven times earnings. Dodson believes the setback is temporary and added to the position in the company last year because Gilead has a strong balance sheet, plenty of cash and innovative scientists and managers capable of bringing new products to market.

The manager says he plans to continue looking for contrarian plays like these for a long time as manager of Endeavor, although he is doing some succession planning for the firm and other funds he manages. Benjamin Allen, who co-manages the firm’s flagship Core Equity Fund, was recently named the firm’s president and will assume the mantle of chief executive officer from Dodson in 2018. Dodson is also currently the lead manager on the Parnassus Fund and Parnassus Asia Fund, but plans to cede more control to his co-managers within the next few years.