In late August of last year, Parnassus Fund's huge cash allocation-at 62% of assets, more than 10 times the industry average-reflected manager Jerome Dodson's concerns about high stock-market valuations and a souring economy. This dash of conservatism paid off after the terrorist attacks of September 11 sent stocks tumbling. By the time the year had drawn to a close, the fund gained 7.84%, compared with a loss of 11.89% for the S&P 500 Index.

"Some of the fund's strong performance for the year was because of good stock-picking," says Dodson, "but much of it was because we had about half our assets in cash for most of the year."

Mutual funds normally keep their cash positions well below 10% with the idea that shareholders pay stock fund managers to invest in stocks, not warm the bench. Until a couple of years ago, Dodson did that, too.

"There were two previous times in the fund's history, in 1987 and in 1990, when I thought the market was greatly overvalued. But I didn't have the confidence to act on that belief. And both years, I lived to regret it." By the time 2000 rolled around, his belief that the market was ripe for a tumble finally prompted him to move on his conviction and take some money off the table.

The main downside of a high cash stake, of course, is that a fund risks getting left behind if the market takes off. "I think that risk is outweighed by the reduction in risk you get when stocks are overvalued," says Dodson. "And at current levels, I don't see much upside for stocks anyway."

For the rest of 2002, he predicts, "Either one of two things will happen. There could be a sharp correction that will pull valuations in line with business prospects. Or, we'll just see minimal, single-digit market gains. I don't have too many concerns about the market running away from us."

And what about the potential fallout from financial advisors, whose asset-allocation strategies unwind when a fund moves into cash? "I've had a couple of advisors bring up that point," says Dodson. "But for most of our shareholders, the main priority is getting a good return."

Betting On Telecom

Dodson points out that while a heavy cash position certainly helped the fund last year, it was not the only factor behind its strong performance. Of the fund's nearly 8% gain, almost 6% came from the equity side of the portfolio. Big winners included PETsMART, up 242% for the year, and chip-maker Adaptec, up 96%. "There wasn't any one sector that led the market," he says. "It was more like a retailer here, a tech name there."

Today, Parnassus Fund's cash position is down to about 30% of assets. After the stock market re-opened in late September, market levels were so low that Dodson used his cash stake to buy stocks at what he considered bargain levels.

Many of these stocks, which remain in the portfolio today, are in the battered telecommunications sector. "Telecom is the only area of the market that's still selling at bargain levels, yet has the potential for growth. Every other industry with growth potential is fully valued."

Dodson won't buy a stock unless it's selling below its five-year average for measures such as price/earnings, price/book and price/sales. A stock's P/E ratio also must be no higher than the company's projected earnings growth rate over the next year.

He also looks at a company's intrinsic value, which he bases on its future cash flows. He will buy a stock only when it is selling at two-thirds or less of what he considers its intrinsic worth.

The strategy often lands his picks squarely in the "fallen angel" camp-an inevitable result, he says, from shopping for growth stocks trading at value prices. "A lot of times, our stocks will go down for awhile before they go up," he says. "No one rings a bell at the bottom."

If there were such a bell, it would certainly not be ringing yet for the fund's telecommunications stocks, which had fallen by about 7% as of mid-April. The drop in the sector is the main reason the fund was down 5.14%, compared with a drop of 1.59% for the S&P 500 Index.

Dodson attributes the downturn to continued cutbacks in capital spending by long-distance telephone carriers, which directly affect many of the telecommunications-equipment companies in the portfolio. Although the downturn has lasted longer than Dodson thought it would, he believes that an improvement in orders will help the stocks make a comeback by the end of the year.

Parnassus' telecommunications plays, like the rest of the fund, represent a mix of small, mid-sized and larger companies. His largest holding, Ciena, maintains a 60% share of the optical-switching market. The stock, priced in the high sixties a year ago, had collapsed to about $7 a share as of mid-May. Dodson figures the stock will rise to $16 within the next 12 to 18 months. The fund's second-largest holding, Redback Networks, is a small telecommunications-equipment maker whose stock has fallen to less than $2 a share from more than $25 a share a year ago. Dodson calculates its intrinsic value at around $15 a share.

Can Socially Responsible Investing Beat A Bad Rap?

As a mutual fund that specializes in socially responsible investing, Parnassus Fund does not invest in stocks of companies involved in the manufacturing of tobacco, alcohol and weapons, or companies that derive revenue from gambling or that generate electricity from nuclear power. It also looks for companies that respect the environment, treat their employees well, have effective equal-opportunity policies, good community relations and ethical business dealings.

While criticizing such admirable ideals may seem like kicking a choirboy in the stomach, detractors believe that limiting an investment universe in this manner hurts returns. Proponents like Dodson say more than enough stocks are left after their screens to put together a winning portfolio, and investment performance has more to do with the talents and style of the individual investment manager than social criteria. "If the fund hasn't done well in a particular year, it isn't because of any social criteria," says Dodson. "It's because I haven't picked the right stocks."

Many socially responsible funds, including Dodson's, missed the rebounds in stocks of tobacco companies, weapons makers and energy companies over the last couple of years. But they also managed to sidestep the fallout from the litigation woes that plagued the likes of Philip Morris and the stagnation of oil-company stocks when the price of crude was mired in sludge. Those that leaned toward "clean" industries such as technology plugged into the sector's performance surge in the late 1990s, although that bias backfired in the more recent tech wreck.

In the long run, socially responsible investing may just be a different approach that, by virtue of a bias toward more growth-oriented, "clean" industries, outperforms during some periods and underperforms in others. Over the last three years, the Domini Social Index 400, a socially screened index designed to mirror the S&P 500, fell an average of 3.9% annually, compared with a drop of 2.46% for the S&P. But the Domini Index was slightly ahead for the five- and 10-year periods, with returns of 9.2% and 13.27%, respectively, compared with 8.45% and 12.41% for the S&P.

Beyond the question of performance are the notions that social screens can't possibly filter out every manner of bad behavior and that almost every company has skeletons in its closet. And while investors may agree with one social screen, they many not support another. One of the more controversial ones these days, says Dodson, is weapons manufacturers. Many people simply don't put corporate polluters and those involved in national defense in the same category, particularly after the September 11 terrorist attacks brought patriotism back into fashion. "We have gotten letters from a number of shareholders asking us if we intend to change our policy on weapons manufacturers," he says. "When the fund was started in late 1984, the country was spending way too much on the military, which isn't the case anymore. I believe we need a strong defense, and we're having a dialogue with shareholders on the issue right now. It's certainly not as clear-cut as our other screens."