Investing with socially respon­sible criteria has long been viewed as a way to align one's principles and pocketbook. But as the economic clouds darken, it's also important to consider that improved ethics might also improve the bottom line, benefiting shareholders in the long run. At least that's the belief of Todd Ahlsten, manager of the Parnassus Equity Income Fund. 

Like other broad-based socially responsible funds, Parnassus Equity Income screens out companies involved in the manufacture of weapons, tobacco and alcohol; those companies related to nuclear power; companies with gambling operations; and businesses that have poor workplace or environmental practices. Once those are tossed from the potential investment universe, the fund zeroes in on companies that promote women and minorities, have good environmental practices, pay executives a fair amount rather than an excessive amount, and pursue ethical business and governance practices.

"Socially responsible investors run the gamut from the Birkenstock sandal crowd that hates Target to traditional guys in business suits who love it," says the 37-year-old Ahlsten. "We fall somewhere in between the two."

The fund manager says his screens have a built-in bias toward companies with staying power in tough times. "There are a lot of prongs to socially responsible investing, but I think the basic underpinning is sustainability," he says. "Companies that are socially conscious keep their eye on the ball and are always aware of what they can do to make their businesses strong and sustainable. And that makes them more resistant to recession."

He believes that the new Obama administration will help bring ethical and social principles to the forefront, which will benefit those companies that already practice them. "We're going to see more focus on renewable energy and sustainable infrastructure and greater scrutiny of labor laws and executive compensation practices," he contends. "All of these things have been on our radar screen for years."

For now, however, his near-term outlook for both the banking sector and the economy remains grim. Ahlsten says that while the government bailout will likely avert the worst case and abate the severity of the downturn, it will take at least three to five years for consumers and companies to wring out the excessive levels of debt they've amassed before a recovery can take place. "This deleveraging process is unavoidable and must run its course if we are to have a free-market economy," he says.

As that painful process continues, Ahlsten hopes the fund will continue to beat the market. Last year it fell by 23%, outperforming the S&P 500 by 14 percentage points and its Morningstar large blend peer by about the same margin.

According to Morningstar analyst Wenli Tan, shareholders in Ahlsten's fund have recently benefited from well-timed moves out of overheating spots. Tan noted in a recent review that Ahlsten sold most of the fund's housing-related financial picks in 2005 when he became concerned that the housing bubble could burst. Ahlsten also trimmed bets on non-nuclear energy companies with good environmental records, such as XTO Energy and Apache, before oil prices peaked in the summer of 2008. The fund's cash stake, which climbed as high as 15% in September 2007, provided a cushion during the credit crisis. "These moves have all worked in the fund's favor," Tan observes.

The fund's hefty stakes in recession-resistant health-care companies such as Johnson & Johnson have also had a positive impact. By year-end, the fund had 21% of its assets in the sector, 6 percentage points more than the S&P 500 index did. It also has a larger weighting than the index in technology companies, which have held up better than other corners of the stock market.

Ahlsten cites ethical screens as a major reason the fund avoided the financial sector's worst offenders. "We looked at Washington Mutual and Countrywide and didn't approve of the way they were stuffing their loan portfolios with subprime mortgages," he says. At other companies, such as AIG, excessive executive compensation and rosy reported earnings added to his conviction that the firms were skirting the boundaries of ethical business practices and that those earnings were not sustainable.

The whiff of industry problems became a stench as 2008 unfolded, and Ahlsten had just 11% of his fund's assets in the financials sector as the fourth quarter approached while the S&P 500 index had a higher 16% industry weighting.

Nonetheless, the presence of JPMorgan Chase and Wells Fargo in his portfolio might raise some eyebrows. Ahlsten says JPMorgan Chase has a more diversified business, better loan practices and fewer credit card defaults than many competitors, as well as a favorable policy toward gays and lesbians in the workplace. Wells Fargo "does a lot of cross-selling, so people often have checking, savings, home mortgages and investments there. The bank has a lot of information about the people they lend money to and was willing to lose market share to minimize toxic loans." Although both banks have had to be propped up with bailout money, he believes they "will eventually emerge as banking powerhouses."

Between Birkenstock and Business Suits
Critics of socially responsible investing say there are too many gray areas when it comes to interpreting ethical behavior, and they believe the practice rules out too many attractive companies. Ahlsten admits the fund's socially responsible charter prevents him from investing in some recession-resistant industries such as defense, alcohol and tobacco. And occasionally he has had to unload companies he likes when their business practices deviated from what he considered acceptable criteria. A few years ago, he sold Merck because he felt the company had not been forthcoming about the cardiovascular issues associated with its painkilling drug Vioxx. More recently, he sold Caterpillar because it does business in Sudan, whose government has been roundly accused of abetting genocide in the Darfur region.

On the other hand, there are companies that do pass the social screens and offer stable revenues and predictable business demand-companies such as WD-40 (the lubricant manufacturer) and food services provider Sysco. A number of the staples Ahlsten has owned for years in the portfolio are financially sound and have good growth prospects.

Another is Microsoft. Though the company has had to lay off employees and cut operating costs as revenues stagnate, it has more than $20 billion in cash and does not have to rely on banks to fund its research and development. Ahlsten believes the stock is a "remarkable value" that could double over the next five years. There is also Google, "a blue chip of tomorrow" that has tightened its hold on the online search engine market. He thinks that stock could well trade as high as $750 within the next five to seven years. With $14 billion in cash and no debt, Google "is a cash cow and a cheetah all in one."

Since 1996, Ahlsten has also owned Energen-both a utility company and one of the top 20 U.S. owners of natural gas and oil reserves-because "it has great, long-lived oil and gas assets and is run by good people," he says. While he recently sold portions of many of the fund's energy investments, he held on to Energen because it had hedged a lot of future production at good prices to lock in profits.

Beyond social criteria, Ahlsten looks for larger companies that are growing faster than the rest of the economy, companies with good business fundamentals that become temporarily undervalued because of market sentiment. A stock needs to have twice as much upside potential as downside risk, a catalyst that will lead to appreciation, and sell at a 20% discount to intrinsic value calculations.

He also looks at what he calls the "management DNA factor," his assessment of what makes managers tick, what motivates them and how ethical he believes they are in their business practices. A company's core ethics are hard to measure, but Ahlsten and his team try-logging hundreds of thousands of miles in travel each year to visit and speak with their companies' top officers. And they ask for more than rosy numbers.

"I want to know what their hobbies are, where they went to school, who they admire. I ask a lot of touchy-feely questions and get answers you don't find in a press release. Common sense and ethics start at the top and filter down."

Ahlsten doesn't expect the market to take off as a result of the bailout monies, but he says we will see several brief, supernova stock market rallies over the next 18 months. The Standard & Poor's 500 index, he adds, should bounce around a trading range of 750 to 950 for the rest of the year.

"These will be quick, 10% pops as investors speculate on a quick economic recovery," he says. "But given the large structural debt issues affecting the economy, I don't expect the stock market to have a sustained rally until this financial deleveraging concludes and the housing market begins its recovery."