Small-company stocks have been hot of late, but Parnassus Small-Cap Fund (symbol PARSX (opens in new tab)) has been even hotter. Over the past three years, Parnassus has beaten its category by an average of more than nine percentage 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 sketchy accounting.
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Although small-company stocks have historically delivered higher returns than their large-firm 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 past year's strong results have been a pleasant exception.
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