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By Kathryn Young | 06-08-2011 11:22 AM

Investing in Energy Sustainably

Using a sustainable investing lens can help boost your long-term energy sector returns, according to Parnassus' Ben Allen.

Kathryn Young: Hi. I'm Kathryn Young from Morningstar. I'm here at the Morningstar Investment Conference with Ben Allen, of Parnassus. He is the Portfolio Manager of Parnassus Mid-Cap and is also the firm's director of research.

Ben, thanks so much for being here.

Ben Allen: Thanks for having me.

Young: So all the Parnassus funds are invested with a focus on sustainability. Can you tell us what that means for your investment process and what advantage you feel that provides?

Allen: Sure. Well, for us the most important factors are environmental, social, and governance. Those are sort of the three main categories for responsible investment. We've always integrated this ESG process into our investment philosophy and ever since the firm's founding in 1984. So what it means to us is really two things. The first thing is that we exclude certain companies that don't fit our criteria, and that's relatively a straightforward process. It's a percentage of revenue, and we look for companies once, we've screened out. Then we look for companies with positive attributes on those environmental, social, and governance criteria.

Young: Why do you think that is an advantage?

Allen: We view the ESG lens that we look through as another way to understand the fundamental story that we're looking at. So if we were to look at a company--let's say it's an energy company--and we didn't look at its environmental record or its safety record, we think that we'd be missing something in the story. For us, the ESG factors really come into play when the certain issue that we're looking at really ties into the fundamental story. This is because at the end of the day, our primary objective is to generate very good risk-adjusted returns for our shareholders and to do that in a responsible way. That's really the goal of this ESG process. It is to really drive the understanding of the fundamentals and identify risks in the stories that other people might have ignored because they don't have that discipline of looking at ESG factors.

Young: I'm glad you brought up energy, because many people feel that a sustainability focus necessarily diminishes your opportunity set. I think the energy sector is a good example of that. Your fund does have energy exposure. Can you tell us a little bit about how you approach that with your focus?

Allen: Sure, we do invest in energy companies. We do invest in E&P companies, and the way that we do it is, we want to limit the risks and want to limit the unknowns. So, when we look for energy companies, and particularly in the E&P space, we're looking for companies in general that are in the United States. If they are offshore, they are shallow-water firms normally, so we don't want deep-water firms because we see how that can go. We generally are going to avoid operations in countries that we don't feel comfortable with the governance, such as the political situation there or the environmental safety records of those countries.

In general we're going to have U.S.-based companies. The big issue is sort of the split between gas and oil. We generally skew toward natural gas. First of all, for investment purposes, we think it's an undervalued resource right now relative to oil. But that opens us up to some of the risks with regard to fracing. So when we look at fracing and E&P companies that do that, we're going to avoid the most sensitive areas like the Marcellus Shale for example. The Delaware River Valley is also a very politically sensitive area because it happens to be upriver from New York City and Philadelphia. So, it's the kind of thing where if an accident were to happen, the risks are much greater. So we like our companies, generally speaking, in West Texas, the Permian Basin, Colorado, New Mexico, and South Dakota, places where it's important to be environmentally sound, of course, but the risks to large populations are diminished in those areas. So, that's how we believe view that space.

Young: So, maybe relative to a benchmark or a peer set, do you feel that from a performance standpoint that has held your back at all in the energy sector?

Allen: No. We group our energy and utilities together internally. One of the reasons is that one of our largest holdings is Energen. The firm is technically utility because it has a regulated utility. But about 85% of its income comes from an E&P operation. So a lot of our E&P exposure actually comes through utilities. So, we group those two together, and we overweight those two sectors relative to the S&P 500 right now. Again we are skewed toward companies that we can really understand the risks from an environmental and safety standpoint. So, it doesn't diminish at all our ability to invest in that space, and we think it gives us an advantage because we have a discipline to avoid companies with relatively larger risk than our investments would have.

Young: One last question: Many of the risks a sustainability focus is designed to guard against, such as the cost of carbon emissions should that be priced at some point, seem sort of a long way off. Why is it necessary for investors to be thinking about those things now in terms of their portfolio?

Allen: That's a great question. One of the most important things I think when evaluating in ESG strategy frankly is to ask what your investment horizon is. For us at Parnassus, we look at a three-year investment horizon. The actual hold periods are going to vary of course. We've held certain companies for more than a decade, and occasionally we will sell within a year or so. But generally speaking we are looking at three years. So, it's a great question and something that we ask ourselves because a lot of these factors, especially with climate-change issues and the potential for legislation, could be a long way off. So, in general, we are looking to see if one of our companies has an operation that might be hurt some way or another with legislation. We are certainly going to focus on that in the short term.

One of our holdings is Waste Management and waste to energy is one of their operations. They actually got favorable treatment from Congress in viewing that as a renewable source of energy. So, that's an example where this is a global-warming issue, and one of our companies actually benefited from the legislation in the short term. So certain times we are going to see an opportunity to take advantage of legislation, but it's really company-specific.

Young: So, it sounds like some of these costs are cropping up more and more?

Allen: Right.

Young: Well, Ben thanks so much for being here. We really appreciate it.

Allen: Thank you.

Young: Thanks for watching.

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