Starting from the bottom is tough, but it has two key advantages. You are already prepared for the worst and, of course, the only way is up.
It is a long time since TCW’s Diane Jaffee was at the bottom, where she started over 20 years ago, but she keeps in mind the lessons learnt on her way up.
Today she runs over $7 billion in three strategies for Los Angeles-based TCW, but she got her big break in fund management on the Kidder, Peabody Equity Income fund back in the 1990s, in something of a Hail Mary for the then stalling strategy.
‘People joked the reason I got to be a portfolio manager (PM) was that the Kidder, Peabody Equity Income fund was in the bottom quartile and it had just literally blown itself it up,’ she laughs. ‘I was like a ride-in candidate, and the board of directors said to me if I could make this beautiful investment philosophy and present it then I could be the PM. And within 12 months it was out of the bottom quartile and into the top quartile.’
The ‘beautiful philosophy’ she refers to is her relative value investment approach, which in her own words ‘searches for value, but is poised for growth.’ To learn more about Jaffee’s process and philosophy, see section at the bottom of the page. It is what drives the $476.9 million TCW Relative Value Large Cap and $101 million Relative Value Mid Cap funds, as well as the $684.8 million Relative Value Dividend Appreciation fund.
The large and mid cap funds are top quartile over the past year, but drop to the second and third respectively over three years. This does not bother Jaffee for two reasons: one, she started off in a far worse place, and two, she argues these things are cyclical.
‘When we get into the bottom quartile again, and we will because everything is cyclical, I know this philosophy will get us out,’ she says.
Her belief in all things being cyclical is also the basis for a pretty short PhD.
‘If I do ever get my PhD it’s only going to have one sentence in it: everything is cyclical,’ she says. ‘Even passive or index investing.’
Jaffee argues there have been passive booms before, in the 90s, which in part inflated the ‘Four Horsemen’ of the dotcom bubble (EMC, Cisco Systems, Oracle and Sun Microsystems – which collectively underperformed the wider index), and the 80s too, although she concedes the current rally has run longer than any before.
Her belief in active managers, or one at least, is in play in the Large Cap fund, where she added Invesco in the first quarter of 2017.
‘The valuation is unbelievably attractive,’ she said. ‘We do feel that it’s a new product, a new market story. They have put out a series of active ETFs that have been gaining shares, so flows have actually been pretty good, not like T. Rowe Price or some others, which have been more heavily beaten up. Also 33% of its client base is non-US, and they have not moved to the same degree to passive as we have.
‘They had some significant PMs leave two years ago and the stock price was a bit depressed because of that. We have been watching that carefully and that stabilized. They have a big London office, but with fears about Brexit they also have licences in Frankfurt, Paris and Amsterdam.’
Brexit is one of Jaffee’s favorite topics, and aside from her skepticism about prime minister Theresa May and admiration for central banker Mark Carney, she believes the shock vote for the UK to leave the European Union marked the end of this current passive rally.
‘The bell rang on active versus passive with Brexit,’ she says. ‘No one expected that vote. If you’re an index manager [the next day] you pro rata money into the larger weighted names, but that night we were processing that information and we took fairly significant action the next day.’
She introduced commercial real estate services firm Jones Lang LaSalle (JLL), which is listed in the US, after it fell on Brexit due to concerns over UK and European property prices.
‘It came down because it had this European exposure, but we assessed quickly what the damage could be from Brexit to JLL and liked the fact it had these maintenance revenues even if there were not a lot of transactions. And guess what? If 3,000 Londoners have to go to Frankfurt there are going to be lots [of transactions].’
While Donald Trump’s election as president of the US is not as popular a subject of conversation for Jaffee, she says reacting to the shock result again highlighted how active managers could prove their worth versus an index.
‘November 8 happens, and that evening I’m really upset, thinking about never coming to work again. But I get up and come into work, and now we know the outcome I make moves in healthcare and in financials, and we proceeded to continue to outperform until the end of the year. That’s my job,’ she says.
Jaffee (pictured above) had been underweight healthcare going into the third quarter of 2016 and was unsure how to play it given the candidates’ contrasting positions.
Since Trump’s win she has bought medical device company Metronic and Medicaid-managed care organization Centene.
In both instances the catalysts for growth are company restructuring and potential new markets.
Despite threatened cuts to Medicaid by the Trump healthcare bill, Jaffee sees some significant new markets opening up for Centene.
In March 2016, the firm completed its acquisition of Health Net, which gave the company deeper penetration into California, which has the largest US Medicaid population.
‘Their stock had been depressed because they entered the California market with the acquisition, and basically they became the outsourced agent for Medicaid in California. [But] there are going to be $70 billion of requests for proposals from states to outsource their Medicaid over the next year to 18 months, and Centene is the largest Medicaid managed care company with a very high degree of expertise. Texas, Florida and North Carolina all are coming up for bid.’
The passive cycle is not the only one Jaffee believes is coming to an end. She argues investors’ preference for FANGs and utilities too has had its time, with valuations in these sectors stretched. ‘The international investor in the American market is like: “I’m going to buy technology stocks and balance it out with utility stocks.” And that’s not quite how we think of the world.
‘Relative value is coming into its own,’ she says. ‘We have found that having exposure to all the major economic sectors has maybe pinched us in terms of shorter time periods, but over time the results are good and the risk is better. We believe in shorter-term inefficiencies but longer-term investors will realize the truth will out.
The 'beautiful philosophy'
Jaffee’s funds seek undervalued stocks where the company has a fundamental catalyst or competitive advantage that will ultimately be recognized by the market place and appreciate in value.
Jaffe and her team look for short-term inefficiencies in the market to exploit over the long term, such as firms with a period of depressed earnings, meaning they have fallen off analysts’ coverage and therefore other investors’ radars.
Stocks are then assessed against five valuation factors: price to book, price to cash flow, price to sales, price to earnings and dividends equal or greater than the market.
They must hit the mark against at least one, but usually three. A valuation target is then set depending on which factor is most relevant to a company’s industry. When holdings reach within 10% of that target, they start to be sold off.
On the downside, if they drop 10% to 15% in the large-cap fund, and 15% to 20% in the mid-cap fund, Jaffee and her team conduct a fundamental review into the holding, which can lead to a selloff. These reviews used to take place within two weeks of a red flag. Since the financial crisis of 2008 they are completed and action is taken within one week.
‘We found through attribution the faster we moved in 2008, the better the outcome,’ says Jaffee. ‘So January 1 in 2009 we moved to one week or less for a fundamental review.’
While taking a bottom-up approach to stock selection, Jaffee maintains a weighting to all industry sectors.
She currently has significant overweights to basic materials, industrials, financials and to a lesser extent energy and consumer discretionary, with underweights to telecoms, utilities, consumer staples and real estate.
Frank Talbot, head of investment research, Citywire
It has been a tricky period for the TCW Relative Value Large Cap strategy over the past few years – probably its toughest of the past decade.
Nevertheless, the fund has only slipped marginally behind the benchmark over the past seven years and remains firmly ahead of the peer group.
While returns of that caliber are hardly awe inspiring, the strategy doesn’t put your capital at a great deal of risk relative to the index, despite holding just 49 stocks.
If they are really in a cyclical low point, then it would appear to be an opportune moment to invest. Just don’t expect massive amounts of outperformance.