A familiar story played out in the market this week as a sharp two-day decline in tech stocks quickly reversed.
It was the latest example of an equity market shock being quickly forgotten, with investors using weakness as an opportunity to buy.
Jaffee runs a handful of value-focused strategies and funds at TCW. In other words, she’s out there looking for bargains — but only if the underlying company’s fundamentals are up to snuff.
In an interview with Business Insider, Jaffee spoke about the tech sell-off, earnings growth, stock valuations and market conditions for active managers.
This interview has been edited for clarity and length.
Joe Ciolli: What’s your take on the tech sell-off we saw on Friday and into Monday? Is it something to be worried about, or is it just another patch of weakness that allows for opportunistic dip buying?
Diane Jaffee: I wouldn’t be surprised if that was just a little nervous selling as we awaited second-quarter earnings results. We shouldn’t get so hung up on just a little bit of market rebalancing. We’re so used to this luxurious feeling of very little volatility, but as an active manager we like for things to bounce around, to make sure everyone does their homework.
The year-over-year earnings growth rate for tech was, on average, over 30% in the first quarter. The estimates for 2017 are supposed to come down. So the sell-off in technology had some merit. But it was a controlled sell-off. It wasn’t a throw out the baby with the bath water kind of thing. It’s very over-owned.
Micron is reporting this week. As one of the backbones of the technology world, investors will be watching their results closely.
We believe that technology is a vastly important sector for the US economy. It’s something that we pay attention to not only on a macro basis, but also from a bottom-up valuation perspective.
Ciolli: It sounds like you view earnings growth as an important driver. But does it trump all else? Is it truly the bull market backstop?
Jaffee: It’s incredibly important, and technology was a big leader for the market in the first quarter. Earnings growth is really what’s holding up the market right now.
Ciolli: Since you build so much of your strategy around valuation, what are your preferred metrics?
Jaffee: As a value-oriented manager, a company has to meet at least one of our five valuation factors. Generally speaking, they have to meet three or more.
We do a statistical correlation analysis to determine significance. For many technology companies in the software space, price-to-sales is the most important. They rarely meet our five valuation factors because they’re so heady on a price-to-sales basis.
In the hardware space, we find that price-to-book is the most significant. It’s interesting that a sector like technology has different sub-industries that are valued on different measures. And, of course, price-to-earnings ratio can sometimes work.
Ciolli: There’s data showing that while tech got smoked for two days, the broader market was resilient. This has been attributed to a rotation into areas like financials and energy. What do you make of this rotation?
Jaffee: The rotation bodes very well for value. In fact, through the end of May, the differential between value and growth hit almost one standard deviation, year-to-date. This is still very much an active management market — in particular for value. Money started falling into areas like financials, energy and industrials, all areas that we’re overweight.
We stress test every bottom-up stock story. For the energy space, we use an average WTI crude price of $US40 for the next one to two years. Any energy stock in our portfolio has to be able to withstand that, among other things like balance sheet strength and company-specific catalysts. You want to be prudent, but we’re slightly overweight.
Ciolli: You’ve mentioned that this is a good environment for active management. Are there dislocations occurring in the market, where stocks are trading more independently?
Jaffee: Absolutely. Correlations have come down this year among both stocks and sectors. That provides buying opportunities across the board.
Ciolli: What are your specific sector calls? What about specific companies?
Jaffee: We’re overweight industrials, materials and energy. We’re equal-weight consumer discretionary. And we’re underweight consumer staples, healthcare, real estate, telecom and utilities.
Technology is an underweight versus the S&P 500. There are some names that don’t meet any of our five valuation characteristics: Facebook, Amazon, Netflix, Google.
In our top 10, we own Cisco and Microsoft. They’re finding new ways to interact with new technologies. With Cisco it’s through the security cloud, and with Microsoft it’s through their Azure cloud database.
Ciolli: More philosophically, what’s the best piece of advice you can give to an investor just starting out right now?
Jaffee: I determined early on that it was a good idea to be a student of market history — to try and get as much knowledge as I could about prior cycles. Not just the last three to five years, but during different time periods. Like Mark Twain said, the song might be a little different, but the melody is the same.
History provides the quantitative framework we use for everything. Our team has gone through many cycles together, which gives us a good idea of how to think about the current environment. Even on a stock-specific level, when we do our regression analysis, we go back 25-plus years to see the different timeframes.
It feels a lot like the 1990s, when volatility was in the low-20s for nearly a decade, and economic growth was similarly anemic to what we’re seeing now. But it was one of the best equity markets ever. It helps when we’re looking at individual companies, like General Electric, which is in our top 10. This company has a more than 100-year history. We know the framework to be able to evaluate various situations.
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