Portfolio review
Equity markets continued to rally sharply higher in the second quarter as investors cheered the re-opening of economies following the pandemic. In a reversal from the prior quarter, growth stocks resumed leadership over value stocks. Top performers included sectors and industries most exposed to an accelerating economy and the re-opening such as real estate, select retailers and consumer credit providers thanks to soaring consumer demand. Semiconductors, the most cyclical subindustry in technology, also led the way within the sector. In addition, several of the mega-cap tech-related companies that are unowned in the portfolio including computer graphics processor provider. Nvidia and media platform Facebook, led the market higher.
The Fund is a conservatively managed large cap growth portfolio with a heavy focus on downside risk. The portfolio generally has lagged in exceptionally strong up markets and performed best during more volatile periods. The strong market rally in the second quarter where valuation and earnings durability were underappreciated proved to be challenging for the Fund’s style. The portfolio had zero exposure to the energy sector, traditional real estate companies and consumer credit providers because MFS believes they generally do not offer long term-growth compounding potential.
The Fund has long held a sizeable position in Alphabet, which is a leader in digital advertising due to its dominance in search and online video content, not to mention the increasing demand for its cloud services platform. Many of the high-quality businesses held in the portfolio, whose durable growth doesn't change markedly from quarter to quarter, lagged. In health care several of the medical equipment stocks such as Stryker, Boston Scientific and Becton Dickinson started to see a late-quarter recovery in surgical procedures with COVID waning but it has not yet fully reflected in revenues or earnings. In consumer staples, holding Colgate performed reasonably well yet investors focused on the drag from near-term raw materials inflation even though revenue growth was aided by pricing power resulting from their strong brand equities and premiumization strategy.
In aggregate, the portfolio manager does not believe these performance headwinds are sustainable and remain confident in the Fund’s investment style, approach and extensive research platform. the portfolio manager firmly believes the consistent application of the Fund’s investment process will lead to durable outperformance over the long term with careful consideration for downside risks.
Despite today's higher market valuations, the team continues to seek out and find great opportunities in steady growth compounders they feel are reasonably valued as a result of a sharp cyclical rotation and short-term focus of other investors. The Fund started a position in Xcel Energy following some excellent discussions with experts on our utilities sector team. The Fund became more interested in evaluating utilities as a potential fit for a growth portfolio due to the potential for low double-digit return compounding relative to the overall market's arguably above-trend earnings growth profile today, especially considering the lower risk profile from utilities. The Fund see’s upside risk to utility growth given the high need for investments in the electrical grid and renewables as well as potentially more headroom for rate growth over time as other elements of the customer utility bill decline. The portfolio manager is increasingly viewing utilities as "part of the solution" for tackling climate change, which could possibly result in higher valuations. The Fund is attracted to Xcel's strong management team with a consistent history of execution, attractive geographies in good regulatory jurisdictions of Colorado and Minnesota, with plenty of wind and sun as well and a serious plan to decarbonize. The purchase was funded by trimming lower conviction holding Cigna.
The Fund swapped its Comcast holdings into a new Charter Communications position which the team considers to be an upgrade to the Fund’s cable exposure. MFS believes Charter has a better growth outlook with 100% cable exposure, lower broadband pricing, either provides more opportunity to raise pricing in the future or less risk from regulation and better capital allocation. As with Comcast, the long-term thesis of continued broadband strength leading to higher margins and lower capital intensity appears to be playing out now. While Charter is expensive compared to Comcast, Charter's lower pricing strategy is a lever in their back pocket that the team feels they may be able to monetize over time. A hypothetical overlay of Comcast's pricing structure onto Charter's cost structure suggests Charter's free cash flow is considerably below where it could be. With that lens Charter actually looks cheap relative to Comcast. The Fund decided to further pare back its Danone position whose categories have deteriorated over time. Water, infant nutritional’s, dairy and an uninspiring track record even when these categories were stronger.
In summary, the Fund’s commitment to its investment process and philosophy remains unchanged. The portfolio manager maintains its long-term investment horizon and focus on owning durable growth compounders where the team has high confidence in the sustainability of profits over the long term. The team will continue to apply its buy and sell criteria consistently, and its analysis of company fundamentals and relative valuations will continue to determine how the portfolio is ultimately positioned. The Fund’s objective is to add value for clients through a series of individual, bottom-up investment decisions, rather than through difficult-to-predict macroeconomic events. Additionally, the Fund remains fully invested in the equity markets, since MFS believes it is challenging to predict equity market returns over the short term
Significant impacts on performance
