Sun Life MFS Global Value Fund

Fund commentary | Q2 2022

Opinions and commentary provided by MFS Investment Management Canada Limited.

Market Review

Equity markets have fallen sharply in Q2 with the MSCI World Index (C$) down -13.44%  for the quarter, hard on the heels of a -5.38% decline in Q1, resulting in a -18.8% decline so far this year and tipping investors into bear market territory. This marks the worst first half for equity markets since 1970.

The economic mood has clearly changed – from worries about inflation to added worries about how much rates will rise and the risk of recession. Investors are anxious and face more complexity and uncertainty over the path ahead. Central bankers now face a real policy dilemma – how far and how fast to raise rates into a weaker and slowing economy? Not doing enough risks stagflation (a toxic mix of fading growth and high inflation) whereas moving too far risks tipping the economy into recession – the risk of policy error has certainly risen.

What is most interesting is that there has been no place to hide. Most major asset classes have fallen sharply at the same time. The historic relationship between equity and bonds has broken down – both have fallen sharply. Bonds have seen their worst downturn since 1990 as investors brace for rapid rises in interest rates. Traditionally, bonds are supposed to act as a counterweight that tends to rally when riskier assets suffer. Even cash, the ultimate safe asset, has lost value in real terms due to surging inflation.

Within equity markets, the stand-out feature has been the one-dimensional nature of returns with energy topping the leaderboard again in Q2. Virtually every sector has fallen double digits year-to-date, whereas energy is up +25% ($US). There has never been a period when energy has outperformed by this much. Consumer discretionary and information technology were again the biggest decliners at the sector level after also falling sharply in Q1.

From a style perspective, there has been a clear shift to ‘deep value’ stocks and away from high growth stocks, resulting in the biggest gap between the MSCI World Value Index (-12% year-to-date) and the MSCI World Growth Index (-29% year-to-date) for 20 years. Expensive technology stocks have continued to fall sharply, as the valuation of these long-duration assets can be more vulnerable to rising interest rates, as growth is set far into the future. Investors have preferred to back near-term certainty. The problem with energy, of course, is its sharp cyclicality and historic volatility. Whilst so far it has all been a supply issue, one would now expect to see demand destruction start to bite as oil prices stay high and economies slow down.

Opportunities/risk management

This is a value strategy, not a ‘deep value’ strategy, with a clear focus on business durability and valuation. The team thinks carefully about the long-term prospects of businesses they own and pay a lot of attention to understanding the downside risk to business models. The Fund’s average holding period has been 6-7 years. The team continues to find great opportunities across industries and geographies in good businesses with shares trading at attractive valuations, often overlooked in the short-term focus of other investors. During the quarter, the team started 4 new positions and eliminated 2 to finish the quarter with 99 holdings:

Add/Buy

• Alphabet (new) – The Fund started a new position in Alphabet, the parent company to Google. The team has always liked the dominant global position in search (~85% market share) and its clear scale advantage, plus the ability to exploit opportunities like YouTube. Alphabet has been very successful at growing its cloud business to become a strong third player behind AWS (owned by Amazon) and Microsoft. The team recognizes the cyclical risk to Alphabet as most earnings come from advertising, but now believe the valuation is attractive to start a position. The valuation can now be justified based without needing to make heroic assumptions on the start-up businesses.
• Julius Baer (new) is a pure play on the growth of wealth management, benefitting from long-term structural growth, whilst being a capital light business model with limited credit risk. Whilst based in Switzerland, it operates with strong positions across Europe and Asia and could grow, helped by strong execution and branding. 15% of revenues are tied to net interest income, which will benefit from higher interest rates, without the credit risk of a bank. The balance sheet is conservative, with surplus capital, and the stock has paid close to a 6% dividend yield and has traded under 10x forecast earnings. 
• Icon (new) is a Clinical Research Organization (CRO), which is contracted by pharma and biotech companies to manage clinical trials and complex medical testing. It is now the joint market leader after the recent acquisition of PRA Health Sciences. The business has grown 7% pa over the last decade and has plenty of scope for further growth. The nature of trials is growing more complex, time sensitive and subject to regulatory scrutiny, giving economies of scale to larger players. This is a highly cash generative business aimed to pay down debt and return more cash to shareholders. 
• LVMH (new) is the world’s leading luxury goods business, with coveted brands in fashion and leather goods, watches and jewelry and spirits. The industry has historically grown faster than GDP. It’s brand history, legacy and high investment create strong barriers to entry and pricing power. LVMH are experts in brand management and historically proven they can grow brands that were mismanaged by others. The stock has de-rated due to China risk, providing an interesting entry point at an attractive valuation.
• The team added to several existing positions based on stronger conviction behind the investment thesis and/or opportunities presented by recent price weakness, such as Bayer, Nasdaq, Charles Schwab, Hitachi, Regal Rexnord, ENI, Roche, Hess, Experian, Microsoft and Schneider

Trim/Sell

• KBC (exit) – The team sold the remaining position in KBC, the Belgian bank, to fund the new position in Julius Baer, where valuation is arguably more attractive, and it has less credit exposure. KBC is more exposed to the risk of recession across its European businesses.
• Nomura Research Institute (exit) – The team sold the remaining position in Nomura Research Institute (NRI), the Japanese IT consulting business. Whilst the team continues to like its strong market position in Japan and top tier capital allocation, the valuation is now full and adequately reflects these qualities.
• The team trimmed large positions in consumer staples such as Nestle and Diageo, which have performed well and look more fully valued to fund other opportunities.
• The team also trimmed large positions in health care which have performed well such as Novo Nordisk, Johnson & Johnson and Quest Diagnostics
• The team  trimmed several other positions after recent outperformance, such a Texas Instruments, KDDI, Travelers, Chubb and Honeywell, to fund better opportunities.

Fund Positioning Outlook

The correction in markets seemed long overdue as investors came into the year with high valuations and high levels of earnings – peak profits, peak M&A, close to peak valuations and peak returns – a dangerous cocktail which has now started to unwind. All of the correction so far is due to ‘multiple compression’ – in other words, valuations have fallen but earnings have held up remarkably well (so far). The team feels the next shoe to drop looks to be an earnings decline as companies are hit by falling demand and some fail to pass through stubbornly high input cost inflation. It is impossible to predict how much earnings might fall, with historical precedents like the Global Financial Crisis and tech bubble collapse not necessarily good guides to the future. Stock markets are forward looking and at some point will look through the earnings decline to brighter times ahead. Arguably, for many cyclical stocks, this may already be happening. It is impossible to predict exactly when the market might bottom or whether this is just the start of a longer ‘bear’ market. It is a challenging time for central bankers as they try to cool inflation without tipping economies into recession. Investors are definitely in a period of ‘regime change’ with rising interest rates ahead of us and the start of quantitative tightening (QT). No one knows what this will mean as QT has never been done before.

It seems right to question how the spectacular returns from owning equities over the last decade can be repeated. Predicting the outcome in the near term is impossible, but the team feels it seems prudent to forecast lower overall returns from equities over the decade ahead. The good news is that starting valuations are notably lower than they were six months ago.

The shape of the portfolio has not changed materially as the team invests for the long term and likes what they own. The top sector overweights relative to the MSCI World Index are industrials, financials and consumer staples, where they continue to see attractive opportunities. The team has been reducing the position in consumer staples by trimming stocks that have outperformed, notably Nestle and Diageo. The portfolio is underweight information technology and consumer discretionary, where many valuations still look rather stretched, but the team has used the opportunity to buy new stocks such as LVMH and add to Microsoft.

Given the Fund’s bottom-up approach, the decisions are not driven by trying to predict the exact path of macro variables such as inflation and interest rates. The team is, of course, very mindful of how these concerns weigh on company prospects and valuations. Overall, they believe the companies owned in the portfolio have sustainable competitive advantages and relatively strong pricing power aimed to withstand the impact of rising input costs better than peers. The team is seeing companies across the portfolio raising prices, notably in consumer staples, industrials and paints. With regards to rising interest rates, the portfolio is overweight financials, which they feel could benefit if economic growth holds up and cushioned by little exposure to bond proxy sectors like utilities and real estate. The portfolio is less exposed to ‘long duration’ assets, notably technology stocks with high terminal values, which are at risk from bigger discounting as interest rates rise.

¹Returns for periods longer than one year are annualized. Data as of June 30, 2022.

²Partial calendar year. Returns are for the period from the fund’s inception date of September 30, 2010 to December 31, 2010.