Sun Life MFS International Opportunities Fund

Market review

Global equities fell sharply in the second quarter of 2022, with longer-duration, growth-oriented stocks and sectors hit particularly hard. Both equities and bonds were under pressure as investors moved to price in further raising of interest rates and an increased risk of recession. Inflation continued to move higher in many major economies during the quarter. The international growth index, represented by the MSCI All Country World ex-US Growth Index saw the largest quarterly decline since the first quarter of 2020. All sectors posted negative returns for the quarter. Economically or cyclically sensitive areas of the market performed poorly towards the end of the period amid rising recessionary risks. Stocks in sectors such as materials, industrials and information technology underperformed the growth index as investors girded for a slowdown in growth. Traditionally defensive areas of the market, such as the health care, consumer staples and utilities, outperformed the growth index. Uncharacteristically, the consumer discretionary sector outperformed the growth index due to the larger weight of Chinese names that were up substantially.

With higher inflation, rising interest rates and slowing growth, a “regime change” is underway after many years of stimulus policies that fueled high equity returns. The equity markets are facing lower liquidity as a result of central bank actions, higher cost of capital, tightening lending standards and risk aversion, coupled with a volatile macro environment including deglobalization, Russia/Ukraine, inflation and energy prices. Within the growth index, the market's appetite for hyper-growth, high-multiple stocks continued to fade. Largely a function of rising interest rate expectations on the back of persistent inflation, the most expensive stocks underperformed the least expensive stocks akin to the market dynamic in the first quarter. Many of those names that were impacted were long duration, expensive, loss-making and many deemed "speculative growth". When interest rates rise, cash flows are discounted at higher rates and many longer-duration growth stocks’ P/Es decline, as future cash flows become less valuable today. This can be seen in the rise of real rates over the course of this year which has driven the underperformance of growth versus value given the longer duration of growth.

Performance Review

The Sun Life MFS International Opportunities Fund F outperformed its benchmark, MSCI EAFE Index. Within the portfolio, a contributor to outperformance has been the contraction in the gap between the most expensive companies and the cheapest, with real and nominal rates continuing to rise during the quarter. Perhaps more so this quarter, the Fund’s defensive positioning has helped relative performance as the market starts to price in the possibility of recession.

Opportunities/risk management

With so much uncertainty in the near term, the team remains focused on long-term investing. They also use short-term market volatility as an opportunity to add and trim (and start and eliminate) positions. They have a clear strategy of investing in companies with durable growth, returns and cash flow generation through the cycle, but with an added focus on downside risk management and assessing risk that others often seem willing to overlook. Longer term, the team continues to believe that stock selection will be the key component of generating alpha and avoiding significant drawdowns. During the quarter, they continued to build or initiate positions in high-quality businesses that they believed had attractive risk/return profiles while trimming or eliminating companies that had become more fully valued or were facing structural headwinds. Key trades during the second quarter included:

Add/Buy

• The team initiated a position in Showa Denko, a Japanese chemical company with a new management team that has the opportunity to dramatically improve the culture, as well as the profitability and quality of the business by focusing on their semiconductor chemicals business where they have a strong competitive position.
• The team added to gold miner Agnico Eagle Mines and gold streaming company Franco-Nevada Corp. Gold has been a relatively disappointing asset over the last year given the pickup in inflation, and as the miners and streamers have underperformed the metal, they now look inexpensive.
• The team initiated a position in Aveva Group, a British multinational information technology consulting company. The company is a global leader in complex industrial software that the team believes has the potential to grow earnings at an above average rate.
• The team added to Amadeus, a technology company serving the travel industry. Their hotel software business is developing very strongly and the competition in the GDS business is in disarray given their high levels of gearing and historic underinvestment. The stock has underperformed since the start of the pandemic, but the team believes they will emerge from the travel downturn as a much stronger business.

Trim/Sell

• The team trimmed consumer staples companies Diageo and Nestle at a higher valuation after relative outperformance due in part to their strong pricing power.

Fund Positioning

The correction in markets seemed long overdue as investors came into the year with stocks trading at expensive valuations and companies' overearning, 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 next shoe to drop looks to be earnings decline as companies are hit by falling demand and inflationary pressures. It is impossible to predict how much earnings might fall, as today’s circumstances are different from those of the Global Financial Crisis and the Tech Bubble. Stock markets are forward-looking and, at some point, will look through the earnings decline to brighter times ahead. It is impossible to predict exactly when the market might bottom or whether this is just the start of a longer ‘bear’ market.

The macro environment is certainly changing. Following a decade of falling interest rates, investors are in the midst of a 'regime change.' The equity markets are facing lower liquidity as a result of central bank actions, higher cost of capital, tightening lending standards and risk aversion coupled with a volatile macro environment including deglobalization, Russia/Ukraine, inflation and energy prices. With a backdrop of such market dynamics and others, these conditions may present opportunity for active management.

The Fund’s focus on high-quality, above-average growth companies continues to drive portfolio positioning. The team seeks to invest in companies that have the potential to compound above-average growth at high returns. These companies typically are market leaders with durable business models that have experienced management teams and competitive advantages that should allow them to maintain higher returns and earnings growth than their peers. The team seeks to apply their buy criteria in a disciplined manner, irrespective of economic conditions. Combined with a long-term investment horizon, this typically results in very modest shifts in portfolio positioning from quarter to quarter.

The portfolio was overweight consumer staples and materials. The team has long favored consumer staples companies that have strong brands, durable, above-average growth and geographically diverse revenue sources. Should inflation persist, many of the portfolio’s consumer staples companies have pricing power. In particular, the Fund has an overweight to the alcoholic spirits industry which has generally been able to pass on price increases. The weighting in materials has increased with the recent additions of Showa Denko and Nitto Denko, whose products are used in semiconductor, smartphone and health care applications. This quarter the team also added to metals and mining companies Franco Nevada and Agnico Eagle Mines, which have exposure to gold. The team has long owned industrial gas producers Linde and Air Liquide, which the team believes are high-quality cyclicals that have generated returns above their cost of capital and significant free cash flow over a full cycle. They also own specialty chemical suppliers Symrise and Sika and Akzo Nobel, a global manufacturer of coatings and paint products.

The portfolio was overweight information technology and underweight communication services. Aside from software, the portfolio has an underweight to many of the industries within the sector such as electronic equipment instruments and components, tech hardware and communications equipment. While the sector offers many businesses with attractive characteristics in terms of growth and returns on capital, the team continues to struggle with current valuations, despite the recent sell. More than half of the sector underweight is in semiconductors and semiconductor equipment, where the Fund owns Taiwan Semiconductor and ASML. The Fund’s underweight to communication services is primarily the result of not owning many telecommunications companies that do not meet the team’s minimum growth hurdles. Most of the communication services exposure is in the interactive media and services industry with companies such as Tencent, and Naver.