Portfolio outlook and positioning
During the quarter, the equity market seemingly climbed a wall of worry as the number of items to worry about increased. The list of worries grew to include slowing economic growth, potential stagflation, Fed tapering, increasing COVID-19 concerns and uncertainty around taxes, among other items. These worries proved too much and in September, the S&P 500 experienced its worst month since March of 2020. The other notable factor influencing market returns has been interest rates. Sector and factor leadership shifted with the direction of interest rates, with higher yields leading to outperformance of value and cyclicality, and lower rates leading to outperformance of growth, technology and quality. Towards the end of the quarter, Federal Reserve Chairman Jerome Powell provided taper guidance indicating they could move ahead at their next meeting, setting off a spike in rates and volatility that put pressure on the growth and quality trade.
In Information Technology, the team continues to favor vertical software businesses, such as Adobe, Autodesk and Cadence Design Systems, that do not trade at extreme price/sales multiples. MFS prefers vertical software businesses over horizontal software due to the focused nature of improving and optimizing a product set for one specific industry versus trying to be all things to all people. The team avoids extremely expensive names, notably on a price/sales basis, where the upper end of a wide range of outcomes is largely priced in, leaving little room for error on a valuation basis.
In professional services, the Fund has overweights in data providers such as Verisk, which provides data analytics for customers in insurance, energy markets and financial services, data analytics firm Clarivate and CoStar Group, which provides commercial real estate information and analytics to credit reporting agencies TransUnion and Equifax. The Fund favors this area of the Industrials sector given the capital light nature of the business and the high barriers to entry provided by proprietary data. Top holdings in entertainment include gaming companies Electronic Arts, Activision Blizzard, Take-Two Interactive and ROBLOX. Alphabet remains a top name in interactive media and services.
In health care equipment and supplies, the team is positive on names such as Danaher, Boston Scientific and Abbott laboratories. Focused on the potential range of outcomes, the team’s conviction in a tighter range of positive outcomes for these names has increased. Tailwinds continue to build as the expanding needs of drug development is expected to drive accelerated growth in new diagnostic and therapeutic platforms, resulting in a strong therapeutic innovation cycle, of which these companies are likely to participate.
The Fund’s long-term outlook for durable growth businesses that exhibit pricing power remains unchanged.
The team looks at the US equity landscape from an industry perspective and seeks to identify which companies are growing at above market rates (versus those that are not) and where the profit pools may go over the next decade. This provides a helpful check on the outlook for growth stocks. Moreover, it highlights why the team feels certain growth-oriented companies, despite the near-term market rotation, continue to take market share and why MFS believes this trend will continue over the longer-term.
Take the autos and housing industry and think about where future growth potential is likely to come from. Here, one could argue, any future growth is likely to come from underpenetrated areas of the industry with large addressable markets such as electric vehicles and the Internet of Things (i.e., smart elevators, smart cars, connected homes, etc.), just to name a few. Even in traditionally lower-growth areas, such as consumer staples, niche brands and healthy eating, there are long term trends which are enabled largely by the internet and ecommerce as consumer have more choices available to them. This trend can be seen in more traditional value sectors such as energy and financials. In energy, profits and growth are coming from solar or other alternative sources of energy, while in financials, most of the growth is coming from fintech.
In health care, the team feels growth is likely to come from areas such as biotech, telehealth, next generation tools and life sciences companies. In industrials, similar to autos and housing, it is all things digital, direct-to-consumer and the Internet of Things. Within leisure, expected potential growth is expected to be in areas like streaming video on-demand as well as video games. Finally, in retailing, it's all about e-commerce, digital or omni-channel or more direct to consumer businesses.
With that said, there will always be points in time where companies, many of which lack real pricing power, will be aided by some external driver of earnings growth (i.e., higher GDP, higher interest rates, higher inflation, etc.). MFS believes over time sustainable earnings growth will come from those companies that possess pricing power, the result of sustainable competitive advantages, high barriers to entry, intellectual property and differentiated products and services, many of which reside in the Fund’s investible universe.
Key Transactions
- The team added to its medical device holdings, notably Boston Scientific, Edwards Lifesciences and Abbott Labs. The combination of current position size, valuation and earnings growth potential relative to other portfolio holdings led to incrementally upsizing the positions.
- The Fund trimmed its position in broadband cable operator Charter Communications. The team believes the potential range of outcomes has widened, with increased risks from potential subscriber slowdowns and regulatory intervention.
- The Fund exited its position in Global Payments as competition has intensified in the payment processing space. The team has consolidated its positions in the diversified card networks that operate the rails and the digital wallet/payment opportunities.
- The team exited positions in Spotify and Pinterest, where valuation remains demanding for the fundamental opportunity.
The portfolio is focused on companies the team believes can generate above-average, sustainable earnings growth over the next two to three years. The Fund’s strategy focuses on companies that have the following characteristics: pricing power, strong secular growth, large potential opportunity sets, sustainable competitive advantages, superior business models and strong management teams. In addition to above-average, sustainable earnings growth potential, stock valuations are important when considering investments for the portfolio.
