MFS Meridian® Funds - Prudent Capital Fund: Strategic outlook and Portfolio Positioning Update

MFS Meridian® Funds – Prudent Capital Fund Update: Strategic Outlook and Portfolio Positioning

UNLESS OTHERWISE STATED, THE DATA REFERENCED IS AS OF 28 JUNE 2024. THIS INFORMATION IS FOR MARKETING PURPOSES ONLY.

RECORDED ON 5 SEPTEMBER 2024

 

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How has the portfolio performed year to date?

We've had a slow start to the year. Why is that? Part of it’s asset allocation. So, as you know, the fund can hold multiple asset classes in order to hedge risk, and at present, we're very, very defensively positioned.

We have to hold a minimum of 50% equities in the portfolio, and we're really just above that allocation of 50, about 51% right now. Now, within the equity portfolio, we had a very, very strong performance last year and having had a good performance last year, the stocks have done fine this year, but they haven't gone up as much as the broader index. Part of that reflects the fact that we've also changed what's in the equity portfolio. So what drove return last year were things like US large-cap growth and technology stocks. Today, those stocks are very, very expensive. They've re-rated really dramatically. And so in order to build space in the portfolio for new ideas, we've been selling down our US stocks, our large-cap growth stocks and our technology stocks in order to buy what we think are very attractively priced European midcap stocks today.

How is the portfolio currently positioned, and what changes have you made?

Let's start with asset allocation. As I said before, we're very conservatively positioned today with just over 50% in equities. That hasn't changed versus our positioning in 2023. However, within the equity portion of portfolio, we're underweight the US and we're now particularly underweight US large-cap companies.

Given that the US economy has been delivering quite high levels of GDP growth the last year or so, and the S&P in particular has been delivering very strong earnings growth, why have we further reduced exposure to the US? Because it feels like a kind of counterintuitive thing to do. Now, there's two aspects to our decision. One is valuation and one is deteriorating macro fundamentals in the US. So if we look at US equities today, they look very expensive relative to both history and to the opportunity set in fixed income, i.e., bonds. One helpful exercise that you can do is we can look at the historical returns of the S&P 500 and ask ourselves, if I paid this valuation at a given moment in the past, what would one-, three- and five-year returns look like, have looked like, in the future? So if I pay a high price, do I get a high return or do I get a low return?

So, Bloomberg has good data on the S&P 500 going back to the early 1990s. Using that data set, we can see that today the price to earnings ratio for the S&P 500 is more expensive than it has been for over 90% of the periods studied.

The same is true if we look at the EV to sales ratio, that's the enterprise value of companies relative to their sales from the last 12 years. So no estimates, just the market cap plus the debt that companies in the S&P 500 hold relative to their sales during the last 12 months. If we do that exercise, what we see is the S&P has only ever been more expensive during the dot-com bubble and during the COVID asset bubble that emerged in 2021 just before a very, very steep sell-off in stocks. So put differently, if we look at valuations over the last few years, the S&P 500 is in the ninth or 10th decile in terms of EV to sales ratio.

If we look at history, we can see that, on average, owning the S&P 500 when it's in the 10th decile has typically produced weak or negative returns over one, three, and five years. Now, why does that matter? It matters because we're paying a very, very high valuation for very high expectations of future growth for the US economy and US businesses. But if we look at the data, what does it show? It shows that wage growth is slowing, unemployment is rising, credit card defaults are rising, auto loan defaults are rising, corporate bankruptcies are rising. Fundamental data that you see in the US economy today is not at all consistent with the valuations that investors are paying.

With valuations stretched, where is the team finding new opportunities in the portfolio?

Whilst equities in aggregate appear to be expensive to us, it doesn't mean that there aren't some quite attractive ideas out there. In general, the valuation of small- and midcap companies looks very attractive relative to larger market cap companies. And if we go outside the US, midcap companies start to look very attractive indeed. So relative to US equities, European equities, in particular now, are the cheapest they've been in 20 years. Why is that? Well, part of the reason for equities being so cheap is that people have been selling them. If you look at equity fund flows data, going back two, three years, really since the beginning of early 2022 when Russia invaded Ukraine, there have been consistent flows out of European equities. Now it takes time for that to be reflected in valuations, but after three years of negative flows, investors selling European equities to buy US equities, there's now a situation in Europe where even really, really very good businesses, businesses with dominant market positions, strong balance sheets, great returns in invested capital, above market growth, great cash conversion, they're now trading at very attractive multiples.

So, in our investor letters, we talked about some of the things we've been adding to in the portfolio, and it's predominantly European businesses. So we started a new position in Edenred this year. We started a position in Deutsche Boerse. We made Euronext a very large position. There are a number of other names as well, and we talk about them in the letters. So to summarize, the risk/reward for equities today doesn't look great for the asset class overall. Record high valuations coupled with deteriorating fundamentals. On the other hand, we're quite optimistic for Prudent Capital because the fund is positioned for that. On the overall asset allocation, we're very conservatively positioned. We own low risk bonds, we own gold. We own a good amount of tail risk protection in case there's a big macro event. And on the equity side, for the 50% or so that we hold in stocks, we own a consolidated portfolio of very good businesses with very good balance sheets trading at very reasonable valuations. So, we actually feel very good about the portfolio as it stands today. Thank you for watching.

 

 

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