Finding Value in Compounding Returns Through a Cycle

The Asymmetry of Losses

Why is understanding the impact of negative returns so important? As shown in Exhibit 2, when markets go down, investors need to generate returns higher than the loss to recoup their initial investment. For example, if the market loses 50% of its value, it needs to appreciate 100% to fully return to its original value.

This simple math helps explain how a strategy that focuses on downside risk management can keep pace through a market cycle — even if it does not fully participate during periods of strong absolute performance. “Winning by not losing” is indeed a winning strategy over longer-periods of time.

Outperformance in Down Markets Matters

Making informed investment decisions with a keen appreciation for the importance of downside risk management has been a hallmark of the MFS Large Cap Value strategy since its inception. “Downside capture” is a metric used to measure how well a strategy protects investors in down markets. For example, if a manager returned -9%, but the benchmark returned -10%, the downside capture ratio would be 90%. In general, a lower ratio is an indicator of better downside protection. Since its inception, the MFS Large Cap Value strategy has had an average three-year downside capture ratio of 88.0%%, significantly outpacing its peer group as shown in Exhibit 3.

We see the strategy has strong downside capture metrics in high, low and negative returning periods, which we believe is evidence of the consistency in our approach to building and managing the portfolio.

As a recent case-in-point, the Russell 1000^® Growth index appreciated nearly 43% in 2023, far outpacing the MFS Large Cap Value strategy, which was up 8.2%. However, when we look at the three-year period ended December 31, 2023, the returns of each were quite similar at 8.9% and 8.6%, respectively. To see how this is possible, look no further than 2022, where the strategy offered significant downside protection relative to the Russell 1000^® Growth index. We see a similar, albeit less dramatic result versus the Russell 1000^® Value Index, where downside protection in 2022 largely offset underperformance versus the index in 2023.

Evaluating and assessing risks are key elements that help in our ability to manage downside risk and our portfolio management team considers risks on multiple dimensions. During the portfolio construction process, we carefully consider factors such as the impact of technological disruption, the level of government spending in the face of rising fiscal deficits and macro economic factors such as inflation and interest rates. This analysis helps to ensure that bottom-up security selection decisions come together in a portfolio that can be resilient in difficult environments.

Risk management at the individual security level also plays a critical role in creating a more resilient portfolio. Company-specific risks are assessed from operational, financial and valuation dimensions. Taking a longerterm view to understand the range of potential outcomes a company might experience, combined with a focus on the company’s level of free cash flow generation and valuation, help to increase the likelihood that the companies owned in the portfolio exhibit a higher degree of resilience and lower downside risk over time.

Difficult market environments very often coincide with challenging economic conditions and declining earnings. Owning companies with more attractive valuations and more resilient earnings has been an important contributor to the MFS Large Cap Value strategy’s management of downside risk. The result of this risk management focus during protracted bear markets can be seen in Exhibit 5. This shows how the earnings of the companies owned in the MFS Large Cap Value strategy have been resilient, declining far less than the earnings for the Russell 1000^® Value Index during these protracted crisis periods.

A Long History of Navigating Difficult Environments

Since inception, the strategy has experienced two protracted bear market environments, the Tech Bubble (2000–2002) and the Global Financial Crisis (2007–2009), plus one brief, but extreme, sell-off during the beginning of the COVID-19 Pandemic in early 2020. Exhibit 6 shows how during each of these protracted bear markets, the strategy outperformed the Russell 1000^® Value Index, as the more durable stocks owned in the MFS Large Cap Value portfolio lost less of their value versus the broader indices.

As noted earlier, strategies with lower drawdowns have typically needed more moderate future returns relative to those that suffer larger declines to get back to the same place. This means that, in most cases, strategies that protect on the downside can recoup losses more quickly.

As shown in Exhibit 7, the greater downside protection of the MFS Large Cap Value strategy during these bear market periods means that the strategy didn’t have to return as much as the Russell 1000^® Value Index in order to recoup its losses, shortening the overall recovery time.

For perspective, it took the Russell 1000^® Growth Index eleven years from the bottom of the Technology Bubble, to fully return to the value of its prior peak in September 2000. In contrast, it only took the MFS Large Cap Value strategy less than one month to recover. As Albert Einstein once said, “The most powerful force in the universe is compound interest,” or, in the world of investing, compounding returns. Starting from a higher  base can be incredible advantage for investors to help generate value over long periods of time.

In addition, experiencing less of a capital loss than the market can help keep investors invested in the market: They may feel less compelled to limit further losses after a significant sell-off by exiting the market at what could be the bottom. Behavioral finance studies have shown that investors often feel the pain from the loss of capital to a greater degree than they receive joy from capital appreciation, which may cause them to make poor decisions, such as re-allocating to cash at or near a market bottom, and subsequently missing out on the market recovery.² This can potentially lock in losses that otherwise may have been recouped over time. We believe providing downside risk management can help investors avoid some of these behaviors, which may lead to better outcomes.

Staying Actively Invested for the Long Term

The MFS Large Cap Value strategy has always had a long-term focus, as evidenced by the strategy’s average holding period of 8.2 years as compared to the average holding period of a US stock of eight months.

Over the past decade, the average turnover for the strategy has been roughly one-third that of the US Large Cap Equity peer group, while generating higher excess returns and taking less risk than peers. We believe this longterm view has given investors in the strategy an opportunity to compound value through time.

Valuation is a Key Consideration for Long-term Investors

While there is limited correlation between valuation and short-term performance, over time, valuation is one of the most important drivers of stock price performance across market cycles. Our analysis has shown the higher the starting level of valuation, the lower the level of future returns that should be expected, with the opposite being true as well.

The MFS Large Cap Value strategy applies a disciplined framework to assess valuation and the potential downside risks of paying too much to own a company. We believe taking a long-term approach that focuses on durable businesses with strong returns bought at attractive valuations helps avoid against owning value traps — companies that look cheap based on earnings estimates, but whose businesses are fundamentally challenged and are not good investments. We believe our focus on owning higher-quality, reasonably valued companies that can compound earnings through the market cycle should ultimately deliver positive results for clients. This is evidenced in Exhibit 11, which demonstrates that the MFS Large Cap Value strategy has significantly outperformed the Russell 1000^® Value Index since inception.

Conclusion

With the last protracted downturn occurring over 15 years ago, we believe many investors may have lost sight of the importance of downside risk management in generating long-term returns. While we don’t know  what the next equity market downturn will look like, we believe that the MFS Large Cap Value strategy’s disciplined focus on valuation, long-term business durability of the companies it owns and strong focus on downside risk management will serve our clients well in the future as it has for the last three decades.

End notes

¹ Source: SPAR FactSet Research Systems Inc. Performance for the S&P 500 Total Return Index for the period 3/31/2009 through 3/31/2024.

² Source: Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American Psychologist, 39 (4), 341–350.

Important Risk Considerations
Stock markets and investments in individual stocks are volatile and can decline significantly in response to or investor perception of, issuer, market, economic, industry, political, regulatory, geopolitical, and other conditions. The portfolio's investments can continue to be undervalued for long periods of time, not realize their expected value, and be more volatile than the stock market in general.

Benchmark and Vendor Disclosures
Frank Russell Company ("Russell") is the source and owner of the Russell Index data contained or reflected in this material and all trademarks, service marks and copyrights related to the Russell Indexes. Russell^® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell's express written consent. Russell does not promote, sponsor or endorse the content of this communication.