Market Commentary as of 6/30/08
Is Energy the Next Bubble?
We had hoped that the general market malaise that kicked off 2008 would have resolved itself by the end of the first quarter. Unfortunately, the second quarter of the year brought more of the same—with few places to hide on an absolute basis outside of energy—as the Fund's Russell 1000 Value Index benchmark finished down more than 5%. Credit market dislocations remain largely unresolved as many financial companies remained under stress, forcing them to raise record amounts of capital. Oil prices hit a record $140 per barrel, putting considerable stress on consumers and businesses alike. All of which contributed to the heightened market volatility and risk aversion that began nearly a year ago.
With the increase in oil prices—and the commensurate increase in the stocks of many energy companies—Energy has become the largest sector in the S&P 500 Index (at more than 16%) for the first time since 1980. Is this a replay of the Technology bubble of the late 1990s or the financial services "bubble" of this decade? It's hard to know. The rigorous bottom-up work our global analyst team has done in the sector suggests that a majority of the price increases we've seen in commodities has been a function of demand exceeding supply as opposed to speculation. We're not in the business of making macroeconomic calls, and while the Fund's exposure to Energy has been reasonably close to the benchmark during the past several years, strong absolute performance has driven up the Fund's weight in the sector during the most recent quarter.
We continue to focus primarily on the bottom-up, fundamental analysis of individual energy companies, and prefer the portfolio to own those firms that do the best job of allocating capital for the benefit of long-term shareholders. In our view, these are typically companies that are well positioned to grow production given their resource footprint, and trade at attractive valuations. That has meant that over the last several years—and today—that a majority of the Fund's exposure to the sector is in the integrated energy plays, at the expense of service and exploration/production companies.
Winners
Although the Fund generated a negative absolute return during the second quarter of 2008, it strongly outperformed its Russell 1000 Value Index benchmark. Owing to the aforementioned stronger-than-anticipated commodity price environment, integrated energy companies significantly outperformed the market. Top-10 holding Hess was the best performing of the integrateds, as the market grew increasingly optimistic regarding its exposure to a potentially large oilfield off the coast of Brazil. The shares of Total SA also performed well in this environment.
Other winners in the portfolio included Lockheed Martin, Wyeth, and software firms Accenture and Oracle. The market reacted positively to news of several contract wins for Lockheed, including a new global positioning satellite contract worth potentially $3.6 billion and a $2.2 billion F-35 jet contract for the Air Force. Wyeth's stock price rose after the company announced quarterly results that beat Wall Street estimates and reaffirmed its full-year earnings guidance figures, despite the introduction of generic competition for its acid reflux disease treatment and lower net income. Both Oracle and Accenture delivered better-than-average quarterly results that helped each to outperform the market significantly during the quarter.
The Fund also benefitted from what it didn't own. An underweight stake, combined with solid stock selection, in battered Financials greatly benefitted relative performance. We completely avoided American International Group (AIG), one of the worst performers in the group. The portfolio also held relatively minor stakes in underperforming Citigroup and JPMorgan Chase. The overall malaise in the financial markets affected both stocks, while JP Morgan also faced concerns about the credit exposure it inherited from its acquisition of Bear Stearns and increasing worries about the company's derivative exposure to Credit Default Swaps and the prospect of large future write-downs.
Laggards
The dramatic increases in the price of oil created dual headwinds for Royal Caribbean Cruises. Higher fuel costs—one of the company's largest expenses—caused the company to lower its earnings expectations going forward. In addition, its valuation multiple suffered as investors factored in the impact of higher energy costs on future consumer spending for leisure activities.
Although Chevron significantly outperformed the overall market like other integrated energy companies, the Fund was underweight the stock versus the benchmark—negatively affecting relative performance. Underweight positions in Exxon Mobil (nearly 6% of the index), ConocoPhillips, as well as our avoidance of Occidental Petroleum, also detracted from returns on a relative basis.
Positioning
The biggest change within the portfolio during the quarter was a decrease in Financials. Some of the decline is certainly due to lower stock prices, but we did make some tactical changes. We increased the holdings of a select few high-quality companies that we think have limited credit exposure and are trading at attractive valuations. Still, our concerns regarding the size and scope of future credit losses, coupled with generally weaker balance sheets has made it a challenge to find new ideas that meet our stringent quality and valuation criteria—despite significant price declines. The Fund's positioning within the sector remains the same as it has been for the past several years—skewed toward insurance companies, trust processing banks and brokers, and asset managers at the expense of credit-sensitive regional banks and REITs.
We increased the weighting in Consumer Staples with strategic reallocations of the portfolio's tobacco holdings as well as an increase in food company stocks. In general, we're finding that food companies have been more successful compensating for rising raw material costs through increased prices than companies in other industries—affording them more margin and earnings protection.
Although 2008 has begun on a difficult note from an absolute performance perspective, we've taken the opportunity to add a number of high-quality companies trading at incredibly attractive valuations to the portfolio. Any time we can buy firms with slightly faster growth than the market, without having to pay a valuation premium, we think that's a great value proposition given our three- to five-year time horizon.
MFS Investment Management
As of June 30, 2008, Hess comprised 2.92% of the portfolio's assets, Total SA - 3.09%, Lockheed Martin - 4.20%, Wyeth – 2.37%, Accenture – 1.53%, Oracle – 2.29%, Citigroup – 0.00%, JPMorgan Chase – 0.71%, Royal Caribbean Cruises - 1.31%, Chevron – 1.82%, Exxon Mobil – 3.68%, and ConocoPhillips - 1.16%.
Note: Value investing involves buying company stocks that are out of favor and/or undervalued. Depending on market conditions, a fund's return may be adversely affected during market downturns.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.