Being Prudent Means Being Risk Aware Not Risk Averse
Reduced risk due to market conditions
“Why are you so defensively positioned?” was a question often asked to the Prudent portfolio management team in 2024.
Our response throughout this period has been consistent: while we cannot know what future returns will look like for equity markets, we can look at history and ask ourselves a simple question: “When the market has been this expensive in the past, how attractive have returns been over the ensuing one, three and five year periods?”
Of course, there are different ways of measuring whether a stock market is expensive (Is the price-to-earnings ratio elevated? Are corporate profit margins cyclically inflated? Are equities cheap relative to lower risk instruments such as government bonds?), but at present – and for most of the last 18 months – the stock market has looked expensive by almost any metric.
One metric we particularly value is Enterprise Value to Sales, which compares the total debt and equity value of companies to their sales over the last twelve months. Unlike forward price-to-earnings ratios, this metric avoids projections or assumptions about future growth rates or margin levels. In our research of various financial metrics, we have found Enterprise Value to Sales to be one of the best predictors of future equity market returns (both positive and negative). Looking at history, since 1990 the S&P 500 has only been more expensive during two periods: the dot-com bubble (2000) and the post-COVID bubble (2021). By way of comparison, and because most financial commentators focus exclusively on the price-to-earnings ratio of the S&P 500, we have also included the chart below. While not as elevated as the Enterprise Value to Sales, the price-to-earnings ratio paints a similar picture: US equity markets have rarely been more expensive, and have typically only reached current valuation levels toward the end of a financial bubble.
Given this backdrop, our view throughout much of 2024 was that the data did not support increasing exposure to risk assets. Equity markets were among the most expensive in history, even as U.S. interest rates remained at their highest levels since the 2009 financial crisis. With potentially attractive returns available through our fixed-income allocation, we were content to remain patient, defensively positioned, and wait for compelling opportunities on the equity side to emerge.
Increased uncertainty presents opportunity
Being prudent does not mean being risk-averse; it means being risk-aware. It also means remaining agile to add equity exposure when the risk/return profile improves. Increased uncertainty during April, driven by U.S. trade policy, led to heightened market volatility and greater price dispersion. For prudent investors this type of volatility creates opportunities, which is one of the key reasons we maintain defensive positioning with a significant weight in cash and short-term fixed income.
We are hyper-aware of the price we pay for securities, and the market downturn in April presented attractive risk/return opportunities in many companies we had been monitoring. Following the sell-off, we increased net equity exposure post-”Liberation Day”, adding to existing holdings and broadening our equity portfolio into sectors such as technology, semiconductor capital equipment, quality cyclicals, and even energy. However, with the rapid market rebound since mid April, we have since adopted a more cautious approach, trimming many positions that experienced strong rebounds during April and May.
Our ultimate goal is to grow client’s capital in real terms over time. To achieve this, we remain patient and disciplined, deploying capital when compelling opportunities arise. We continue to actively search for these opportunities and remain agile in our investment approach to capitalize on them when they emerge.
The future is hard to predict but quite possible, in our view, to prepare for — and the recent market turmoil illustrates the value of a prudent approach.
As long-term investors, we embrace the concept of looking ahead and continue to stay disciplined and diversified. One of the strategy’s goals is seeking to manage downside risk and we have an absolute return focus. When current prices are high and forward returns appear poor, the portfolio will be defensively positioned. However, the recent market volatility offered us opportunities, on an idiosyncratic basis, to find high quality, durable franchises trading at valuations we have not seen in a long time.
Our belief is that investing in companies with durable business models, underpinned by durable cash flows and managed for long-term success will generate attractive risk-adjusted returns for clients.
Please note this is an actively managed product.
The views expressed are those of MFS, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product.
The fund may not achieve its objective and/or you could lose money on your investment in the fund. Stock: 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, environmental, public health, and other conditions. Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio’s value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity. Derivatives: Investments in derivatives can be used to take both long and short positions, be highly volatile, involve leverage (which can magnify losses), and involve risks in addition to the risks of the underlying indicator(s) on which the derivative is based, such as counterparty and liquidity risk. Value: 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. Strategy: There is no assurance that the portfolio will achieve a positive rate of return or have lower volatility than the global equity markets, as represented by the MSCI World Index, over the long term or for any year or period of years. In addition, the strategies MFS may implement to limit the portfolio’s exposure to certain extreme market events may not work as intended, and the costs associated with such strategies will reduce the portfolio’s returns. It is expected that the portfolio will generally underperform the equity markets during periods of strong, rising equity markets. Please see the prospectus for further information on these and other risk considerations.
See the fund’s offering documents for more details, including information on fund risks and expenses. For additional information, call Latin America: 416.506.8418 in Toronto or 352.46.40.10.600 in Luxembourg. U.K.: MFS International (U.K.) Ltd., 1 Carter Lane, London, EC4V 5ER UK. Tel: 44 (0)20 7429 7200. European Union: MFS Investment Management Company (Lux) S.a r.l. 4 Rue Albert Borschette, Luxembourg L-1246. Tel: 352 2826 12800 .
MFS Meridian Funds is an investment company with a variable capital established under Luxembourg law. MFS Investment Management Company (Lux) S.ar.l. is the management company of the Funds, having its registered office at 4, Rue Albert Borschette, L-1246 Luxembourg, Grand Duchy of Luxembourg (Company No. B.76.467). The Management Company and the Funds have been duly authorised by the CSSF (Commission de Surveillance du Secteur Financier) in Luxembourg.
MFS Meridian Funds may be registered for sale in other jurisdictions or otherwise offered where registration is not required.
MFS Meridian Funds are not available for sale in the United States or to US persons.