MFS Stock-Pickers See Strong Earnings, Jobs: Vital Signs Portend Double-Digit Gains in Second Half of 05

The investment pros at MFS Investment Management, the nation's oldest mutual fund firm, aren't seeing any signs of the type of slowdown in the U.S. economy that Wall Street has been predicting. In fact, the Boston-based fund shop believes vital signs are pointing toward a very strong second half with the economy benefiting from having the wind at its back.

"The breadth of the job recovery is occurring in almost every industry, monetary policy is still accommodative, and the tax cuts of two years ago are still providing stimulus to the U.S. economy," said James Swanson, chief investment strategist at MFS, on a conference call last week.

We're Making Money'

Anecdotally, Swanson pointed to the feedback MFS has received from its deep research analyst team, which showed no signs of waning demand or wobble in sales.

MFS analysts assigned to nearly every sector of the marketplace are hearing the same thing from the companies they cover: "We're making money."

This is significant because the cause and effect in any economic cycle is driven by the profitability of corporations, capital expenditures and job creation, Swanson said.

Indeed, corporate profits hit record levels last year taking in more than $630 billion across the S&P 500 Index along with record breadth, levels not seen since World War II. Further, the Bureau of Economic Analysis' National Income and Product Accounts (NIPA) data has shown that the U.S. is on the cusp of continuing all-time highs in percent profits of gross domestic product (GDP). Business spending is up roughly 15%, Swanson noted, "a welcome sign" considering it represents 20% of the U.S. economy.

As for the employment situation, the U.S. is creating jobs at a rate of about two million a year, which MFS believes "dwarfs the slowing effects of higher oil or interest rate increases on the short end of the yield curve."

Swanson also offered a historical perspective on the current economic cycle, demonstrating through a chart that the average expansion to the next economic recession is approximately eight years, which puts the U.S. at the halfway mark. The trend in these cycles, he illustrated, is that corporate profits decelerate and then bump back up again after the midway point.

"There are a lot of residuals from the collapse of the equity markets more than two and a half years ago," Swanson said. "The market is overcome with fear and bad news, but missing the fundamentals. By year-end the market will realign with earnings - double-digit gains, in fact."

Strong corporate earnings will drive that rally and abate fears, he added.

Storied Tug-of-War

Having set the economic backdrop, the discussion then shifted toward the financial markets and the storied tug-of-war between growth and value. With value stocks having outperformed growth stocks for the last five-and-a-half years, industry observers and investors alike are wondering when the tide is going to turn, if at all.

Peggy Adams, an associate portfolio manager for large-cap growth stocks at MFS, scoffed at the supposition that the trend of value outperformance relative to growth is really just a "mean reversion," the notion that stock prices will eventually move back towards the mean or average return.

In other words, the prevailing sentiment is that what has taken place since 2000 is an unwinding of an overly frothy growth market.

But upon closer look at long-term returns, Adams illustrated that while growth had a great run in the mid- to late 1990s, value actually outperformed growth for the 10 years ended March 2005, as measured by the Russell 1000, by an average of 4.66% per year. That includes the bubble.

If it were merely an unwinding, she argued, then, the performance would be neutral.

Further, value has incurred less risk and still managed to outperform growth, which Adams believes is "just not sustainable."

Not a Mean Reversion But a Pendulum Swing

"Is it a mean reversion? No, we think it's actually a pendulum that has swung way out in favor of growth, gone through neutral and now way out in favor of value," Adams said. She noted that growth has closed the gap on value in recent months, but that only time will tell if the market undergoes a major sea change.

Kate Mead, a large-cap value manager, conceded that value has become slightly more expensive. However, Mead offered a different perspective on the tale of two investment styles.

"While I do think there is certainly room for growth outperformance versus value," she said, "it doesn't suggest to me that we need to be running for the exits in value.

"We're finding lots of places to invest that might be slightly different from the traditional segments of value, [notably,] large-cap pharmaceuticals and specialty retailers.

Extraordinary Opportunities Overseas

Looking overseas, MFS sees extraordinary opportunity in Europe, Asia and the emerging markets. The recent decline of the euro versus the dollar is "a bit overdone," said Thomas Melendez, a portfolio manager of international equities.

Melendez believes there is a lot of short-term noise that needs to be weeded out such as France and The Netherlands voting to reject a proposed constitution for the European Union. While certainly a significant political development, Melendez said it does not affect the fundamentals or earnings growth of companies operating in EU nations.

Across the international landscape, he sees better valuations and stronger earnings growth rates, what he calls "a recipe for success."

In addition, the structural story on emerging markets has changed. Over 50% of emerging market debt is rated investment grade, Melendez continued. A string of labor, financial and economic reforms have swept through the emerging markets, buoyed by unfettered access to the Internet and the indigenous peoples' growing refusal to accept their own situation. Further underpinning that movement is the fact that investors have become more sophisticated and see problems as unique to a particular country and not indicative of a trend throughout the entire region.

All of this has fueled excitement at MFS over international markets.

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