Jan. 19, 2005 — Continuity is the byword for MFS Value Fund/A (MEIAX). After Lisa Nurme retired in May 2004, co-manager Steven Gorham stayed on to run the portfolio, and Edward Baldini, now a portfolio manager, continued to oversee separate accounts run in the style, handling communications with the fund’s extensive team of analysts. The firm, which traditionally promotes from within, eventually may replace Nurme with another co-manager. “But it’s not urgent,” Baldini said. “We’ll wait until we find the right person.”

To date, the fund’s management process, team-oriented approach, and investment philosophy have all remained unchanged. Now with $6.9 billion in assets, the fund is sticking to its conservative, bottom-up strategy, identifying undervalued but high-quality large-cap stocks, and holding them for two or more years. “We also look at cash generation relative to net income growth,” Baldini says of stock selection. The fund is required to keep 65% of its portfolio in dividend-yielding stocks.

For the five years ended in December, MFS Value rose 8.1% annualized, versus 3.7% for the average large-cap value fund. For the three-year period, the fund returned 7.4% on average, versus a gain of 5.3% for its peers. And in calendar 2004, MFS Value also managed to edge out the competition, rising 15.1%, versus 12.5% for its peers.

To meet its goal of outperforming the Russell 1000 Value Index with less volatility (the fund’s standard deviation is lower than that of its peers), the managers take what Baldini calls a “consistent approach to value,” avoiding the “racier, high-beta names.” This helped to insulate the portfolio from the ravages of the technology meltdown. From March 2000 through October 2002, MFS Value slid 4.0%, versus a decline of 32.7% for the style index, and 43.7% for the category index.

The fund also reduces volatility by avoiding sectors with “tough balance sheets,” like airlines, and staying underweight in those that don’t generate much cash, like technology and energy merchants. “We are typically focused on the Russell 1000, as well as large, liquid ADRs and global companies — a universe of about 1,200 stocks,” Baldini said. As of the end of December, the fund’s largest sectors were financials (29.3%), energy (11.0%), consumer staples (10.7%), utilities and communications (10.7%), and basic materials (9.8%).

Of its 98 holdings, one that typifies the fund’s investment style is PPG Indus (PPG). The specialty chemicals company has a dividend yield of about 2.7%, Baldini said, and operates in a number of areas of the specialty chemicals business, including coatings, sealants, glass, and chemical operations. Its chlor-alkali business is benefiting from a cyclical rebound, while a restructuring at the firm is reducing costs and increasing cash flow, he noted. “It’s a higher-quality inexpensive chemical company with restructuring and a cyclical recovery helping to support the outlook,” Baldini said.

Another representative holding is Altria Group (MO). The firm’s domestic and international businesses are significant cash generators. The Kraft food business has survived the low-carb craze intact, Baldini believes, while tobacco litigation liabilities are largely settled, and the threat of future judgments may be diminishing. “Even in the worst-case scenario, if the U.S. tobacco business were ultimately bankrupted, the company would still be able to pay its dividends from the non-U.S. business,” Baldini said. “The franchise wouldn’t be threatened.”

Recently, the MFS Value Fund reduced its exposure to energy and to wireline telecom stocks, including SBC Communications (SBC) and BellSouth Corp (BLS), while initiating new positions in wireless-oriented Sprint (FON) and Vodafone Group ADR (VOD). It also bolstered its typically small retail holdings by purchasing Gap (GPS) shares. “They’ve stumbled, but are now focused on shrinking square footage, investing in improving efficiencies, and expanding operating margins,” Baldini said. “We would expect them to raise the dividend in the next year or so.”

Another change that the fund recently has weathered is the investigation of the mutual fund industry by New York Attorney General Eliot Spitzer and the Securities and Exchange Commission. For several years, the firm had restricted trading in its international, small-cap, and high-yield funds, whose pricing inefficiencies could have been exploited by market timers, explained John Reilly, senior vice president of communications for MFS Investment Management. The fund family’s prospectuses stated that market timing would not be allowed. However, the practice was not actually forbidden in its large domestic funds, as the company had determined those funds were not vulnerable.

The firm’s February 2004 settlement with the SEC concerned prospectus language about market timing. The firm paid a $50 million penalty and $175 million in restitution, which will be returned to shareholders by an independent distribution consultant. “We will make shareholders whole,” Reilly said. He added that according to a third-party economic analysis supervised by the SEC, the majority of harm to investors had been due to late trading, which was conducted by brokers who had falsified their records without the firm’s knowledge.

For the MFS Value fund, the SEC settlement has led to a reduction in management fees, to 0.55%, from 0.60%, and to the imposition of a 2% fee on shares redeemed within five days of purchase. According to Baldini, the settlement has had no other effect on the fund’s management or investing strategy.

Looking ahead, Baldini described the market as “constructive.” “Valuations in general are pretty attractive, earnings have improved a lot this year,” he said. “We’re still finding plenty of attractive, higher quality, inexpensive stocks, though in different places than a year ago. We don’t see this as a frothy market by any stretch. Interest rates will rise, but that will get people focused back on stock picking, on sustainable businesses.”

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.