Sprott Focus Trust Manager Commentary Dec. 31, 2017
The following commentary is an excerpt from the Sprott Focus Trust 2017 Annual Report.
February 1, 2018
Dear Fellow Shareholders,
We are pleased to report that Sprott Focus Trust performed well during 2017, fulfilling our investment objective of generating solid absolute returns. For the 12-month period, Focus Trust achieved an 18.46% increase in net asset value (NAV) and a 22.17% gain in market price (both figures reflect reinvestment of dividends). Our performance compared favorably to the 21.13% total return of our longstanding benchmark, the Russell 3000 Index. We were encouraged in 2017 by incremental narrowing of the discount-to-NAV at which Focus Trust shares trade in the marketplace. By year-end, Focus Trust traded at an 11.31% discount to NAV, compared to a discount of 14.40% just 18-months ago (6/30/16). Focus Trust’s intermediate returns continue to improve relative to our benchmark, with our three- and five-year average annual returns of 9.54% and 9.56% comparing more favorably to respective Russell 3000 returns of 11.12% and 15.58% than they had in recent years. The further we separate from seven years of interest rate suppression by central banks, which distorted traditional time preferences and rewards of capitalism, we expect our investment discipline to generate improving relative returns. Focus Trust’s long-term results (15-year, 20-year and since inception) remain very solid.
2017 Market Review
Despite daily headlines of political angst, 2017 featured very few market-moving surprises. Little of consequence emanated from Washington this past year, until the December passage of the Tax Cuts and Jobs Act. The Federal Reserve raised rates three times as promised. There were no sovereign defaults or financial calamities, and markets became progressively desensitized to simmering geopolitical threats such as North Korea, Brexit and U.S. government shutdowns. In fact, all-time records for equity-market stability were set in 2017, with the S&P 500 experiencing no correction of 5%-or-more in well over a year (400 days and counting). Last year’s historic market quiescence was calming to long-term investors such as ourselves while proving challenging to volatility focused traders. Given that 2017 was such a remarkably benign year, it would be naïve to expect a repeat in 2018, however pleasant that prospect might seem.
As we begin the new year, markets seem to be accelerating to the upside, with favored FANG-type stocks once again leading the way. Indeed, January felt a bit like a “melt up,” in which investors who have not participated in this mature bull market were finally jumping in, out of “fear of missing out” (FOMO). As we experienced in the late 1990s, the terminal phase of an aging bull market can persist for a long time, but often ends painfully, like the dot-com meltdown of 2000-2001. An ongoing trait of the current advance has been that surface stability of broad equity averages has masked extreme volatility in individual stocks. Among Focus Trust portfolio companies, 10% swings on days without news items are becoming more common, and dislocations of 20% or more (up or down) are not unusual on days with significant news events. It is hard for us to reconcile how consensus opinions can change so abruptly on companies we have studied for years. Clearly, there is less market liquidity than commonly appreciated at the individual stock level. With fewer investors employing fundamental analysis and liquidity increasingly stretched, opportunities for profitable investment are sure to abound when market volatility returns to normal levels.
2017 Portfolio Activity
Sprott Focus Trust’s portfolio turned over 29% in 2017, consistent with our historical average. We cannot stress enough how critical low turnover can be to achieving superior long-term performance. When individual stock liquidity is low, particularly with smaller companies, transaction frictions can be quite high. This means that every decision carries a high hurdle for success, and less movement can lower the odds for mistakes. Obviously, low turnover fosters longer holding periods and better tax outcomes for shareholders. This in turn, produces higher absolute returns after taxes, fees and inflation, which is our primary goal. Somewhat unusually, 2017 marked the second year running during which Focus Trust did not lose a key portfolio holding to acquisition. Our business-focused, value approach has traditionally resulted in annual mergers and acquisitions migration of 5% to 10% of portfolio NAV (even higher near market peaks). To us, the lack of natural takeover activity during the past couple of years only increases probabilities for pent-up transactions in 2018. Acquisitions of smaller companies have always served as an attractive alternative to painstaking capital expenditures by larger companies. With new tax laws in place, perhaps lower corporate rates, combined with repatriated capital, will help rekindle this important contributor to our historical success.
Top 2017 Performance Contributors and Detractors
During 2017, Focus Trust’s top-five performers were Apple, Sanderson Farms, Westlake Chemical, MKS Instruments and Lam Research. This was the second consecutive top-five performance for MKS Instruments, leading to a relative valuation motivating us to downsize the position to bottom-half portfolio status. The same is true of longtime favorite Westlake Chemical, which appreciated 91% in 2017. Interestingly both companies made strategic acquisitions in 2015 and were rewarded for their efforts with significant earnings accretion and expanded multiples.
During 2017, we eliminated positions in Century Communities, Nu Skin Enterprises, Jacobs Engineering Group, Ferroglobe and Kirby Corporation, after each achieved or exceeded our valuation targets.
Our Myriad Genetics holding was liquidated (perhaps a bit prematurely) due to perceived deterioration in its business model. We swapped our small holding in Chico’s FAS for shares of Williams-Sonoma, which we view as a stronger retailing format. Finally, oil and gas driller Unit Corporation and gold miner Roxgold were replaced by more compelling opportunities in their respective industries (Carbo Ceramics and Osisko Mining). Additional positions initiated in 2017 included Syntel, Marcus & Millichap, Amgen and Pretium Resources.
Top Contributors to Performance
Year Ending 12/31/17 (%)1
|Sanderson Farms, Inc.||2.05|
|Westlake Chemical Corporation||2.02|
|MKS Instruments, Inc.||1.93|
|Lam Research Corporation||1.15|
1 Includes dividends
Top Detractors from Performance
Year Ending 12/31/17 (%)1
|GameStop Corp. Class A||-1.06|
|Birchcliff Energy Ltd.||-0.79|
|Kennedy-Wilson Holdings, Inc.||-0.54|
|Chico’s FAS, Inc.||-0.26|
1 Net of dividends
While our top five winners contributed a little more than half of our total portfolio performance in 2017 (+9.28%), our top five “sinners” only detracted 3.3%. During the year, GameStop contributed negative portfolio performance of 1.06%, earning Focus Trust status as our most perplexing disappointment. As a franchise with considerable brand equity, trading at five times current earnings with a 9% dividend yield, and with 36% of outstanding shares sold short, GameStop fits our methodologies to a tee. Chastened, we have reduced the position to a level unlikely to embarrass us in 2018. Energy holdings Unit and Birchcliff combined for negative portfolio contribution of 1.44%. Energy was one of the very few negative market sectors in 2017, and we took advantage of this weakness to add to our exposure over the course of the year. Finally, as previously mentioned, retail clothing chain Chico’s FAS was eliminated from our portfolio, costing us 0.26%.
In 2017, we experienced positive contributions from all industry sectors other than Energy, which declined by 1.7%. Information Technology added 6.1%, Materials (thanks to Westlake Chemical) were up 5.0% and Financials, mostly asset managers, gained 4.1%. We took considerable profits in Information Technology and added to our Energy exposure.
Sprott Focus Trust began 2018 nearly fully invested, with a cash position of only 6.3%. It is somewhat unusual for us to maintain such a low cash position immediately following such a strong two-year advance for broad equity averages. Our fully invested status is a reflection of a mercurial market environment in which steep premiums are paid for growth-and-momentum equities and cyclical industries are viewed with harsh skepticism. Throughout 2017, we were able to find compelling values and keep our portfolio’s risk/ reward ratios favorable. At the end of 2017, Focus Trust held 47 positions, which is about average. Our top sector weightings were Information Technology (17.4%), Materials (15.9%, primarily gold and silver miners), Financials (15.3%) and Consumer Discretionary (15.2%). We ended the year overweight Energy at 11.5% and underweight Industrials and Health Care at 2.0% and 1.5%, respectively.
Those tracking Focus Trust’s portfolio will notice that four of our top 10 positions have changed since year-end 2016, and three of these rotations occurred in the second half of 2017. MKS Instruments, Sanderson Farms, GameStop and Westlake Chemical have been replaced by Helmerich & Payne, Pason Systems, Thor Industries and Federated Investors. All four of these top-10 newcomers were existing portfolio holdings which have been upsized, and all four of our top-10 deletions remain in Focus Trust at reduced weightings. In other words, price and fundamental changes during 2017 were responsible for this reweighting.
Portfolio Sector Breakdown as of 12/31/17
(% of Net Assets)
|Cash and Cash Equivalents||6.3|
Top 10 Positions as of 12/31/17
(% of Net Assets)
|Western Digital Corp.||4.2|
|Franklin Resources, Inc.||4.2|
|Cal-Maine Foods, Inc.||3.9|
|Kennedy-Wilson Holdings, Inc.||3.7|
|Helmerich & Payne, Inc.||3.5|
|Pason Systems Inc.||3.2|
|Thor Industries, Inc.||3.0|
|Federated Investors, Inc.||2.8|
Portfolio Diagnostics as of 12/31/17
|Fund Net Assets||$228 million|
|Number of Holdings||47|
|2017 Annual Turnover Rate||29%|
|Net Asset Value||$8.93|
|Average Market Capitalization1||$6,325 million|
|Weighted Average P/E Ratio2,3||18.1x|
|Weighted Average P/B Ratio2||2.4x|
|Weighted Average Yield||2.08%|
|Weighted Average ROIC||20.16%|
|Weighted Average Leverage Ratio||1.89x|
|Holdings ≥75% of Total Investments||29|
|U.S. Investments (% of Net Assets)||84.4|
|Non-U.S. Investments (% of Net Assets)||15.6|
The portfolio diagnostics support our contention that Focus Trust is exceptionally well-positioned for outperformance in 2018. During 2017 many of Focus Trust’s relevant portfolio metrics actually improved despite solid nominal performance. Our weighted average price-earnings ratio (P/E) increased from 17.9 to 18.1. The weighted average yield remained at 2.1% while the price-to-book ratio (P/B) rose to an undemanding 2.4x, from 2.1x. Even more encouraging was a modest decline in Focus Trust’s weighted average leverage ratio (1.89x versus 1.91x a year earlier) coincident with a dramatic increase in weighted average return on investment (ROIC) from 14.3% at year-end 2016 to 20.2% at year-end 2017. We view all of these metrics as superior to our Russell 3000 benchmark.
At the time of this writing (February 1, 2018), major equity market indices had been setting all-time records. The good news is that we are beginning the year with a new, surprisingly pro-business U.S. tax code. The offset is that lower corporate tax rates come with the potential cost of a $1.5 trillion increase to the federal budget deficit during the next decade. Deficit hawks are about as out of favor in Washington as active managers are on Wall Street. Two quotes come to mind. The first is from my branch manager at Oppenheimer in 1980, “If you don’t change directions you’re going to end up where you’re headed.” (No, Yogi Berra was not my branch manager.) A paraphrase of the second quote, used by folks from Warren Buffett to Jim Grant observes, “debt does not matter until the day it does, and then it’s all that matters.” These two simple adages, combined with our current leader’s propensity to accelerate problems to a crisis point as a strategy for solving them, promise to make 2018 an interesting year. Yields on 10-year Treasuries are testing a 35-year downtrend. The U.S. dollar has fallen to three-year lows. Oil and other commodity prices are rising. And decades of U.S. trade deals are up for renegotiation.
What could possibly go wrong? Thankfully, we are not in the market prediction business. We just try to identify great businesses and buy them when they go on sale. Given the current backdrop, we expect our disciplined approach to be rewarded with attractive opportunities for investment throughout 2018. We are encouraged that corporate credit spreads remain tight and that our new tax bill may spur a round of competitive tax cuts around the globe.With the Focus Trust portfolio, we own a collection of highly profitable, unlevered companies. Because we have always employed operating income (pre-tax earnings) as our valuation metric, our models required no adjustment to factor in lower corporate tax rates. However, we believe investor consensus is more focused on after-tax earnings, and post-tax-bill adjustments to modeled valuations may rerate our holdings more favorably in the marketplace. Additionally, some of our largest positions hold significant, offshore cash balances which are likely to be repatriated, increasing probabilities for shareholder-friendly activities such as dividends, share buybacks and acquisitions. In conclusion, Focus Trust’s risk/reward profile looks quite favorable, but we maintain our over-exposure to hard-assets in case the long sought return of inflation appears with a vengeance.
|1||Geometric Average. This weighted calculation uses each portfolio holding’s market cap in a way designed to not skew the effect of very large or small holdings; instead, it aims to better identify the portfolio’s center, which Sprott believes offers a more accurate measure of average market cap than a simple mean or median.|
|2||Harmonic Average. This weighted calculation evaluates a portfolio as if it were a single stock and measures it overall. It compares the total market value of the portfolio to the portfolio’s share in the earnings or book value, as the case may be, of its underlying stocks.|
|3||The Fund’s P/E ratio calculation excludes companies with zero or negative earnings.|
|4||Source: Sprott Gold Report. For the period 1/1/2001 – 12/31/2017, Spot gold has posted positive annual performance during 14 of the past 17 years, amassing a compound return of 9.65%, significantly exceeding the 6.32% compound return of the S&P 500 Index (including reinvestment of dividends).|
The views expressed above reflect those of Mr. George only through the end of the period as stated on the cover of this report and do not necessarily represent the views of Sprott Asset Management USA, Inc. or any other person in the Sprott organization. Any such views are subject to change at any time based upon market or other conditions and Sprott disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for the Sprott Focus Trust are based on numerous factors, may not be relied on as an indication of trading intent on behalf of the Sprott Focus Trust.