Sprott Focus Trust Manager Commentary Dec. 31, 2020

 

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Whitney George
Whitney George

The following commentary is an excerpt from the Sprott Focus Trust 2020 Annual Report.

February 15, 2021

Dear Fellow Shareholders,

We start this letter by wishing all of you a safe and healthy New Year, and we hope that the COVID-19 crisis will be lessening by the time you receive this letter. It’s hard to know where to begin to describe the events of 2020. We will start with the year’s end results. For 2020, Sprott Focus Trust’s (FUND) total return based on net asset value (NAV) was 6.80%. FUND’s market price appreciation, reflecting the re-investment of dividends, was less at 2.86% due to a widening of the market price trading discount to NAV. We will discuss more on this later. Our benchmark Russell 3000 Total Return Index was up 20.89%. With the Russell 3000’s ever increasing weighting in mega-capitalization technology names, we find this comparison less and less relevant.

We seem to have completed a full market cycle in just one year in 2020, starting with a historic bear market in the spring followed by a rapid bull market for the remainder of the year. FUND’s performance was trailing as we entered the late February/early March crash. We recovered in the second and third quarters of the year, performing more in line with the market. Our strategy began to outperform during the fall, a welcome development that has continued into the New Year. It has been quite the ride and we find ourselves once again in the same place we were this time last year, gently selling individual positions into a bull market. FUND’s portfolio in aggregate is slightly cheaper in absolute terms and massively less expensive relative to its benchmarks, and the portfolio’s cash position, having been fully deployed last spring, is once again rising.

Equity markets in 2020 were dominated by one factor: The liquidity of U.S. dollars. The global economy has functioned on a U.S. dollar standard for 50 years as of this year, and last March this system broke. The scramble for scarce dollars in March caused a worldwide margin call that required the liquidation of virtually every other available asset. The moment the U.S. Federal Reserve (Fed) stepped in to provide the “whatever it takes” dollars to the global system, the crisis passed. Massive amounts of capital were printed and flooded the system in response to the COVID-19 global pandemic. With most developed economies in lockdown, this capital had nowhere to go other than the fixed income and equity markets. While the crisis did pass, the underlying conditions that caused it remain with us (i.e., massive debt levels and the inability to service them at free-market interest rates). As we have observed for years, the most likely way out of the current global financial mess is the significant debasement of those currencies in which the debt is denominated (mostly the U.S. dollar). We believe that we hit the tipping point in 2020.

In September, we wrote an article titled 2020 vs. 1968: This Too Shall Pass, which can be found on Sprott’s website under the Insights blog menu tab (https://sprott.com/insights/2020-vs-1968-this-too-shallpass/). In 1968, our economy and society had reached another tipping point due to the massive debts built up from President Lyndon Johnson’s Great Society government expansion and the escalating Vietnam War. Like 2020, 1968 was characterized by political and social unrest and even a global pandemic, the Hong Kong flu. What followed was more than a decade of higher inflation, higher interest rates and slow growth punctuated by recessions.

In the 1970s, we experienced stagflation, a time in which good inflation (stocks and bonds) suffered and bad inflation (food and energy) were constantly on the rise. We guess that the economic adjustments required back then to put our fiscal house in order will take significantly less than a decade this time around. Given the speed at which information travels and markets react, we are prepared for massive volatility, rapid rotations and significant changes in the global financial system.

Activity

FUND’s annual portfolio turnover for 2020 was generally consistent with the last few years at 35%, although slightly higher than implied by our historic three- to five-year holding period. Heightened volatility can create short-term trading opportunities in existing positions, driving portfolio turnover higher, which was the case in 2020.

We established two new positions since our semi-annual letter despite the strong recovery in equity markets during the second half of 2020. Vishay Intertechnology is one of the world’s largest manufacturers of discrete semiconductors and passive electronic components. From humble roots in 1962, Vishay has grown through dozens of acquisitions of other electronic component manufacturers to become a global provider of products that help bring modern technology to life, every day and for everyone. Vishay’s products span almost every sector, including automotive, industrial, consumer, telecom, medical and more. Electric vehicles, factory automation, 5G wireless networks and the Internet of Things realm of connectivity are strong growth areas for Vishay. We believe that Vishay’s net cash balance sheet, strong free cash flow generation and commitment to maintaining a prudent capital structure lend confidence that the company’s record of value-creating capital allocation should continue in the years ahead. Much has been written recently about the proliferation of specialpurpose acquisition companies (SPACs). These are non-operating companies formed to raise capital for the intended purpose of acquiring an existing company, referred to colloquially as “blank check companies.” In the closing days of 2020, Sprott Focus Trust participated in one such acquisition that was faltering due to insufficient capital and fears of COVID-19 related business risk. AerSale Corp., a global leader in aviation aftermarket products and services, agreed to combine with Monocle Acquisition Corp. before the COVID-19 pandemic struck. The sudden arrest of global travel put this transaction on hold and eventually at risk of failure. In need of additional capital, very attractive terms were devised to attract outside investors and on December 22, 2020, the deal was consummated with Sprott Focus Trust participating. AerSale management has a long history of success in the lucrative aftermarket aerospace industry, having previously founded California-based AeroTurbine, Inc., which it ultimately sold to Dutch aircraft leasing and asset management company AerCap Holdings N.V. The December transaction gives AerSale significantly greater financial resources to expand its asset purchase program, to expand passenger-to-freighter conversions and to bring innovative AerAware technology to market. You should be aware that statements above about Vishay Intertechnology and AerSale Corporation only reflect our views and are subject to risks and uncertainties. Actual events or results concerning these companies may differ substantially.

In total, we sold eight of FUND’s portfolio positions in 2020. We discussed five of these in detail in the semi-annual report, namely Apple, Amgen, Birchcliff Energy, Pretium Resources and Stelco Holdings. In the second half of 2020, shares in Exxon Mobil Corporation, Lam Research and MAG Silver were liquidated. We sold Exxon Mobile in favor of redeploying proceeds towards higher-quality oilfield services companies already in FUND’s portfolio, specifically Pason Systems and Helmerich & Payne. Notional exposure to the energy industry was maintained, although both Pason’s and Helmerich & Payne’s net cash balance sheets mitigate financial leverage while preserving operating leverage in a recovery. Lam Research shares were sold following tremendous price appreciation exceeding our estimate of fair business value. Lam’s leading position within the semiconductor equipment industry will continue to serve it well in the current growing demand environment. Finally, we sold shares in MAG Silver from our precious metals miners’ basket following significant price appreciation.

Top Performance Contributors and Detractors

Top Contributors to Performance
Year-to-date through 12/31/20 (%)1

Artisan Partners AssetManagement, Inc. 3.21
Westlake Chemical Corporation 1.97 
Seabridge Gold Inc. 1.43
Kirkland Lake Gold Ltd. 1.28
Fresnillo plc 1.28

1 Includes dividends

Top Detractors from Performance
Year-to-date through 12/31/20 (%)1

Pason Systems Inc. -2.73
Helmerich & Payne, Inc. -2.02
Kennedy-Wilson Holdings, Inc. -1.61
Exxon Mobil Corporation -1.38
Biogen Inc. -0.66

1 Net of dividends

Figure 1

Figure 1 lists our top five performance contributors and detractors for the full year. Artisan Partners Asset Management was the largest contributor to portfolio performance. Consistent with shares of most other asset managers, Artisan Partners suffered a short but sharp decline during the early days of the COVID-19 crisis. Its recovery was equally sharp and our decision to buy more shares during the March swoon helped the position contribute more than 3.21% of the FUND’s 6.80% NAV return for the year. Our strategy of staying focused on the long term helps to ease the burden of difficult decisions during extremely volatile periods such as we had in 2020. Westlake Chemical Corporation contributed 1.97% to 2020 performance as PVC (polyvinyl chloride) prices strengthened from a combination of pent-up construction demand, low-interest rates and a potential post-COVID-19 infrastructure package. Similar to our report to you at mid-year, the remaining three of the top five contributors to FUND’s performance in 2020 were components of our basket of precious metals producers. Seabridge Gold, Kirkland Lake Gold and Fresnillo plc together contributed nearly 4% to FUND’s annual performance. Equities of gold and silver miners benefited from resilient and rising spot prices, inexpensive valuations, prodigious free cash flow generation and value-enhancing capital allocation — all of which are still present across many gold and silver miners today.

Three of the five largest detractors from FUND’s performance during the 12-month period were concentrated in the energy patch. Pason Systems and Helmerich & Payne were repeat offenders from our semi-annual report, while Exxon Mobil joined the energy sector’s suffering. Together, the three detracted 6.13% from 2020 performance. Interestingly, and hopefully a sign of good things to come in 2021, both Pason and Helmerich & Payne were among the five best-performing positions for FUND during the fourth quarter of 2020, while we sold Exxon Mobil for tax-loss purposes. KennedyWilson Holdings detracted 1.61% during the year as sentiment toward office real estate values soured and investors contemplated potential demand destruction resulting from the success of workfrom-home. Finally, shares in Biogen fell after results from an important Advisory Committee review of its Aducanumab Alzheimer’s drug revealed challenges with clinical trial data; it detracted 0.66% from FUND’s 2020 performance.

Positioning

The Fund had 37 investments at year-end 2020, down from 43 investments at the end of 2019. This is not surprising to us, given the strength in the recovery of markets and our disciplined approach to security selection. It is slightly disappointing, however, since we tend to find better opportunities when markets are under pressure. FUND’s cash position, which had been building as the year progressed, stood at 1.15% at year-end due to the AerSale Corp. purchase in December.

Once again, Materials was our largest sector exposure (27.1%) at the end of 2020, comprised of precious metals miners that we believe have very attractive investment characteristics. The defensive role that bonds have traditionally played in portfolios seems to have largely run its course as rates are near zero, offering very little upside and potentially great downside from here. This might lend further support for other defensive assets such as gold and silver, underpinning the valuation of gold mining stocks. Bountiful free cash flow should drive further dividend increases and share buybacks in the future.

Top 10 Positions as of 12/31/20
(% of Net Assets)

Western Digital Corporation 5.0
AerSale Corp. 4.9
Berkshire Hathaway Inc. 4.8
Artisan Partners Asset Management, Inc. 4.8
Kennedy-Wilson Holdings, Inc. 4.4
Federated Hermes, Inc. 4.4
Helmerich & Payne, Inc. 4.4
Pason Systems Inc. 4.4
Westlake Chemical Corporation 4.4
Biogen Inc. 4.0

Portfolio Sector Breakdown as of 12/31/20
(% of Net Assets)

Materials 27.1
Financial Services 20.2
Energy 9.5
Industrials 8.7
Technology 8.0
Real Estate 8.0
Consumer Staples 7.1
Consumer Discretionary 6.2
Health Care 4.0
Cash and Cash Equivalents 1.2

Figure 2

Portfolio Diagnostics as of 12/31/20

Fund Net Assets $242.9 million
Number of Holdings 37
Trailing Annual Turnover 35%
Net Asset Value $8.08
Market Price $6.90
Average Market Capitalization1 $3.13 billion
Weighted Average P/E Ratio2,3 17.2x
Weighted Average P/B Ratio2 1.8x
Weighted Average Yield 2.4%
Weighted Average ROIC 16.06%
Weighted Average Leverage Ratio 2.08x
Holdings ≥75% of Total Investments 21
U.S. Investments (% of Net Assets) 70.34%
Non-U.S. Investments (% of Net Assets) 29.66%
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

Figure 3

Outlook

As we write this letter, markets are setting new all-time highs daily. The unimaginable monetary and fiscal stimulus created in 2020 is driving the bull market and is expected to continue, if not expand, in 2021. With short-term rates at 0%, and expected to remain there for years, we are hearing the very dangerous explanation of “TINA” (there is no alternative). Even with low inflation, investors are faced with negative real returns (interest after adjusting for inflation) in fixed income markets. It should come as no surprise that speculative bubbles are now resurfacing. Legendary value investor Jeremy Grantham gives many examples in his annual letter, Waiting for the Last Dance (available at https://www.gmo.com/americas/research-library/waiting-for-the-lastdance/). But we were most intrigued by his discussion about the popularity of SPACs. Grantham writes that in 2020 there were 480 IPOs (initial public offerings), of which 248 were SPACs — which have no business, just the hope of acquiring one someday. As mentioned, we did participate in one SPAC, but only after the acquisition was identified following the return of its cash. By comparison, Grantham points out there were 406 IPOs in 2000 at the height of the dot.com bubble. There are many other examples of euphoric speculation but we need to be mindful that these conditions can persist for longer than one might expect. Remember Alan Greenspan’s warning of “irrational exuberance” in late 1996 and three-and-a-half years before the dot.com peak? Our focus will remain on FUND’s portfolio and the valuations of its individual holdings. While our cash position is starting to build again and the number of holdings is starting to shrink, we are comfortable with the current aggregate valuations.

As value managers, we are always asking ourselves, what could go wrong? Firstly, the COVID-19 pandemic has accelerated many changes that were already in place and created some new ones. Perhaps the expected U.S. economic recovery will not unfold as predicted or resemble what we have seen in the past. The U.S. consumer may continue to choose to save more of their stimulus checks rather than spending them. Or worse, yet, be forced to pay more for essentials like food and energy as the depreciating U.S. dollar drives up the cost of commodities. There is also the possibility that many of the changes we have been forced to make during the COVID pandemic will become permanent. The way we sleep, the way we travel, learn and even work have been altered, and in some cases, permanently. This will cause some dramatic restructuring in our economy with some unexpected outcomes, many of them negative. Finally, we must contend with the policy changes that come with our new federal leadership under President Biden. New spending priorities, regulations and tax policies could create challenges for corporations and investors once we move beyond the COVID-19 crisis. Reversing the Trump corporate tax rates would create an immediate reduction in corporate profitability. This, in turn, would likely be met with unwelcome cost cutting and restructuring, perhaps impacting employment. High taxes on investment returns for individuals would increase the cost of capital for new growth initiatives. Past experience has taught us that there is always a higher cost to meet and comply with new regulations. These are all considerations that could derail a U.S. economic expansion before it begins, and we don’t believe this potential outcome has been priced into the current market.

On the flip side, as long-term investors who have repeatedly learned that markets cannot be timed, we find much to make us optimistic. Last fall, we witnessed some mean reversion in the historic spread between growth and value investing styles. As the markets started to look forward to an economic recovery due to the arrival of COVID-19 vaccines, cyclical sectors like industrials, financials and energy came into focus. FUND’s portfolio, which tends to favor hard asset themes, began to outperform — a welcome development. Active management assisted in the sorting process as investors began to assess the pandemic lockdown’s longer-term effects and the ramifications of our November election results. Merger and acquisition activity picked up the pace, unlocking value in some of our favorite sectors like asset management. Also, there is perhaps a glimmer of hope that politicians can agree on some badly needed infrastructure investment that would benefit our industrial and materials holdings. Finally, while precious metals paused in the fourth quarter of 2020, the fundamentals of precious metals miners have never been brighter. Repeated results from our gold and silver mining stocks are strong and improving on all metrics, including balance sheets, revenue growth, operating margins and free cash flow. Based on all the previously discussed macroeconomic conditions, we would expect the mining sector to be discovered by a much wider audience in 2021.

As promised earlier in this letter, we will now discuss the unfortunate widening of FUND’s trading discount to net asset value in 2020. After several years of progress towards narrowing this spread, the market volatility and FUND’s weaker performance earlier in the year set us back. Our continued investment coupled with attractive portfolio metrics (strong balance sheets and high returns of capital) and reasonable valuations (relatively low price-to-book and price-to-earnings ratios) were not enough to attract new investors. In November, we announced a share repurchase plan. While the plan is somewhat limited by volumes on a daily basis, we expect that it will have a significant long-term benefit. Further, we are permitted to buy large blocks of stock should they be presented. We hope that as all of our shareholders become aware of this initiative, it will improve liquidity and the value proposition that FUND offers.

This year we would like to thank Basia Dworak for her herculean accomplishments under extreme circumstances. Basia is the Office Manager of our Darien, CT office, the Executive Assistant to the President of Sprott and supports all those associated with the management of Sprott Focus Trust. Despite having two small children requiring homeschooling for nearly a year now, Basia kept us all functioning at 100% through COVID. Additionally, she headed our Connecticut COVID-19 Committee and managed an office move at the beginning of November. This crisis has been difficult for many, but none more so than working parents with children at home. Thank you, Basia.

I would also like to thank my investment partner, Matt Haynes, for his continued support and insights, as well as his heavy assistance on this letter. A big thanks also to the entire Sprott team for its expertise and efforts in helping manage FUND during a global pandemic as if it were a normal year. From trading to administration and accounting, we have been fully supported and encouraged and are proud to be part of Sprott.

Finally, thank you to our shareholders for your continued support and patience. We look forward to hearing from you at any time. Our office number is 203.656.2430. Please don’t be shy.

Sincerely,

W. Whitney George,

Senior Portfolio Manager

The views expressed above reflect those of Mr. George as of the date stated above 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.

 

1 Average Market Cap is a  weighted calculation that 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 Since Inception (SI) date is 11/1/1996. FUND was formerly Royce Focus Trust, from its inception to March 8, 2015 and was managed by Royce & Associaties, LLC. Effective March 9, 2015, Royce Focus Trust became Sprott Focus Trust.  
3 These returns are not annualized.
4 The Price-Earnings, or P/E, Ratio is calculated by dividing a company’s share price by its trailing 12-month earnings-per-share (EPS). The Fund’s P/E Ratio calculation excludes companies with zero or negative earnings (7.2% of holdings as of 9/30/2022).
5 The Price-to-Book, or P/B, Ratio is calculated by dividing a company’s share price by its book value per share. 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.
6 Return on Invested Capital (ROIC) is calculated by dividing the estimated net profit by the sum of the estimated shareholder equity and total debt of the security.
7 Leverage is calculated by dividing the estimated Total Assets by Total Equity of a security.

The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and the principal value of an investment will fluctuate, and shares, if redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

Sprott Focus Trust, Inc. (the “Fund”) is a closed-end investment company whose shares of common stock trade on the Nasdaq Select Market. Closed-end funds, unlike open-end funds, are not continuously offered. After the initial public offering, shares of closed-end funds are sold on the open market through a stock exchange. For additional information, contact your financial advisor or call 1.203.656.2430. Investment policies, management fees and other matters of interest to prospective investors may be found in the Fund’s prospectus and shareholder reports.

The Fund is a closed-end registered investment company whose shares of common stock may trade at a discount to their net asset value. Shares of the Fund’s common stock are also subject to the market risks of investing in the underlying portfolio securities held by the Fund.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 3000 Total Return Index measures the performance of the largest 3,000 U.S. companies. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Sector weightings are determined using the Bloomberg Industry Classification Standard (“BICS”).

NOT FDIC INSURED • MAY LOSE VALUE • NOT BANK GUARANTEED

Sprott Asset Management LP is the investment manager to the Fund. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada or the United States should contact their financial advisor to determine whether securities of the Fund may be lawfully sold in their jurisdiction.

© 2022 Sprott Inc. All rights reserved.

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