Sprott Focus Trust Manager Commentary June 30, 2020
The following commentary is an excerpt from the Sprott Focus Trust 2020 Semi-Annual Report.
August 31, 2020
Dear Fellow Shareholders,
We are only halfway through 2020 and what an extraordinary year it has been. As the year began, we had expected increased volatility given the highly charged domestic and international politics in a U.S. presidential election year. Trade wars, slowing economic growth and impeachment proceedings were all on our radar screen in those early days. No one predicted that the global economy would succumb to a virulent pandemic in March. The political rhetoric and responses spread even faster than COVID-19, setting off a global margin call and a sudden severe bear market. As the market was making its historic crash, the Federal Reserve unleashed a flood of liquidity ($3 trillion and counting) followed by Congress passing massive fiscal support (also measured in trillions of dollars). This unleashed a new bull market that dominated the second quarter.
Through this turmoil, Sprott Focus Trust (FUND), based on net asset value (NAV) fell 28.74% in Q1, rebounded 22.56% in Q2 and ended -12.67% for the six months ended June 30, 2020. Based on market price, FUND was down 19.84% in the first half of the year, compared to a decline of 3.48% for the Russell 3000 Total Return Index, our benchmark index.
FUND’s relative underperformance occurred in the first two months of the year, prior to the start of the COVID-induced bear market. 2019 was an excellent year for FUND’s portfolio and we started 2020 by giving back some of our late 2019 advantage. We were in the process of building FUND’s cash position before the market peaked and had deployed it all during March. More recently, we have been net sellers into the spectacular recovery. We don’t recall such rapid changes in valuations and corporate fundamentals. Unfortunately, most of the pre-COVID-19 trends remain in place and these favor mega-cap growth stocks. The current environment is dominated by the need for liquidity with fundamental sorting still on hold. While we did outperform the Russell 3000 Total Return Index in 2020’s second quarter (22.56% versus 22.03%), we are just starting to see the benefits of the portfolio’s positioning in strong balance sheet companies with brightening prospects in a new and rapidly changing economic environment.
In the past year, we have written about the potential arrival of MMT or Modern Monetary Theory. It has now arrived and more dramatically than anyone could have envisioned. The notion that a country can have the ability to print its own currency in unlimited quantities to support its society is now our new reality. The U.S.’s monetary and fiscal responses to the severe COVID-19 lockdowns appear to have been the tipping point. The problem is that every country outside the U.S. would like to use our populace’s tool, but most of the global financial system is tied to the U.S. dollar.
While the Federal Reserve has recently provided massive supplies of U.S. dollars to our allies in the short term, other less-friendly economies have been forced to find an alternative. The U.S.-dollarbased global financial system that has been in place since 1971 is starting to break down. For most of the last 50 years, we have supported global growth by running increasingly large trade and fiscal deficits. We have allowed other countries to build their economies on the back of U.S. consumers buying their cheaper goods and services; in return, these countries would invest a good portion of their profits in our Treasury bonds and bills to help finance our deficits. That relationship began to change after the 2008-2009 global financial crisis. Our trading partners started to find other investments for their profits, gold being one of the most favored. The breakdown of this system first resulted in the trade tensions which have been such a prominent feature of the Trump administration. The more recent, less noticeable outcome has shown up in diminished foreign appetite for our debt issuance. We are increasingly financing our own deficits, with one arm of the government (the Federal Reserve) buying from the other (the U.S. Department of the Treasury). The move to a new global financial system is well underway and it is unlikely to feature the U.S. dollar so prominently.
While the swift market decline in March created many opportunities to add to FUND’s existing positions in high-quality companies at attractive prices, our search for new ideas did not bear much fruit. We initiated only one new position, Garmin — which was later sold, following its quick recovery — during the six months. Shares in Garmin, a leading producer of Global Positioning System (GPS) enabled products, fell nearly 40% from their high in February to an attractive level for an R&D (research and development) position. Regrettably, Garmin’s shares recovered almost as quickly. The only other “new” position added to FUND was gained by receiving shares in Kirkland Lake Gold from its acquisition of Detour Gold, which we held at year-end. We like the reconstituted collection of assets at Kirkland Lake Gold and favor its net cash balance sheet and prodigious free cash flow generation.
We liquidated five positions in the first half of 2020. Apple has been a longstanding and very profitable position in FUND’s portfolio but following its seven-fold increase since mid-2011 — which has generated annualized returns of 25% since then and through year-end 2019 — we believe that much of Apple’s exceptional business performance and prospects are now factored into its share price and valuation. Our approach to investing is from the perspective of a buyer of the entire business, which means that at a certain valuation 2 | 2020 Semi-Annual Report to Stockholders MANAGER’S DISCUSSION for every company, we are happy to sell to less discerning buyers. With algorithms increasingly driving investment decisions and passively managed index funds weighted toward the largest companies, Apple’s valuation has expanded beyond our estimate of fair value. Amgen was sold as it, too, performed in accordance with expectations after generating significant profits for FUND. Two small positions in Birchcliff Energy and Stelco Holdings were sold at a loss amid the COVID market downdraft, but not before their indebted balance sheets illustrated the negative effect that debt can have on highly cyclical businesses. Finally, Pretium Resources was sold from our basket of precious metals miners in favor of other more attractive gold miners.
Top Contributors to Performance
Year-to-date through 6/30/20 (%)1
|Barrick Gold Corporation||1.28|
|Kirkland Lake Gold Ltd.||0.96|
|Thor Industries, Inc.||0.89|
|Seabridge Gold Inc.||0.74|
|Pan American Silver Corp.||0.62|
1 Includes dividends
Top Detractors from Performance
Year-to-date through 6/30/20 (%)1
|Pason Systems Inc.||-2.72|
|Helmerich & Payne, Inc.||-2.45|
|Kennedy-Wilson Holdings, Inc.||-1.99|
|Western Digital Corporation||-1.26|
|The Buckle, Inc.||-1.17|
1 Net of dividends
Figure 1 lists our top five performance contributors and detractors in the first half of 2020. Unsurprisingly, the list of top contributors is dominated by our basket of precious metals producers. Four of the five largest contributors were gold and silver miners including Barrick Gold, Kirkland Lake Gold, Seabridge Gold and Pan American Silver Corp. Together, these four contributed 3.61% to FUND’s performance during the period, serving their role as a ballast amidst the tumult in equity markets. Thor Industries ranked third among the top five winners following increased demand for recreational vehicles (RVs) as restless consumers escaped the confines of home in search of new and safe modes of travel and lodging during the pandemic. While the portfolio benefited from having very little exposure to the decimated consumer discretionary sector, Thor Industries saw increased demand for its products because of COVID.
The five largest detractors from performance were Pason Systems, Helmerich & Payne, Kennedy-Wilson Holdings, Western Digital and The Buckle. Both Pason Systems and Helmerich & Payne serve the oil and gas industry, which suffered from the rare coincidence of both supply and demand shocks during the period. Oil prices plummeted after Saudi Arabia and Russia cut prices and boosted production in an apparent war for market share. Demand for crude oil and petroleum-based fuels fell sharply around the world because of the COVID-19 pandemic, taking oil prices lower still. Although crude oil demand and prices have rebounded somewhat as the world reawakened, demand for the drilling services and technology that Pason Systems and Helmerich & Payne provide will likely take some time to recover. Both companies’ leading competitive positions in the industry and cash-rich balance sheets should enable each to emerge from this downturn stronger. Kennedy-Wilson is a real estate investment management company with a long history of opportunistic and contrarian-driven success. While the company’s shares have fallen due to near-term expectations for lower net operating income (NOI) and demand for office space, management recently raised $2 billion with esteemed joint venture partner Fairfax Financial to pursue first mortgage loans secured by high-quality real estate. When the going gets tough, Kennedy-Wilson gets busy in its pursuit of long-term value creation. Western Digital eliminated its dividend during the period under review to accelerate debt reduction stemming from its 2016 acquisition of Sandisk. Shares in The Buckle, the only retailer in the portfolio, declined along with other brick-and-mortar focused retailers as stay-at-home orders hurt retail sales (-43% versus Q1 2019) and its online business was too small to offset the decline (approximately 15% of total sales).
Top 10 Positions as of 6/30/20
(% of Net Assets)
|Westlake Chemical Corporation||4.5|
|Artisan Partners Asset Management, Inc.||4.5|
|Kennedy-Wilson Holdings, Inc.||4.4|
|Western Digital Corporation||4.3|
|Berkshire Hathaway Inc.||4.0|
|Franklin Resources, Inc.||3.9|
|Reliance Steel & Aluminum Co.||3.8|
|Federated Hermes, Inc.||3.5|
|Helmerich & Payne, Inc.||3.5|
Portfolio Sector Breakdown as of 6/30/20
(% of Net Assets)
|Cash & Cash Equivalents||7.3|
FUND at mid-year had 38 equity positions and a cash position of 7.3%. Cash will always be a by-product of the opportunity set we perceive in the markets and had grown to approximately 10% in the weeks before the markets fell in February and March. The rapid pace of declines in FUND’s portfolio holdings opened a very narrow and attractive window to redeploy that cash, FUND was nearly fully invested again by late March. Following the snap-back in markets, we are once again allowing cash to build as we pare back on positions into recent strength. As shown in Figure 2, Materials (28.0% of the portfolio) continues to be our largest sector, dominated by our appreciating exposure to precious metals producers. We are quite fortunate to benefit from the internal expertise of Sprott’s various teams of precious metals experts. While gold has been characterized as a “barbarous relic” from a by-gone era of physical money in the current age of digital bitcoins and fiat currencies, it continues to stand the test of time in protecting wealth for thousands of years. Our worries about the impact from global central banks’ issuance of trillions of dollars in COVID relief are somewhat allayed by the degree of financial protection such exposure to gold should provide FUND shareholders. We are hoping for the best while being prepared for the worst.
Eight of the portfolio’s top ten positions remain consistent from year-end 2019, with the addition of two asset managers (Artisan Partners and Federated Hermes) replacing Pason Systems and Cirrus Logic (which was pared back after significant appreciation earlier in the year). Although the portfolio is slightly more concentrated than at year-end 2019, with 38 equity positions compared to 43, the capital committed to the top ten is virtually unchanged at 40.5%.
Portfolio Diagnostics as of 6/30/20
|Fund Net Assets||$202 million|
|Number of Holdings||38|
|2020 Semi-Annual Turnover Rate||20%|
|Net Asset Value||$6.93|
|Average Market Capitalization1||$3.3 billion|
|Weighted Average P/E Ratio2,3||13.1x|
|Weighted Average P/B Ratio2||1.5x|
|Weighted Average Yield||3.25%|
|Weighted Average ROIC||17.80%|
|Weighted Average Leverage Ratio||2.2x|
|Holdings ≥75% of Total Investments||25|
|U.S. Investments (% of Net Assets)||70.9%|
|Non-U.S. Investments (% of Net Assets)||29.1%|
|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|
We have discussed in the past how our current President or “Commander in Tweet” approaches serious issues. Take a problem, blow it up into a crisis and then work on a solution. Some might find some merit to this approach as opposed to the practice of “can kicking” that had become the political norm. Now we have the global pandemic of COVID-19, an economic shutdown and policy responses that neither Bernie Sanders nor Elizabeth Warren could have dreamed of accomplishing with two terms in office. We have clearly reached the fiscal tipping point and the pace of change has accelerated. The way we conduct business, educate ourselves and our children and socialize, has all changed profoundly this year. While the liquidity crisis has come and gone, the sorting process has just begun. For us, it is pointless to predict how the recovery will play out or what shape it will take. Instead, we spend our time researching what businesses will survive or even thrive in this new world and which have become permanent value traps.
The current conditions are reminiscent of the late 1960s and early 1970s. As a country, we have clearly made more promises than we can keep. We have spent beyond our means. We have crowded our investments into a small group of behemoth technology companies (remember the Nifty 50). Our fear is that the world post-COVID-19 will feature a period of stagflation. As bad as it sounds, there will be opportunities, just like there were in the 1970s, to protect and compound wealth. We will continue to favor hard assets themes in FUND’s portfolio. We will also maintain a higher cash level to avail ourselves of the inevitable opportunities that will present themselves. After 40 years of experience in this business, I trust that the next few months will reveal whether that is an asset or a handicap. With FUND currently trading at roughly a 15% discount and value strategies badly lagging growth, the market seems skeptical. We, on the other hand, remain optimistic, but we do not intend to manage a value trap. With the help of our talented Board, we will continue to pursue the best outcome for all shareholders.
Finally, I would like to thank Matt Haynes who penned a good portion of this letter and continues to provide valuable research support to FUND. Also, I would like to acknowledge the incredible teamwork and seamless execution of all the other Sprott employees who contribute to the FUND effort through these challenging times. As always, many thanks to our fellow shareholders for your support.
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 (6.8% of holdings as of 6/30/2022).|
|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.
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Sector weightings are determined using the Bloomberg Industry Classification Standard (“BICS”).
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