Sprott Focus Trust Manager Commentary June 30, 2021
The following commentary is an excerpt from the Sprott Focus Trust 2021 Semi-Annual Report.
July 27, 2021
Dear Fellow Shareholders,
We are pleased to report that Sprott Focus Trust (FUND) posted strong performance in the first half of 2021. For the six months ended June 30, 2021, FUND’s net asset value (NAV) advanced 19.25% and its market price increased 26.62%, reflecting the reinvestment of dividends. This compares favorably to FUND’s benchmark, the broad-based Russell 3000 Total Return Index, which gained 15.11% in the first six months. For the trailing 12 months ended June 30, 2021, FUND’s NAV and market price appreciated by 45.85% and 55.33%, respectively, compared to the Russell 3000 Total Return Index’s 44.16% advance. While Sprott Focus Trust still trails on some longer-term measures, we are optimistic about improvement ahead.
The underpinnings of FUND’s first-half success are the long awaited return of active investing and a shift in preference to undervalued, economically sensitive companies. During 2020’s COVID-induced economic shutdown, a new audience discovered stock market investing. Armed with new savings and easily accessible cheap (or commission-free) trading platforms, a new breed of retail investors discovered stocks for the first time. This new class of investors seems disinterested in passively betting on indices or ETFs and has found new non-traditional Wall Street research sources. They seem to prefer to find their gurus on social media platforms. While their initial targets were heavily shorted stocks like GameStop Corp. (yes, we did once own it and sold it near the bottom), their interest seems to have broadened out to seek other fundamental factors. As the first half of 2021 progressed, small-cap stocks with higher quality metrics and more compelling valuations were discovered by these more active and engaged investors.
We entered a corrective phase in the second quarter (which persists at this writing) due to fears that the Delta variant of COVID-19 might slow the rapid economic recovery. We expect the correction in value and small-cap strategies will be short lived. The markets are taking their cues from the U.S. Treasury bond market, and it seems that the massive risk-off rally in bond prices has run its course. Further, given the level of interest rate manipulation by the Federal Reserve (“Fed”), we would not trust the historically reliable signals delivered by bond yields. It also seems likely that more fiscal stimulus is on its way and its inflationary impacts will be far from “transitory.” The reversal of relative performance between value and growth styles was the most dramatic we have seen since 2000 and we believe the powerful mean reversion in our favor is just beginning.
With its heavy emphasis on quality balance sheets and high returns on capital, FUND’s portfolio was well positioned when the markets turned their attention toward economic recovery with the arrival of COVID vaccines at the end of last year. Our overweighting in hard assets themes like Energy Services, Industrials, Materials and Real Estate was finally rewarded. Many of FUND’s portfolio companies posted all-time record results in the first quarter of 2021. The early read for the second quarter is more of the same, with even brighter prospects for the balance of 2021. We are enjoying intelligent share buyback activity and dividend increases among most of our portfolio holdings. Our heavy exposure to asset management companies positions us well for the continued asset appreciation in markets (good inflation). Finally, during the 2020 COVID recession, many companies found new ways to improve their business models and are now enjoying record operating margins. The current domestic competitive landscape looks more like the 2000-2010 period than the last decade (2011-2020) which was characterized by disinflation. We have remained fully invested and our holdings, while up, are barely keeping pace with their improving fundamentals.
The S&P 500 Total Return Index advanced 96.14% from the March 23, 2020, low last year in an almost straight-line fashion through June 30, 2021. Following a move of this magnitude over such a short time period, we’ve been better sellers than buyers of late, reflected in our lower-than-normal portfolio turnover of 9.11%. We exited four positions during the six months while building only one new position (and started to nibble on another). Positions in Arcosa, Inc. Cirrus Logic, Inc. and Gentex Corporation were liquidated during the period under review after very significant share price moves in each and reaching our estimates of fair value. Fresnillo plc, part of the precious metals basket, was liquidated in favor of consolidating exposure to silver with our higher conviction position in Hochschild Mining plc.
A new position in Australian drilling services company DDH1 Limited (“DDH1”). was initiated during the first half of 2021. Shares in DDH1 languished for a short time following its March 2021 IPO (initial public offering), providing the opportunity to buy a very high-quality business at an even better entry price. DDH1 Drilling started in 2006 with a single diamond core drill rig. Through consistent organic growth and two key acquisitions in 2018 and 2019, DDH1 has grown to become one of Australia’s largest providers of specialized and more technically challenging and deep drilling services. The company’s market share in Australia has grown from 2% (16 rigs) in 2011 to 11% (99 rigs) as of December 31, 2020, a compound average growth rate of 20%. Key elements of attraction that enable DDH1’s resilience through the mining cycle include a focus on large scale low-cost miners with an ongoing need to replenish reserve depletion regardless of the stage in the cycle; a focus on producing mines and near mine development; excellent track record managing fixed and variable costs; judicious use of leverage to ensure sufficient capital to grow in the down cycle instead of servicing debt (DDH1 has a net cash balance sheet today); exploration exposure targeting higher-margin work; diversity in commodity exposure, and sufficient scale in each; specialization requiring greater skills, garnering higher day rates; a focus on increasingly deeper drilling industry trends — drilling rates per meter increase as depth increases.
During the first half of 2021, we also started to nibble on shares in leading scrap steel producer Nucor Corporation before record high steel prices during the period propelled shares beyond our targeted buy range. We remain disciplined and patient, hoping for a better entry price in the second half of 2021.
Performance Contributors and Detractors
In our last letter to shareholders (annual report dated December 31, 2020), we explained that in the closing days of 2020, Sprott Focus Trust participated in a faltering SPAC (special purpose acquisition company) transaction involving AerSale Corporation, a global leader in aviation aftermarket products and services. It was an opportunistic purchase since very attractive terms were needed to entice outside investor participation and enable the deal with Monocle Acquisition Corporation to be consummated. Since the closing of the transaction, AerSale shares advanced strongly, producing the greatest source of portfolio performance during the period under review (3.10% contribution). Shares in high-quality denim retailer The Buckle, Inc. contributed 2.67% of portfolio performance thus far this year as consumers returned to in-store shopping while online sales activity remained elevated, driving better than expected operating results. Biogen Inc. delivered strong share price performance during the period as the FDA approved its controversial Alzheimer’s drug aducanumab. Shares surged 41.42% through June 30, 2021, contributing 1.82% of total portfolio performance. Shares in Helmerich & Payne, Inc., the largest U.S. oil and gas drilling services company, contributed 1.80% of total performance as drill rig utilization rates continue to rebound from the deep 2020 trough.
The greatest detractors from Sprott Focus Trust’s performance during the first half of 2021 were all miners in the precious metals basket. The spot price of gold declined 6.76% in the first six months of this year on the belief that the Fed will raise interest rates sooner than later to tame what is believed to be transient inflationary pressures related to the reopening of the post-COVID global economy. Against this pricing headwind, shares of precious metals producers across the globe struggled, despite strong underlying fundamentals at the current cyclically depressed spot prices. The bottom five portfolio positions in aggregate detracted 1.69% from FUND’s total portfolio performance. (This compares favorably, however, to the aggregate contribution of 10.66% from the top five performers discussed earlier.) Today, precious metals mining equities offer generally clean balance sheets, strong expected free cash flow and among the most compelling valuations in 20 years, which translates into tremendous perceived risk-reward opportunities. Great investment opportunities are often preceded by significant declines. We believe this is the case today with our basket of gold and silver miners, despite the market’s recent sell-off.
Top 5 Contributors to Performance
Year-to-date through 6/30/2021 (%)1
|The Buckle, Inc.||2.67|
|Helmerich & Payne, Inc.||1.80|
|Western Digital Corporation||1.27|
1 Includes dividends
Top 5 Detractors from Performance
Year-to-date through 6/30/2021 (%)1
|Hochschild Mining plc||-0.56|
|Seabridge Gold Inc.||-0.44|
|Pan American Silver Corp.||-0.31|
|Barrack Gold Corporation||-0.18|
1 Net of dividends
Sprott Focus Trust at mid-year had 35 equity positions and was nearly fully invested with cash at 2.59%. As shown in Figure 2, the Fund’s greatest sector exposure remains the Materials sector at 25.14%, consisting of both industrial and precious metals producers and drilling services companies. Almost as large, is the Fund’s exposure to the Financials sector (20.70%), consisting primarily of asset managers and longtime holding Berkshire Hathaway Inc. We still own no banks (a differentiating feature among value managers) since their levered business model provides no margin of safety against permanent impairment, a lesson others learned during the 2008 global financial crisis. Six of the previous largest ten positions remain, with AerSale Corporation, The Buckle, Inc., Pason Systems Inc. and THOR Industries, Inc. appreciating into the top Top 10 list by mid- year. Share price appreciation resulted in the portfolio becoming slightly more concentrated today than at year-end. The Top 10 comprised 46.38% of portfolio exposure versus 45.48% at year-end.
Statistically, as shown in Figure 3, the Sprott Focus Trust remains invested across a collection of equity securities of high quality companies with pristine balance sheets, generating solid returns on capital and priced at a discount to our estimates of fair value. The Fund’s long term performance track record demonstrates that a portfolio of companies with these attributes can be expected to deliver attractive returns with less risk over time. As significant co-investors in the Sprott Focus Trust ourselves, we believe the Fund is very well positioned for whatever market conditions the future may hold.
Top 10 Positions as of 6/30/21
(% of Net Assets)
|The Buckle, Inc.||5.2|
|Federated Hermes, Inc.||4.8|
|Berkshire Hathaway Inc.||4.8|
|Helmerich & Payne, Inc||4.5|
|Western Digital Corporation||4.4|
|Kennedy-Wilson Holdings, Inc.||4.3|
|Artisan Partners Asset Management, Inc.||4.2|
|Pason Systems Inc||4.2|
|THOR Industries, Inc.||4.1|
Portfolio Sector Breakdown as of 6/30/21
(% of Net Assets)
|Cash and Cash Equivalents||2.6|
Portfolio Diagnostics as of 6/30/21
|Fund Net Assets||$275.0 million|
|Number of Holdings||35|
|2021 Semi-Annual Turnover Rate||9.11%|
|Net Asset Value||$9.38|
|Average Market Capitalization1||$3.30 billion|
|Weighted Average P/E Ratio2,3||15.49x|
|Weighted Average P/B Ratio2||1.91x|
|Weighted Average Yield||1.94%|
|Weighted Average ROIC||19.03%|
|Weighted Average Leverage Ratio||2.06x|
|Holdings ≥75% of Total Investments||20|
|U.S. Investments (% of Net Assets)||71.31%|
|Non-U.S. Investments (% of Net Assets)||28.69%|
|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|
Two years ago, in our semi-annual report letter to shareholders (June 30, 2019), we wrote about Ray Dalio of Bridgewater Associates, LP and his prediction of a “paradigm shift.” The observation was that with the changeover of decades, there is often a reversal of investment preferences and performance. Strategies that had previously worked for a decade surrender their leadership to the last ten years’ underperformers. We think that a paradigm shift may have occurred in 2020 with the COVID-19 pandemic and ensuring economic shutdown acting as the catalyst. The remarkable monetary and fiscal responses to the sharp but short recession may have broken us out of the disinflationary slumber that persisted for years following the great financial crisis. The low-interest rate/low-inflation environment has given way to higher inflation and negative real interest rates (adjusted for inflation) as far as we can see. We don’t think this is transitory.
Labor is in short supply, at least at current wage levels. The benefits of offshoring labor to cheaper foreign jurisdictions are now viewed as societal negatives with policies designed to bring jobs back onshore. Just-in-time inventory proved costly as supply chains broke down with transportation bottlenecks. The costs of holding inventory are low and the business risks of being caught short are high. As individual consumers, we have certainly learned to keep more toilet paper and cleaning supplies in our homes. Politicians have fully embraced Modern Monetary Theory as a means to pull forward popular spending without concern for the longer-term “pay for.” We believe the sharp rallies we have seen in commodities and value stocks are at the very early stages of what could be a long bull market. For certain, there will be sharp corrections along the way. Markets are aligned and driven by rapid shifts among large algorithmic trading strategies. There will be plenty of macro headlines which will need to be digested. The national debt ceiling has been suspended for two years and needs to be addressed. Political and regulatory attacks on the largest companies are ongoing. And, the market will need to adjust for any new personal or corporate tax changes that emerge in the next six months. But it seems the “paradigm shift” is in play, and we believe that FUND’s portfolio is well positioned for the current market environment.
We would like to include a final word on FUND’s market price versus its net asset value performance. We made some very solid progress during the first half of 2021 in narrowing the discount, which moved from 14.60% as of December 31, 2020, to 9.33% as of June 30, 2021. We believe that our ongoing program to repurchase shares and our relatively strong performance were contributing factors. We hope progress will continue. We can control the first factor. Since we began our share repurchase program in November of 2020, we have retired 1,339,326 shares. In the FUND’s June Board meeting, our Directors approved another 5%. We hope the market will continue to deliver the second part.
As always, we are grateful to our loyal and long-term shareholders for their support and patience. We are surrounded by excited and experienced professionals at Sprott and remain contrarian, innovative and aligned. Once again, many thanks to Matt Haynes for his contributions to our research and co-authorship of this letter. We always enjoy sharing our thoughts with fellow shareholders, so please don’t hesitate to call us directly at 203.656.2430.
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.
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