Sprott Focus Trust Manager Commentary December 31, 2021
The following commentary covers the 12-month period from January 1 - December 31, 2021, and is an excerpt from the Sprott Focus Trust 2021 Annual Report.
February 2, 2022
Dear Fellow Shareholders,
We are pleased to report that Sprott Focus Trust (FUND) had a very good year in 2021. For the twelve months, FUND’s net asset value (NAV) increased 22.93%, we distributed a total of $0.7574 in capital gains and income and repurchased over 2 million shares. These factors contributed to FUND’s notable 36.49% market price total return for the year. This compares to a 25.66% total return for the FUND’s benchmark, the broad-based Russell 3000 Total Return Index. Clearly, 2021 was a great year for most equity investors, and it set a high bar that is unlikely to be repeated in 2022. Yet, due to the many factors discussed in this letter, we remain optimistic about FUND’s prospects, especially in relative terms.
We enjoyed a very strong start in 2021 as the markets discounted a strong post-COVID recovery followed by general weakness in the second and third quarters. While markets had to contend with the implications of new COVID variants, the business fundamentals of most of FUND’s portfolio companies continued to improve, supporting strong fourth-quarter results and more evidence that an active value portfolio management style may be back in fashion.
The biggest financial story in 2021 was the return of inflation. After years of monetary easing and unprecedented fiscal stimulus employed to combat the disastrous effects of the COVID lockdown, the U.S. Federal Reserve (“Fed”) finally got what it wanted. Unfortunately, it emerged faster than planned and in all the wrong places. Rather than boosting wages, which would have reduced the growing global wealth divide, inflation became most pronounced in the essential, everyday goods that everyone requires. Instead of the widely expected progressive taxes on wealthy individuals and corporations, we witnessed the most regressive form of taxation, i.e., inflation. Those who can least afford it are now paying more for food, energy, shelter and transportation. While early expectations that these price increases were “transitory” and entirely related to COVID-related supply chain disruptions, the realization that more permanent drivers are fueling inflation has slowly emerged.
At the same time, the geopolitical landscape is shifting. Specifically, China has grown to the point where its internal demands can no longer support its role as the primary exporter of cheap goods to the rest of the world. We learned that China has structural problems, the most basic being a water shortage. With 20% of the world’s population, China has only 7% of the water supply and much of that is polluted beyond use. Beyond water’s importance to food production, industries like textile manufacturing, power generation and industrial production are water intensive. Having underpriced its water supply for decades, China may have reached the point where exports of water-intensive goods are replaced by imports of food and energy, turning its long-held role as a deflationary force on the global economy to an inflationary contributor.
A second long-term driver of inflation was discovered in 2021: “carbonomics” (i.e., investment opportunities created by decarbonization). Green energy sources worldwide were proven to be less reliable due to weather events in 2021. Severe droughts in many regions reduced the production of hydroelectricity. Lack of wind in the North Sea curtailed wind turbines, and storms and wildfires here in the U.S. uncovered the inadequacies of our existing power distribution systems. As a result, fossil fuel prices of all forms were up in 2021 (some at records) and global coal consumption set a record. We are just now discovering the true costs of decarbonization and the compromises that will need to be made. The political narrative around nuclear power is shifting, but few seem aware of the magnitude of basic materials required to achieve global electrification goals. Compared to an internal combustion engine, it takes six to seven times the amount of mined metals to make an electric-powered vehicle. Given the rising costs of capital incurred by environmental and socially driven regulations, the transfer away from fossil fuels will be more expensive and take longer than most of us can imagine.
Finally, we believe inflation will be driven by the need to catch up on two decades of deferred maintenance. In addition to the massive bipartisan infrastructure bill passed in 2021, there is a real need to rebuild our manufacturing base. The U.S. semiconductor industry is just one example of many that will require massive investment in the years ahead to regain global competitiveness, and the costs will be surprising.
FUND’s portfolio turnover rate was 22% in 2021, which is somewhat lower than recent years and reflects the current late-stage bull market environment. Opportunities to harvest portfolio positions into the rising U.S. equity market — and its corollary, rising company valuations — exceeded purchases of new securities that met our disciplined and time-tested investment criteria. Lower market volatility during the year also contributed to diminished portfolio activity versus prior years.
Consistent with this, we sold six of FUND’s portfolio positions during 2021. In our June 30, 2021, semi-annual letter to shareholders, we discussed four in detail, namely Arcosa, Inc., Cirrus Logic, Inc., Fresnillo plc and Gentex Corporation. Since then, two more positions were liquidated, with sales of Biogen Inc. and Sanderson Farms, Inc. Biogen has been on a bit of a roller coaster since our original purchase in late March 2019. Since then, several dramatic share price moves have given us opportunities to realize significant gains as we traded around the position. However, more recent changes to Biogen’s original investment thesis have negatively impacted our perception of its risk-reward potential going forward. Specifically, the company’s essentially net debt-free balance sheet in 2019 is now materially indebted. In addition, key medications coming off patent are detracting from the company’s ability to generate free cash flow and drive future research and development, make acquisitions and repurchase shares — key elements of Biogen’s historic capital allocation strategy that we believed were underappreciated by the market. By comparison, Sanderson Farms was an easier sale since its full intrinsic value was realized in a generous cash bid to acquire the company made jointly by Cargill, Incorporated and Continental Grain Company.
Three new portfolio positions were added during 2021, with DDH1 Limited discussed in detail in the June 30, 2021 semi-annual report, and positions in Nucor Corporation and Schnitzer Steel Industries, Inc. and more recently. After disclosing to you in our semi-annual letter that we had begun nibbling on shares in scrap steel producer Nucor, our price discipline paid off during the second half of 2021 as we took advantage of weakness in the shares to build our position. The North American steel industry has been on a tear since the lows of 2020 as steel demand came roaring back and prices reached new record highs. Nucor is recognized as a best-in-class operator, representing the future of the steel industry since it relies upon recycled scrap steel as feedstock for its finished products. As North America’s largest steel producer, Nucor’s mills make steel by melting scrap in electric furnaces, a cheaper method that generates an estimated 40% lower carbon emissions than the traditional blast furnace process. The company has been expanding its production capacity in recent years and diversifying its operations across the entire steel value chain, mitigating exposure to any one end market. While the sustainability of the current steel cycle is uncertain, we believe that Nucor is positioned well within the industry to maximize shareholder value while caring for its employees, customers, communities and our environment over the long term.
Somewhat related to Nucor, Schnitzer Steel Industries is one of North America’s largest recyclers of ferrous and non-ferrous scrap metal and manufactures finished steel products. As companies like Nucor and others continue to shift their production from the blast furnace to the electric arc furnace method of producing steel, demand for scrap steel will continue to grow. It is already in very high demand, evidenced by the elevated prices that steel producers currently pay for both ferrous and non-ferrous scrap. Schnitzer Steel uses its 94 auto and metals recycling facilities throughout the U.S. and Canada to acquire auto bodies, railcars, home appliances, machinery and other expired metal products. Schnitzer Steel’s largest source for auto bodies is their network of 50 retail self-service auto
parts stores operating under the brand name Pick-n-Pull. Vertical integration of Schnitzer Steel’s auto parts stores and metals recycling operations provides efficient processing and production of recycled metal products for use by steel mills and smelters around the globe. Schnitzer Steel’s captive steel company, Cascade Steel Rolling Mills, produces finished products including rebar, wire rod, coiled rebar and other specialty products using recycled scrap metal primarily sourced from its internal recycling operations. Safety, sustainability and integrity are core values at Schnitzer Steel, and we believe its leadership on sustainability issues has positioned the company for durable success in the future. Simply put, and in the words of Schnitzer Steel’s very capable CEO Tamara Lundgren, “we salvage the past to ensure the future”.
Finally, in December, we received shares in a newly listed entity named Aclara Resources Inc., spun-off from Hochschild Mining PLC. Aclara Resources is a development stage rare earth mineral resources company in Chile. Aclara’s project represents one of the only scalable sources of heavy rare earth elements outside of China, and the transition to clean energy will drive significant demand for key rare earth minerals. Aclara is working toward being positioned to supply this growing market beginning in 2024.
Performance Contributors and Detractors
Top 5 Contributors to Performance
Year-to-date through 12/31/2021 (%)1
|The Buckle, Inc.||2.62|
|Pason Systems Inc.||2.14|
|Federated Hermes, Inc.
1 Includes dividends
Top 5 Detractors from Performance
Year-to-date through 12/31/2021 (%)1
|Hochschild Mining plc||-1.00|
|Seabridge Gold Inc.||-0.62|
|Pan American Silver Corp.||-0.62|
|Ashmore Group plc||-0.52|
|Barrack Gold Corporation||-0.37|
1 Net of dividends
Figure 1 shows which positions contributed and detracted the most from FUND’s aggregate performance during the year. Our standout performer during 2021 was also the last new position purchased during 2020, AerSale Corporation, which contributed 6.09% to the Fund’s total return for 2021. As we wrote in last year’s annual report, the purchase of AerSale by a Special Purpose Acquisition Corporation (SPAC) was at risk of failure due to insufficient capital. FUND participated in the year end capital raise at very attractive terms. After the transaction closed, public markets quickly recognized the enhanced competitive and financial position that AerSale would enjoy resulting from the financing. We took significant profits during the year and continue to believe that AerSale’s prospects are very attractive. Its innovative new technology, AerAware, is likely to come
to market following FAA (federal aviation authority) approval and deployment with at least one major customer this year.
The Buckle, Inc.’s share price advanced significantly in 2021 and it contributed 2.62% to FUND’s performance for the year. The Buckle’s improved operating performance was driven by a strong rebound in consumer demand, increased online sales at better operating margins and the prevalence of stores located in outdoor malls that drove foot traffic despite COVID lockdown restrictions. Buckle’s debt-free and cash-rich balance sheet enabled it to withstand the deep COVID-related downturn for retailers and emerge in a strengthened competitive position. Pason Systems Inc., the leader in North America for oil and gas drilling instrumentation, data capture and analysis, contributed 2.14% to FUND’s 2021 performance as drill rigs started turning again and recovered from the depths of inactivity during COVID. Pason’s debt-free and cash-rich balance sheet — a theme central to our investment process, for reasons now very apparent — also helped Pason survive the deep downturn. Kennedy-Wilson Holdings, Inc. is an opportunistic real estate investor and developer with a long record of value creation. The COVID period created ample opportunity to invest, which Kennedy- Wilson took advantage of and its shares were rewarded in the market, advancing significantly and contributing 1.67% to FUND’s 2021 performance. We believe the company has a clear path to grow net operating income (NOI) by a 10-15% compound average growth rate over the next three years. Lastly, Federated Hermes, Inc. was FUND’s fifth-highest performance contributor in 2021, contributing 1.45%. Federated Hermes is a global leader in active, responsible investing. It benefitted in 2021 from strengthening capital markets and the resulting impact on its asset base and management fees, and its success in leveraging its leading ESG (environmental, social and governance) franchise.
As we wrote at midyear, precious metals mining companies struggled in 2021. Four of the five greatest detractors from FUND’s 2021 performance were in our precious metals basket. While the spot gold price declined 3.64% for the year, spot silver price declined 11.72%. Miners fared worse with Hochschild Mining, Seabridge Gold Inc., Pan American Silver Corp. and Barrick Gold Corporation collectively detracting 2.61% from FUND’s 2021 performance. Hochschild Mining suffered more than its peer group as political risk from a new left-leaning government in Peru threatened to close four mines in Ayacucho, two of them belonging to Hochschild. This possibility casts doubt on the future of Hochschild’s operations in the country. The likelihood of higher mining royalties and taxes negatively impacted the value of Hochschild’s most important asset, Inmaculada, leading to a significant decline in its shares during the period. Rising real interest rates, even if still negative at year end, damaged sentiment towards the sector generally despite already deeply discounted valuations, clean balance sheets and significant free cash flow generation at current spot prices. We believe that gold miners represent attractive value and may serve as a potential hedge against central bank monetary policy mistakes should inflation prove to be more durable. Ashmore Group shares detracted a modest 0.52% from FUND’s 2021 performance as fund outflows exacerbated the already declining emerging market debt securities in which the company specializes. Shares fell sharply in 2021, reflecting the dismal prospects for Ashmore’s business amid the current emerging market environment. As with all niche asset classes, performance is cyclical. We believe that Ashmore’s net cash balance sheet and solid long-term record will enable it to return to prominence among peers, reversing current negative business trends and its share price.
Top 10 Positions as of 12/31/21
(% of Net Assets)
|Pason Systems Inc||5.0|
|Kennedy-Wilson Holdings, Inc.||5.0|
|Federated Hermes, Inc. Class B||4.9|
|Berkshire Hathaway Inc. Class B||4.7|
|Reliance Steel & Aluminum Co||4.5|
|Westlake Chemical Corporation||4.3|
|Artisan Partners Asset Management, Inc. Class A||4.3|
|Thor Industries, Inc.||4.3|
|Western Digital Corporation||4.1|
Portfolio Sector Breakdown as of 12/31/21
(% of Net Assets)
|Cash and Cash Equivalents||0.8|
Sprott Focus Trust had 35 equity investments at year end, down from 37 a year ago and down from 43 at the end of 2019. Increased concentration has been an unsurprising by-product of the strength in equity markets and our disciplined approach to new security selection. As markets have rallied, our pool of attractive prospects has diminished. However, we are quite happy with those securities we currently hold and are content with the portfolio’s increased concentration. Cash is a by-product of opportunities we derive from the bottom up, and at just 0.84%, it illustrates the degree of our perceived undervaluation of FUND’s portfolio.
Materials remained at year end our largest sector exposure at 33.26%. While the precious metals basket remains an attractive and core strategic exposure, we expect that the beginning of 2022 will mark an increased allocation to the steel sector. Three steel producers, Nucor, Reliance Steel & Aluminium Co. and Schnitzer Steel Industries, comprise of more than 11.26% of the portfolio at year end, versus just 3.70% a year ago.
Portfolio Diagnostics as of 12/31/21
|Fund Net Assets||$269.0 million|
|Number of Holdings||35|
|2021 Annual Turnover Rate||22.23%|
|Net Asset Value||$9.07|
|Average Market Capitalization1||$2.67 billion|
|Weighted Average P/E Ratio2,3||10.36x|
|Weighted Average P/B Ratio2||1.78x|
|Weighted Average Yield||2.15%|
|Weighted Average ROIC||23.60%|
|Weighted Average Leverage Ratio||1.97x|
|Holdings ≥75% of Total Investments||19|
|U.S. Investments (% of Net Assets)||70.84%|
|Non-U.S. Investments (% of Net Assets)||29.16%|
|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 (13.32% of holdings as of 12/31/2021).|
As of this writing, we are in the midst of the steepest correction since March 2020 and the worst January since 2009. In January 2022, the Russell 3000 Index was down 5.88%, while the Bloomberg U.S. Treasury 7-10 YR Index was down 2.35%.*
Inflation is running at its highest level in 40 years and has quickly replaced the COVID-pandemic as the number one political theme in a mid-term election year. Highly valued growth stocks are undergoing P/E (price/earnings) multiple compression while economically sensitive sectors start to discount an economic slowdown. In just two months, the consensus thinking about what Chair Jerome Powell and the Fed will do in 2022 has dramatically shifted. The “transitory” inflation persists and the market has adjusted its expectations from maybe one interest rate increase this year to possibly one at every Fed meeting (about every six weeks). Further, the record expansion of the
Fed’s balance sheet is about to reverse and run off quickly. We don’t think so. While the Fed has announced an end to asset purchases, it has quietly implemented new programs that would allow them to support markets similar to the facilities used in March 2020. While the Fed’s commitment to stable functioning markets remains, its tools have changed. Predictability has left to be replaced with volatility.
One of our favorite strategists, Luke Gromen, wrote about a relatively unnoticed condition in his weekly publication, The Forest For The Trees. Coming out of the 2020 COVID lockdown, our nation’s fiscal and debt position deteriorated to levels not seen since the end of World War II, with federal debt to GDP (gross domestic product) rising north of 130%. Further, with record tax receipts not quite covering “True Interest Expense” (interest and pay-as-you-go entitlements), all other government expenditures need to be covered with additional borrowings. With a diminished appetite among foreign and private investors for negative real returns, these deficits need to be financed by someone. That someone remains the Fed. And increasing interest rates and reducing liquidity will only make things worse. Luke Gromen points out the only way out of our current fiscal position, aside from default, is the path taken 75 years ago. We need GDP to grow rapidly and the currency that the debt is denominated in, U.S. dollars, to depreciate. During 2021 we were making some progress with high nominal GDP growth bringing the debt/GDP ratio closer to 120%. Gromen believes this ratio needs to get closer to 80% before the Fed can allow free markets to determine interest rates without economic accidents. Given all this, we believe the markets are too optimistic about what the Fed might be able to do about inflation this year. At this stage, the global financial system cannot tolerate either higher interest rates or a stronger U.S. dollar. It needs the opposite to avoid defaults no matter what the near-term political consequences.
We have entered 2022 with FUND’s portfolio looking highly attractive from both a quality and valuation perspective. While 2021 was a very strong year, the majority of our portfolio holdings fundamentally preformed even better than reflected in their share prices. Balance sheets and returns on capital have never been stronger. Share buy backs and accretive acquisitions have never been more active and valuations so undemanding. Barring a severe recession caused by a mistaken policy response, we expect to continue to see strong relative performance. We are well positioned for a year we expect to be characterized by increased capital investment in both energy transition and vital infrastructure.
Sprott as an organization continues to grow and thrive and we are so grateful for all those who support us behind the scenes. I would also like to thank my partner, Matt Haynes, for his heavy contribution to research and the writing of this letter. Matt has recently volunteered to take on an additional role at Sprott Asset Management as Chair of our ESG Committee. In this position, Matt will help us better understand the evolution of ESG considerations and how they affect our portfolio holdings. It seems fairly straightforward to us that understanding and implementing these new standards will require a lot of judgement and therefore active management. We will have more to say as this process gets underway. But mostly, we are grateful for the patient and supportive shareholders who have been our partners for so many years. We hope all will feel free to be in contact directly to ask questions or provide insight by calling us at 203.656.2430.
W. Whitney George,
Senior Portfolio Manager
*Source: Bloomberg as of 1/31/2022. Reflects total returns. The Russell 3000 Index is measured by the RAY Index. The Bloomberg U.S. Treasury 7-10 YR Index is measured by the LT09TRUU Index. Bitcoin is measured by the XBTUSD BGN Curncy.
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.
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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