Sprott Focus Trust Manager Commentary June 30, 2018
The following commentary is an excerpt from the Sprott Focus Trust 2018 Semi-Annual Report.
July 30, 2018
Dear Fellow Shareholders,
The first half of 2018 was very productive fundamentally for our portfolio but returns were somewhat mixed. Earnings growth and business expansion within our holdings were offset by multiple contractions, in some cases severe, creating new buying opportunities in some of our longest held and highest conviction ideas. For the six-month period, Sprott Focus Trust’s net asset value declined 1.71%. This compares to a 3.22% gain for the Russell 3000 Index. On a brighter note, continued progress on narrowing the Fund’s trading discount to its NAV (net asset value), produced a positive total market return of 2.0% for the Fund during this period.
The bulk of Sprott Focus Trust’s performance lag in the first half of 2018 can be attributed to a relatively flat start to the year. Many of our holdings achieved peak prices late in 2017 and failed to participate in the final melt-up phase during the first three weeks in January. Passive investors rushed into the largest, most heavily index-weighted stocks following the December passage of Trump’s tax reform (the Tax Cut and Jobs Act) in what appears to have been a final buying capitulation. Since the market sell-off in late January/early February, Sprott Focus Trust’s portfolio has performed more in line with the general market averages. However, leadership among U.S. equities has continued to further narrow to the point where all of this year’s market gains can be attributed to just a handful of mega-cap technology companies. Amazon.com, Inc. alone is responsible for about nearly one-third of the S&P 500 Index’s first-half gain. Microsoft Corporation and Apple Inc. combine for an additional 35%, and just another seven companies make up the rest of the S&P 500’s rise. Meanwhile, nearly half the companies in the S&P 500 are down on a year-to-date basis.
Market Review: H1 2018
Clearly, volatility has made a roaring comeback in 2018. Higher rates, political turmoil and trade wars are now producing daily market swings in the widely followed averages that we had observed in individual stocks last year, but were invisible to those watching and investing in broad indices. We believe the nine-year-old bull market is in a corrective phase that may persist for some time. Interest rates are rising and inflation is returning. While most are focused on the Federal Reserve’s stated goal to raise the Fed’s Fund rate 3 or 4 times this year, it is likely that the Quantitative Tightening (QT) program, which began last October, is having a larger impact on global liquidity. Few are aware that the attempt to shrink the Federal Reserve’s $4.5 trillion balance sheet is escalating every three months. What started as a $10 billion per month program last fall is currently running at up to $40 billion per month and headed for approximately $50 billion come this October. While these numbers may seem relatively small in the context of the Fed’s balance sheet, the U.S. national debt and annual deficits are contributing in a growing way to global liquidity constraints. The negative effects have already been seen within the emerging markets, commodities sectors and some areas of domestic consumer lending. But as has happened in the past, these problems are on the periphery and judged to be “contained”.
As to inflation, it is already running well above the Federal Reserve’s 2% target. It is hard to imagine that the escalating trade rhetoric and actual tariffs will not contribute to growing inefficiencies that will add fuel to that fire. Given this backdrop, we are not surprised that forward progress has become more challenging. We would like to believe that the Federal Reserve will back down on its QT program before the effects become more broadly problematic. History suggests that this will not happen. We are hopeful that escalating trade wars are a product of the election cycle, but fear that President Trump is unique in his desire to keep campaign promises and that markets are still too complacent about this risk. What better time to be a value buyer? While the short-term results may not show it, conditions for long-term outperformance have rarely been this promising.
Portfolio Activity: H1 2018
The vast majority of Sprott Focus Trust’s portfolio activity in 2018’s first half was dedicated to increasing exposure to some of our longest held, highest conviction positions. The market’s correction early in the year, and the aftershocks that followed, created opportunities to rebuild holdings in companies that have historically been among the largest winners for the Fund at bargain valuations not seen since the 2009 financial crisis. The Fund’s cash position, which stood at 6.2% yearend, was reduced to 3.8% as of June 30. Additionally, after two years of minimal action, we have started to see a resurgence of merger and acquisition (M&A) activity in the portfolio. Mergers and acquisitions have always been an important mechanism for value discovery. As we remarked in our 2017 annual letter, we had been surprised by the lack of M&A activity. In fact, many of our favorite portfolio companies had been acquirers during the last five years, most with tremendous outcomes. This tide now seems to have turned in our favor and is consistent with a mature phase of a bull market.
For the first half, our overall turnover has been low. Trailing 12-month churn was 25.52% as of June 30 which is consistent with our historical average and our three- to five-year investment horizon. As a reminder, low turnover helps reduce trading costs, market friction, costly mistakes and short-term capital gains tax, all consistent with our goal of producing strong absolute returns after taxes, fees and inflation.
Top Performance Contributors and Detractors
Top Contributors to Performance
Year-to-date through 6/30/18 (%)1
|Kennedy-Wilson Holdings, Inc.||1.03|
|FRP Holdings, Inc.||0.77|
|Pason Systems Inc.||0.67|
|The Buckle, Inc.||0.57|
1 Includes dividends
Top Detractors from Performance
Year-to-date through 6/30/18 (%)1
|Thor Industries, Inc.||-1.12|
|Federated Investors, Inc.||-0.98|
|Sanderson Farms, Inc.||-0.90|
|Franklin Resources, Inc.||-0.80|
|Cirrus Logic, Inc.||-0.79|
1 Net of dividends
Sprott Focus Trust’s top-five performers in the first half were Syntel, Kennedy-Wilson Holdings, FRP Holdings, Pason Systems and The Buckle. Syntel, a well-run multinational information technology (IT) services company headquartered in Michigan, was added to the portfolio in late 2016 and early 2017 as its shares slumped due to an earnings slowdown. We purchased shares starting at $24 and continued buying as the share price dropped to $16. With a long history of ownership of Syntel, we had a strong sense that the company would stabilize its earnings and recover over time. This year the recovery materialized, Syntel’s stock rebounded and, very recently, management agreed to be acquired for $41 per share. U.S.-based real estate investment companies Kennedy-Wilson and FRP Holdings have both initiated the process of monetizing long-held properties, some acquired during the financial crisis, which has exposed the market to previously unrecognized values. Kennedy-Wilson is now enjoying strong cash flow from rents, real estate asset management fees and mature property disposals. As a result, dividends are increasing and share buybacks are accelerating. FRP Holdings sold a collection of warehouse office holdings to a large REIT (real estate investment trust) for a price that was two-thirds of its then market cap, leaving the company with $200 million in cash, some large ongoing development projects and more than 500 million tons of aggregate reserves that earn a growing royalty stream. Pason Systems, a Canadian energy technology company serving oil and gas drillers, reported recovering results due to increased activity in the U.S., with improvement in the Canadian energy market still to come. Rounding out the top five, The Buckle, like other retail positions in our portfolio, stopped deteriorating. The Buckle, which operates 465 stores across the U.S., had reached a point where it was priced for extinction despite its profitable business, cash-rich balance sheet and robust dividend. In aggregate, these top-five contributors added just over 4% to the portfolio’s returns before dividends.
During the first half, we added one new small position. Smart Sand is a small oil services company that sells specialty sand used in fracking oil and gas wells. We found Smart Sand’s shares to be a compelling value at $5 per share, given that the company had its initial public offering in 2016 at $11 per share with a secondary offering in early 2017 at $17.50. We also eliminated three positions in the first half of 2018: Osisko Mining, CARBO Ceramics and MKS Instruments. Osisko and CARBO were never significant holdings but rather research and development ideas positioned at the bottom of our portfolio. Their removal funded additions to top investments. MKS Instruments was a large and important contributor to our success over the last few years and had reached a full and fair price. We would expect MKS to return to the portfolio at some point.
The top-five detractors to Sprott Focus Trust’s performance in the first half of 2018 were: Thor Industries, Federated Investors, Sanderson Farms, Franklin Resources and Cirrus Logic. Although the combined cost to performance was 4.6% for the six-month period, more importantly, each company became an attractive purchase candidate. We have owned all five companies for many years and have high conviction about each of them. We took advantage of the share price corrections to refresh Sprott Focus Trust’s portfolio with proven winners.
Portfolio Sector Breakdown as of 6/30/18
(% of Net Assets)
|Cash and Cash Equivalents||3.8|
Top 10 Positions as of 6/30/18
(% of Net Assets)
|Kennedy-Wilson Holdings, Inc.||4.7|
|Lam Research Corporation||4.1|
|Pason Systems Inc.||4.1|
|Western Digital Corporation||4.0|
|Thor Industries, Inc.||4.0|
|Franklin Resources, Inc.||3.8|
|Cirrus Logic, Inc.||3.7|
|Helmerich & Payne, Inc.||3.6|
As of June 30, Sprott Focus Trust was fully invested with a cash position of 3.8%. While the portfolio’s cash position has increased since midyear, we are still finding great reinvestment opportunities in the current environment. In our judgment, the market continues to over-reward large-cap growth stories and stocks with momentum, while under-appreciating many great businesses. We currently own 42 of these fine businesses and have continued to concentrate our positions during the frequent market sell-offs. Our top sector weighting remains Information Technology (18.9%) which consists of several enabling hardware companies. We are amazed at the market’s excitement over cloud computing, artificial intelligence, autonomous driving vehicles and blockchain technologies, while many of the hardware companies that will make these innovations a reality are trading at single-digit price-earnings multiples. Consumer Discretionary companies have risen to 15.8% of the portfolio. Materials are down slightly to 15.1% due to generally weak commodities prices. Energy (13.0%) and Financial Services (12.6%) round out the top-five sectors. We remain underweight in Health Care (1.7%) and Industrials (1.4%).
For those who have tracked the top-ten holdings of Sprott Focus Trust, you may notice that Cal-Maine Foods and Federated Investors have been replaced by Lam Research and Cirrus Logic. These two new top holdings are great examples of the previously mentioned technology enablers.
The metrics that follow in the portfolio diagnostics table in Figure 3 are all consistent with prior year figures, with dividend yield, return on invested capital, and leverage ratios all improving at the margin. Statistically, we have a very strong portfolio lacking only high momentum stocks.
Portfolio Diagnostics as of 6/30/18
|Fund Net Assets||$221.2 million|
|Number of Holdings||47|
|Trailing Annual Turnover||25.52%|
|Net Asset Value||$8.50|
|Average Market Capitalization1||$4.6 billion|
|Weighted Average P/E Ratio2,3||18.2x|
|Weighted Average P/B Ratio2||2.3x|
|Weighted Average Yield||2.2%|
|Weighted Average ROIC||20.86%|
|Weighted Average Leverage Ratio||1.87x|
|Holdings ≥75% of Total Investments||26|
|U.S. Investments (% of Net Assets)||68.1%|
|Non-U.S. Investments (% of Net Assets)||31.9%|
While we touched on many of our concerns at the beginning of this letter, there are some compelling offsets to the “wall of worry” that has been created by daily news headlines and tweets. The U.S. economy continues to grow for now. Rising interest rates are beginning to apply some capital discipline to the markets even though it is barely perceptible at this stage. M&A activity has picked up, and based on vast sums raised by private equity in recent years, is likely to continue. Share repurchases have reached staggering levels. My partner, Trey Reik, pointed out in his July letter that share buybacks in the second quarter of this year exceeded their previous quarterly record by 80% totaling $436.6 billion. The equity pie is clearly shrinking. While Trey was pointing out the continuous buildup of leverage in the financial system, our focus has remained on disciplined capital allocators who have been returning excess balance sheet cash and free cash flow at very attractive absolute valuations.
We are certain that the return of volatility is here to stay. We believe that the sustainability of $1 trillion a year deficits in combination with Federal Reserve balance sheet reduction will come into question shortly. We have learned that it is President Trump’s practice to turn every problem into a crisis in order to find a resolution. We continue to maintain, as we have for the past year and a half, that wherever we are headed, President Trump will get us there faster.
After a decade of relative underperformance as active value investors, it is easy to question the relevance of our strategy. As a business buyer, however, it would be hard to imagine any other approach to investing. Many thanks to all our fellow shareholders for your continued interest and support.
|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 (15% of portfolio holdings as of 6/30/18).|
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.