The following commentary is an excerpt from the Sprott Focus Trust 2019 Semi-Annual Report.
August 9, 2019
Dear Fellow Shareholders,
Sprott Focus Trust (FUND) had a very strong start to 2019, posting gains of 16.73% and 20.77% based on net asset value (NAV) and market price (with dividends reinvested), respectively. These returns are comparable to those of the Russell 3000 Index (which gained 18.71% for the period), and represent good absolute progress and one of the Fund’s best first half performances since the beginning of the current bull market in 2009. As reported in our 2018 annual letter earlier this year, 2019 started off with record returns in January for most equity benchmarks followed by strong returns in both February and March. The expectations of a reversal in the Federal Reserve’s monetary policy, combined with hopes of a U.S. trade deal with China, propelled stocks back to their old highs by the end of April. While the Fund’s performance, like the broader equity markets, including small-cap stocks, peaked earlier in March, all markets went into correction mode in May. No trade deal with China materialized and a new tariff threat was launched against Mexico.
The U.S.-Mexican trade threat was potentially more damaging to our economy and devastating to Mexico’s. Further, the potential Mexican tariffs were designed to achieve purely political goals as opposed to economic balance. Through tariff threats and impositions, our country’s leadership has weaponized our relative economic strength and currency. To a man with a hammer, everything looks like a nail. Fortunately, our spat with Mexico was resolved, for now. It also became clear that U.S. central bankers were not just putting policy on hold, but were preparing to stimulate the global economy through interest rate cuts. This created a buoyant month of June in which all asset classes rallied, including gold, which broke out of a five-year holding pattern.
As we have mentioned in prior letters, the old adage that markets climb a wall of worry has never been more relevant. President Trump has a special fascination with building walls. The strong performance in markets so far in 2019 is all about a return to cheap money and little to do with economic progress. Even the idea of infrastructure investment, which all politicians agree on, now seems dead in its tracks. For the next eighteen months, unfortunately, it will be all about the Federal Reserve and the 2020 elections.
We remain convinced that owning a combination of high-quality, dividend-paying, and well-managed companies and some capital protection, like gold, will serve us well in these most uncertain times.
The level of activity in Sprott Focus Trust was average during 2019’s first half. Turnover of 14% was the result of two additions to the portfolio, five deletions, one research and development (R+D) position bought and then quickly sold, and the normal rebalancing required by some dramatic share price moves. New positions were established in Biogen and Gemfields Group. Biogen is a wellestablished large-cap biotech company, based in Cambridge, MA, with a long track record of success and profitability. Unfortunately for Biogen, its promising treatment for Alzheimer’s failed to prove results in late-stage trials. The market reaction to this news at the end of March wiped out more than 30% of Biogen’s market cap, or approximately $20 billion in just one day. This rout placed the valuation of Biogen squarely in our universe. Trading at single-digit price-earnings (P/E) multiples, with a pristine balance sheet, a robust continuing R+D pipeline and large share repurchase program, we believe Biogen is a very attractive long-term investment. We were quite aggressive in our purchases of Biogen as a new position and bought a 2% position for FUND’s portfolio; this holding represents one of our larger commitments in the first half.
We also added a small position (50 basis points) in Gemfields Group in the first half. Gemfields is an interesting South African-listed micro-cap mining company specializing in colored gemstones, specifically emeralds and rubies. Gemfields also owns the Fabergé brand. The company was formally a closed-end fund listed on the London Stock Exchange and recently converted to an operating company. During the last year, Gemfields has sold several minority stakes in owned mines to focus on its emerald mine in Zambia and its ruby mine in Mozambique. We are interested in Gemfields because colored gemstones are becoming increasingly popular, particularly in Asia. We also believe that the company’s combination of cash, mining interest and the Fabergé brand make it worth at least twice its current market valuation. Management has enacted a share buyback program and a special dividend to return excess cash to shareholders. Given the nature of Gemfields business and geographies, it will never become a large position in FUND’s portfolio, but we judge the risk-reward to be excellent at current prices.
We eliminated five positions during the first six months of 2019. Fortunately, four of the five companies were long-term favorites that had served us well over the years and may reappear at lower valuations. These four are Sanderson Farms, Williams-Sonoma, Garmin and MKS Instruments. All but Sanderson were smaller positions that had achieved and exceeded our valuation targets. In the case of Sanderson Farms, not only was our target achieved due to the perceived shortage of global protein supplies caused by Asian swine flu and the resultant increase in demand from China, but we became concerned with the potential cost structure of Sanderson’s industry. Roughly half the cost of producing chickens is in grain. This year’s spring weather has created a large challenge during the critical grain planting season. Even if the weather remains perfect for the rest of the growing season, crop sizes are due to surprise on the downside. We are expecting feed costs to increase, maybe dramatically, which is bound to pressure Sanderson’s financial results. Perhaps this will create a re-entry opportunity for this great long-term investment.
On a sour note, we finally exited our position in GameStop, but not before it nicked our performance by another 92 basis points. GameStop has proven to be the ultimate value trap for our portfolio and perhaps the best example of the greatest risk to a value investor. We will not miss this security.
Finally, we made a small R+D investment in a biotech company, PolarityTE. With the help of our friend Matt Haynes, who often supports us with research, we quickly recognized our mistake and took a small loss. We have been underweight in Health Care for some time, but this was not the solution.
As is customary, in Figure 1, we present our top five performance contributors and detractors—the winners and sinners if you will. Four of our best performers were technology hardware companies, a sector we have admired for some time and added too aggressively in the fourth quarter of 2018. One would be hard pressed to find a group more sensitive to global trade activity. Just as the markets punished these technology stocks last year, it rewarded them in the early part of this year as consensus grew that a deal with China was imminent. We did lighten our positions across the board to manage concentration risk, but not enough to fully mitigate the effects of a reescalation of China tensions in May. In the case of Gentex, an auto parts supplier, many of the same factors were at play and we trimmed our position by 5%.
Top Contributors to Performance
Year-to-date through 6/30/19 (%)1
|Lam Research Corporation||1.70|
|Cirrus Logic, Inc.||1.34|
|Western Digital Corp.||1.27|
1 Includes dividends
Top Detractors from Performance
Year-to-date through 6/30/19 (%)1
|Marcus & Millichap, Inc.||-1.20|
|Pan American Silver Corp.||-0.16|
|Birchcliff Energy Ltd.||-0.12|
1 Net of dividends
The story of our worst performance is far less dramatic. GameStop has been eliminated from the portfolio, as previously mentioned. PolarityTE was a short-term experiment. Marcus & Millichap, a real estate broker, had a disappointing quarter after a string of positive results. Pan American Silver and Birchcliff Energy found themselves in weak sectors, mining and energy, respectively. As an aside, mining and energy are two sectors where we increased our exposures during the first half of 2019 and this tactic has recently started to be supportive of performance.
In terms of sector performance thus far in 2019, all groups are in the black other than Health Care which detracted 0.15% and represents less than 3% of our portfolio (mostly Biogen). Information Technology (+ 5.8%), Financials (+3.2%) and Materials (+2.6%) were the biggest contributors.
Top 10 Positions as of 12/31/18
(% of Net Assets)
|Kennedy-Wilson Holdings, Inc.||4.8|
|Lam Research Corp.||4.6|
|Pason Systems Inc.||4.3|
|Helmerich & Payne, Inc.||4.2|
|Franklin Resources, Inc.||4.2|
|Cirrus Logic, Inc.||4.1|
|Thor Industries, Inc.||4.1|
|Western Digital Corp.||3.8|
Portfolio Sector Breakdown as of 12/31/18
(% of Net Assets)
|Cash & Cash Equivalents||2.1|
As we begin the second half of 2019, we remain nearly fully invested in equities with a cash position of 3.5%. While we added to the cash position modestly during the first months of this year, it was redeployed in May. As of June 30, we owned 41 equity positions ranging from 0.4% to 4.7% of Fund’s weightings. Our largest sector bet is Materials which includes about 16% in precious metals mining firms. Most of the balance of Materials is Westlake Chemical (4.5%) which typically trades more like an energy company. Financials, predominantly asset managers, make up 17.2% of our portfolio, followed by Information Technology (15.9%), Energy (11.7%) and Consumer Discretionary (10.7%).
Among our top 10 positions, eight remained the same as at the start of the year. Apple and Cirrus Logic have dropped out of the leaders, but not by much (they remain as holdings #11 and #12). Westlake Chemical and Berkshire Hathaway are now in our top 10 after we doubled our ownership in both during the first half. We increased our holdings in Westlake as the shares declined precipitously ($80 to $58) following a very disappointing quarterly report. Westlake is a wellmanaged, low-cost, opportunistic chemical company. The company essentially converts natural gas to very high-end plastics and specialty PVC (polyvinyl chloride) products. We have owned Westlake for many years but sold most of our position in mid-2018 at prices well north of $100 per share. While we may have started to repurchase shares of Westlake prematurely, we did dollar-cost-average our investments into positive performance thus far in 2019.
Berkshire Hathaway is also an interesting story, while far less volatile as a holding. Two things occurred to rekindle our interest in Berkshire. In his annual letter, Warren Buffet announced that he was changing his benchmark after more than 40 years. Rather than be judged by the growth in Berkshire’s book value as compared to the S&P 500, Warren will measure his share price performance. There are logical accounting reasons for this change, but perhaps a tiny bit of ego may be involved. Further, Mr. Buffett loosened his share buyback restrictions from 120% of book value to a discount to “intrinsic value” which only he can calculate. Interestingly, in the first quarter of 2019 Berkshire spent $1.7 billion on share purchases. We calculated the average purchase price at $198.80 on the “B” shares (Berkshire’s two-class stock structure complicates the math up to fifth-grade level). In May, when Berkshire’s B shares dropped below $200, we bought more. It will be interesting to see how much of the $120 billion of excess cash Berkshire spent on its shares in the second quarter and at what price.
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.
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.
The Fund’s P/E ratio calculation excludes companies with zero or negative earnings.
Portfolio Diagnostics as of 6/30/18
|Fund Net Assets||$209 million|
|Number of Holdings||41|
|2019 Semi-Annual Turnover Rate||14%|
|Net Asset Value||$7.54|
|Average Market Capitalization1||$4.2 billion|
|Weighted Average P/E Ratio2,3||15.8x|
|Weighted Average P/B Ratio2||1.9x|
|Weighted Average Yield||2.4%|
|Weighted Average ROIC||18.84%|
|Weighted Average Leverage Ratio||2.22x|
|Holdings ≥75% of Total Investments||24|
|U.S. Investments (% of Net Assets)||71.6%|
|Non-U.S. Investments (% of Net Assets)||28.4%|
|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 shows our portfolio diagnostics. This is a snapshot of what we own as if it were a single company. Since the beginning of 2019, our average market capitalization has increased by 25% to $4.2 billion. This occurred via approximately 2/3 appreciation and 1/3 positioning in larger companies, Berkshire Hathaway in particular. Our weighted average P/E expanded from 12.2x to 15.8x over the six-month period. This occurred through a mix of disappointing corporate results (discounted in the fourth quarter of 2018) and share appreciation. The Fund’s weighted average P/E, Price to Book (P/B) ratio and weighted average yield are all comfortably better than the market averages. Our P/E of 15.8x versus 20.3x for the Russell 3000 Index, a P/B of 1.9x versus 1.6x and a dividend yield of 2.4% compared to 1.8% all show the valuation advantage we maintain.
Our weighted average return on invested capital (ROIC) is comparable to the markets (18.84% vs. 20.13%) when one excludes negative returns. A good portion of the Russell 3000 Index’s constituents are negative returners (21%), and, our portfolio contains a much larger weighting of Materials (mining companies) and Energy (depressed on a trading basis) than the benchmark. Lastly, our leverage ratio of 2.22x has risen a bit over the last six months from 1.86x at 12/31/18. This was caused by our increased exposure to larger-cap companies’ ongoing share repurchases by companies and a balance sheet accounting change for all companies who lease real estate (retailers). Our focus on balance sheet strength as a starting point and first defense remains in place. By comparison, the composite leverage of the Russell 3000 Index is 9.71x. Corporate America is leveraging up and we are reminded of the James Grant quote, paraphrased, “balance sheets do not matter until the day they do, then they are all that matters”.
As we begin the second half of 2019, we can observe some long-term tends that seem permanently entrenched. The global rise in populism continues. With 2020 U.S. Presidential election cycle now in focus, long-term issues will require specific proposals. Increased taxes on the wealthy and corporations, breaking-up giant tech companies and the largest banks, free health care for all and student loan forgiveness, are all ideas that have become mainstream. Further, it is now believed by many that these initiatives can be accomplished via “Modern Monetary Theory” (in essence, money printing). The Federal Reserve made it clear early in the year that its interest rate hiking cycle was over and then adopting a European-style approach signaling that it would do “whatever it takes”. Just the other week (July 24) a bill was passed by Congress to suspend the national debt ceiling for two years and guarantee more than $1 trillion in annual deficit spending during the same time. Clearly, there is no appetite for fiscal conservatism. And with the national debt at $22 trillion, not counting all of the unfunded entitlements, the idea of reducing our debt, much less paying it back, has become delusional. It is difficult for one to even conceptualize what a trillion looks like. [We recently saw a video in which the narrator put a trillion in context by using time. One million seconds ago was less than twelve days ago. One billion seconds will take you back to 1988, and one trillion seconds would put you in the Stone Age at about 30,000 B.C.]
Debt monetization is back and here to stay. Gold prices took notice and broke out of a five-year trading range in the first half. The price of silver has also perked up recently, perhaps signaling a new bull market in precious metals. Finally, very successful and widely followed investors, like Ray Dalio of Bridgewater Associates, have started to write about a “Paradigm Shift”, meaning what has worked for the past 10 years may not work well for the next 10 years. For us, Dalio’s “Paradigm Shift” can’t come soon enough. After a decade of watching value investment strategies underperform growth and passive investing outperforming active management, we are more than ready for markets to wake up to fiscal and monetary realities. While we are not permitted to invest in gold or silver bullion directly, we maintain a dramatic overweighting in precious metal mining companies. As an aside, we would recommend that all investors hold some form of precious metals as a proven portfolio diversifier. As active investors, we understand the underlying value of the businesses we own. We are prepared for market volatility, which is likely to increase in the months ahead. Perhaps the combination of $13 trillion of negative yielding global government bonds, falling interest rates and mountains of private equity capital will accelerate the merger and acquisition pace as profitable companies become more scarce. It seems that most active portfolio management is now done privately, leaving passive investing to the public.
Lastly, in our view Sprott Focus Trust continues to trade at an excessively wide discount to its portfolio net asset value. While some progress was made in narrowing the discount in 2019’s first half, we are not satisfied. Our short-term response is to avail ourselves of the opportunity and buy more shares. We and related parties currently own 37% of Sprott Focus Trust. We acquired more in the first half through dividend reinvestments and open market purchases and expect to do so in the second half of 2019. Longer term, capturing the discount spread will become increasingly tempting as our ownership increases. Until then, we are very grateful to our long-term shareholders and looking forward to meeting new ones. We enjoy nothing more than speaking with our clients, so please feel free to call us at (203) 656-2430 so that we can hear your thoughts and answer your questions.
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.
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