Sprott Focus Trust Manager Commentary June 30, 2022
The following commentary covers the six-month period from January 1 - June 30, 2022, and is an excerpt from the Sprott Focus Trust 2022 Semi-Annual Report.
July 20, 2022
Dear Fellow Shareholders,
In our annual shareholder letter six months ago, we suggested that 2021's fantastic performance was unlikely to be repeated any time soon. Further, we did express our optimism about the prospects for relative outperformance given the attractiveness of Sprott Focus Trust's (FUND) portfolio on all relevant metrics. Our predictions proved to be right. For the first six months of 2022, FUND's net asset value (NAV) declined by 9.58% and its market price return was negative 9.09%. This compares to a 21.10% decline in FUND's benchmark, the Russell 3000 Total Return Index.
We have often said that we understand that you cannot spend relative performance. However, it is during difficult periods, like the first six months of 2022, when capital preservation is our main objective for FUND, a strategy that we believe is likely to lead to long-term outperformance. This is best displayed in longer-term performance measurements, for example, one-, three- and five-year returns. Based on NAV performance, Sprott Focus Trust declined 6.80% for the one-year period ended June 30, 2022, outperforming the negative 13.87% return for the Russell 3000 TR Index. FUND was up 10.50% and 7.78% for three and five-year periods, respectively, compared to 9.77% and 10.60% for the Russell 3000 TR Index. Over time, we expect to continue to gain positive traction in FUND's longer-term performance comparisons.
In our January annual report letter, we wrote that we believed that our current inflation problems were longer term and structural in nature. While we were not expecting the Russia-Ukraine war to break out in late February, this tragedy has only further highlighted the massive issues we now face after decades of underinvestment (and even divestment) of critical infrastructure including energy and manufacturing. What was once politically popular is now practically disastrous. Western democracies have overleveraged and underinvested and we believe we are currently undergoing a generational reset. Federal Reserve (Fed) Chairman Jerome Powell and his colleagues are hell bent on reigning in inflation through historically large interest rate hikes and liquidity withdrawals by looking to the worn playbook of former Fed Chair Paul Volcker, who led the Fed from 1979 to 1987. What they, and many, are missing is that when the Fed took on inflation in the early 1980s, the U.S. debt-to-GDP (gross domestic product) ratio was 30% and our annual federal budget deficit was running at 2% of GDP.
Today, the U.S. debt-to-GDP ratio is 120% and our deficits are 6-7% of GDP before factoring in the impact of a likely recession. With the loss of tax receipts and the added government spending that comes with recessions, annual deficits will likely run in the double digits and potentially put us on course for a default. We believe that the Fed's current course of action may cause a market accident that will be more painful than what has transpired in the first six months of 2022, i.e., the worst first-half equity returns since 1970. When this occurs, perhaps soon, the Fed will need to reverse course and continue the fiscal reset that is required. The world needs taxes inflated and a lower U.S. dollar to reprice its debt. This will help inflation to eventually decline, given that it is a year-over-year comparison of change. Consumers, who drive 70% of our economy, will continue to experience economic pain as these events unfold. On the other hand, the process is likely to be much less painful for companies that provide the materials to rebuild infrastructure or produce affordable, reliable energy for Western Economies.
We believe that consumers and markets will be under extreme pressure for several more months. Driven largely by higher energy prices, Inflation is now at levels not seen in 40 years, with June 2022 CPI figures 9% percent higher than a year ago (according to the Bureau of Labor Statistics). Inflation was last above 9% in November 1981. Higher inflation and rising interest rates may have already started a consumer recession. Most asset classes are predictably in decline after the Fed's three rate hikes thus far in 2022, totaling 150 basis points, with more rate hikes expected. We recall that it took six one-quarter basis point (0.25%) interest rate hikes in later 1999 and early 2000 to burst the Dot.com Bubble and throw us into a recession with a bear market that lasted for three years. It took 17 one-quarter basis point (0.25%) hikes between 2004 and 2006 to lay the groundwork for the 2008-2009 global financial crisis (GFC) and recession. At the current pace, we believe that the Fed's current rate hike cycle is nearing its end. Several markets are becoming dysfunctional, and one of the Fed's primary mandates is to support market functionality.
In March, we suspended FUND's daily share buyback program to focus our investments on individual names that had become disproportionately attractive relative to the overall portfolio. Daily and weekly individual stock price volatility created opportunities for us to buy, sell and then repurchase certain holdings, and to capture upside and downside moves that normally take several years. Having an absolute valuation discipline has become increasingly useful. While the second quarter earnings reporting season is about to begin, we feel that FUND's portfolio has already priced in a significant recession, which may or may not happen. Like famed investor Warren Buffett, we are finding tremendous opportunities to get excited about in this market, at the risk of possibly being a bit early.
As the decline in equity markets gathered pace in the second quarter of 2022, our disciplined investment approach allowed us to exercise great patience in waiting for the valuations of companies we like to reach compelling levels. We sold two positions during the six-month period, Aclara Resources and Franklin Resources. Aclara Resources is a rare earths junior development-stage company located in Chile that spun off from Hochschild Mining in December 2021. As a holder of Hochschild Mining, FUND received shares of Aclara. We sold the position given that the company faces significant permitting challenges as it seeks Chilean government and community approvals to begin mine construction. We also liquidated long-time holding Franklin Resources in favor of other higher-quality asset managers already in FUND's portfolio. In recent years, Franklin has been on a buying spree to broaden and diversify its historically value-driven equity fund offerings. We received shares in Agnico Eagle Mines after its "merger of equals" with Kirkland Lake Gold was completed in February. The combined company will rank as the world's third-largest gold producer behind Newmont Corporation and Barrick Gold, with expected Pro-forma production of 3.2 - 3.4 million ounces located in politically safe jurisdictions with strong land title laws. We initiated one new position of significance with the purchase of Steel Dynamics, a leading diversified carbon-steel producer and recycler in the U.S. You may recall our purchases of both Nucor Corporation and Schnitzer Steel in 2021. Steel Dynamics rounds out the Fund's steel exposure with the company's circular manufacturing model, invested entirely in electric arc furnace (EAF) technology, which primarily uses recycled scrap to produce new steel. In 2021, 84% of the material used in Steel Dynamics' furnaces at its six EAF steel mills was recycled ferrous scrap and internally generated iron substitutes. The flexibility of EAF steel production allows Steel Dynamics to generate more consistent free cash flow throughout the production cycle as steel prices ebb and flow with economic activity and demand trends. Lastly, to ensure that our eyes remain laser focused on opportunities in names we either know well and/or have sold previously at much higher levels, we started to nibble on a collection of quality companies, including Exxon Mobil, Cirrus Logic, LAM Research and Sims Ltd. Position sizes are negligible, but we hope for a period of significant market dislocation to allow us to build out these positions in time. We firmly believe that lower near-term stock prices are the friend of the long-term investor.
Top 5 Contributors to Performance
Year-to-date through 6/30/2022 (%)1
|Helmerich & Payne, Inc.||2.64|
|Cal-Maine Foods, Inc.||1.16|
|Pason Systems Inc.||1.03|
|Reliance Steel & Aluminum Co.||0.23|
|FRP Holdings Inc.||0.15|
1 Includes dividends
Top 5 Detractors from Performance
Year-to-date through 6/30/2022 (%)1
|Western Digital Corporation||-1.37|
|Schnitzer Steel Industries, Inc. Class A||-1.17|
|Thor Industries, Inc.||-1.11|
1 Net of dividends
Figure 1 lists FUND's top performance contributors and detractors for the first six months of 2022. We begin with the contributors. Helmerich & Payne, the leading drilling solutions provider to the North American energy industry, tops the list of contributors as its shares surged more than 80% during the first six months of the year and contributed 2.64% to FUND's performance in the first half of 2022. Demand for drill rigs and related drilling services continued to recover from the deep trough that the COVID-19 pandemic created in 2020. The price of crude oil (WTI) reached a high of nearly $120 per barrel in June, creating an impetus for oil producers to drill, while drill rig pricing also improved. Recent commentary by Helmerich & Payne's management that leading-edge day rates on super-spec rigs structured with performance contracts have reached prior near-peak levels drove the company's shares materially higher. Cal-Maine Foods was FUND's second-best contributor, adding 1.16% to overall performance. Cal-Maine is the largest fresh shell egg producer in the U.S. and its shares rose more than 30% during the period as egg prices climbed in response to high feed costs and Avian Influenza-driven supply disruptions. Pason Systems (contributed 1.03% to performance) was another beneficiary of the strength in energy markets this year since its leading oil and gas drilling technology solution enables energy producers to optimize drilling programs. The number of drilled but uncompleted (DUC) wells has declined in recent quarters as producers continued to underspend cash flow. DUC inventory is at an eight-year low, and more drilling is necessary. Reliance Steel also contributed positively during the first half of 2022 (adding 0.23% to performance) as strong and improving demand for Reliance's steel products—from non-residential construction to automotive and semiconductor fab manufacturing— drove the company's shares higher. Finally, FRP Holdings reported record Q1 2022 results in its mining royalty business and contributed 0.15% to FUND's performance. High occupancy rates and rent increases on renewals of multi-family properties in Washington, D.C., for the first time since February of 2020, implied the return to a more normal and buoyant operating environment.
Western Digital led the top detractors for the period; the company's shares slumped more than 30%, and our position detracted 1.37% from FUND's performance. Strong demand from Cloud customers was mostly offset by weakness in the company's Client and Consumer segments in 2022. Investors seem disinterested in Western Digital's early June announcement of a review of strategic alternatives in its Flash and Hard Disk Drive (HDD) businesses which have struggled since Western Digital's ill-fated 2016 acquisition of SanDisk. Any value that might be unlocked could remain unrealized if the company were to buy out its joint venture partner Kioxia, which has been put up for sale by its owners, Toshiba Corporation of Japan. DDH1 is a high-quality drilling contractor focused on Australia, which we purchased shortly after their IPO (initial public offering) in March of 2021; the holding detracted 1.22% from FUND's results in the first half. Despite the business performing well in the continuing mining upcycle, shares inexplicably declined more than 40% during the first half of 2022. Having recently met with its CEO in our Sprott offices and having confirmed strong demand for its specialized drilling services, we remain favorably disposed toward our investment in DDH1. Shares in high-end denim retailer The Buckle, Inc. suffered and detracted 1.22% in performance, as the market started to worry about the impact of slowing consumer demand and as other retailers reported significant increases in inventories. While Buckle's inventory levels were +19% sequentially in the most recent quarter, very strong operating margins indicate the quality of its business despite near-term worries about slowing demand. Schnitzer Steel was a recent purchase by FUND (H2 2021) and remains a very attractive long-term investment despite its recent share price weakness; the holding detracted 1.17% from performance. Schnitzer Steel's shares declined along with others in the steel industry as near-term concerns over a potential recession obscured the long-term investment thesis. Schnitzer's recycling business is central to that thesis since recycled metals require less carbon to produce than mined metals, providing an important solution for companies, industries and governments focused on carbon reduction. Its use of hydroelectric power is a strategic advantage in the trend toward lower carbon footprints among steel manufacturers. Lastly, shares in Thor Industries suffered during the first half of 2022 (costing FUND 1.11% in performance) as investors doubted the sustainability of recent strong demand trends for Recreational Vehicle (RV) sales. Thor has been a beneficiary of increased consumer preference for outdoor camping, brought on partly by the COVID-19 pandemic and "work from anywhere" employee arrangements.
Top 10 Positions as of 6/30/2022
(% of Net Assets)
|Cal-Maine Foods, Inc.||4.9|
|Federated Hermes, Inc. Class B||4.9|
|Artisan Partners Asset Management, Inc. Class A||4.8|
|Pason Systems Inc.||4.7|
|Reliance Steel & Aluminum Co.||4.7|
|Thor Industries, Inc.||4.7|
|Helmerich & Payne, Inc.||4.6|
|Kennedy-Wilson Holdings, Inc.||4.4|
Portfolio Sector Breakdown as of 6/30/2022
(% of Net Assets)
|Cash and Cash Equivalents||1.7|
As of June 30, 2022, Sprott Focus Trust was fully invested in 37 equity positions and held 1.7% in cash and cash equivalents. Cash is a by-product of the opportunity set we perceive in markets today, and our low cash position reflects our confidence in the long-term prospects of the companies we own. As shown in Figure 2, the Materials sector was the Fund’s greatest exposure at 34.4%. The mining upcycle in both precious and base metals continues. However, we are closely watching economic activity and the impact of the unfolding slowdown on miners and drilling contractors. Financial Services, at 17.1%, comprised the second largest exposure and is concentrated in asset managers, including Berkshire Hathaway. Eight of the previous period’s 10 largest positions remain, with the current top 10 comprising 46.22% of FUND’s net assets, nearly unchanged from six months ago.
Portfolio Diagnostics as of 6/30/2022
|Fund Net Assets||$235.0 million|
|Number of Holdings||37|
|2021 Semi-Annual Turnover Rate||11.68%|
|Net Asset Value||$7.93|
|Average Market Capitalization1||$3.04 billion|
|Weighted Average P/E Ratio2,3||7.85x|
|Weighted Average P/B Ratio2||1.57x|
|Weighted Average Yield||2.55%|
|Weighted Average ROIC||28.82%|
|Weighted Average Leverage Ratio||1.99x|
|Holdings ≥75% of Total Investments||19|
|U.S. Investments (% of Net Assets)||72.83%|
|Non-U.S. Investments (% of Net Assets)||27.17%|
|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|
As long-term value investors, we believe predicting markets is a fool’s errand. However, now that we are undeniably in a bear market, we can look to history for some guidance on how the markets and economy may evolve. Today’s bear market appears to resemble some combination of the bear markets that began in 2000 and 2020. In both cases, a withdrawal of global liquidity caused the bursting of speculative bubbles. In 2000, the Fed’s tightening cycle was intentional as the clocks were successfully turned over to a new century. In 2020, the economic shutdown in response to the COVID-19 pandemic was to blame. Today, the Fed is attempting to fight structural inflation over which it has no control. It did not cause the reversal of China from a deflationary force to an inflationary contributor. The Fed did not cause the political forces behind deglobalization. And the Fed had nothing to do with decarbonization goals that have resulted in bad energy policies. The recent historic 75 basis points rate hike and the next hikes that are expected is akin to administering electroshock therapy to a flu patient.
Few investors seem to be paying attention to our national fiscal position. We have often quoted Warren Buffet, “The debt doesn’t matter until it does, then it’s all that matters.” We believe that we are on a fast track to that discovery. We believe this bear market is likely to be far shorter than the drawdown in 2000 but is already longer than the 2020 experience. We find comfort that Berkshire Hathaway began aggressively deploying its massive cash balance in late winter/ early spring this year. In the past, they have tended to be at least six months early in re-entering markets, so we believe that this bodes well for this coming fall. Most of the companies we own have been aggressively buying their own shares back at very attractive valuations, which has helped us increase our share in their businesses. FUND’s portfolio metrics have never been stronger or less expensive. We own a collection of high-returning, low-leveraged companies at less than half the index valuations. Therefore, we would expect continued relative outperformance through the remainder of this bear market and the potential for outsized absolute returns when market liquidity is restored.
Once again, I would like to thank my partner Matt Haynes for his ongoing research support and significant contributions to this letter. Additionally, Matt has taken on the role of Head of Sprott Asset Management’s ESG (environmental, social and governance) Committee. He has helped craft a thoughtful approach and process to address the growing investor interest and regulatory scrutiny in our team’s ESG research process. Finally, I remain grateful to the entire Sprott team, who make this job simple and fun (even in a bear market). I am very proud to serve as the new CEO of Sprott, Inc. As always, I thank my fellow shareholders for your patience and support. Please reach out anytime with questions or concerns. These are challenging times, and we are eager to connect with our partners.
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 (6.59% of holdings as of 9/30/2023).|
|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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