Manager Commentary Dec. 31, 2019

Whitney George

The following commentary is an excerpt from the Sprott Focus Trust 2019 Annual Report. 

February 15, 2020

Dear Fellow Shareholders,

We are pleased to report that Sprott Focus Trust (FUND) enjoyed a strong performance year in 2019 by virtually every measure. The Fund’s total return based on net asset value (NAV) was 32.67%, and market price appreciation with dividends reinvested was 36.17%. This compares to a 31.02% for our mandatory benchmark, the Russell 3000 Index. (While regulations require us to compare our performance to a broadly accepted index, our preferred goal is to evaluate return after fees, taxes and inflation.) 2019 represented our best year since the market recovery of 2009 (up 53.95%) and the bear market recovery of 2003 (up 54.33%), and ranks as our third best year overall. Given the state of the market as we began 2019, we are not surprised by the ensuing recovery but certainly did not expect the pace of change last year.

The chief catalyst behind Sprott Focus Trust’s notable results, and that of most equity strategies, was the dramatic reversal in the Federal Reserve’s policies. We began 2019 with the Federal Reserve (“Fed”) committed to interest rate increases (with expectations of more) and its balance sheet in contraction via quantitative tightening (QT). The Fed then reversed course in June by initiating the first of three rate cuts during the remainder of the year, with the Fed’s balance sheet now in expansion, via quantitative easing (QE). Some will recall a “small technical issue” in September when the “repo” market (overnight lending market) went haywire, causing overnight lending rates to jump to near double digits. What was then characterized as a short-term oversight by the Federal Reserve resulted in more than $400 billion of short-term bond purchases by the Fed in the ensuing months. While not officially called QE, clearly what the Fed encountered was not short-term, minor, or a seasonal technicality. What we believe happened is that we have reached a point when our record U.S. debt levels must be refinanced and our trillion-dollar deficits require additional debt issuance, just at a time when foreign interest in purchasing more of our debt has dried up. Because no buyers were willing to purchase the expanding Treasury issuance other than the Fed, this meant that the money-printing presses were up and running, printing roughly $100 billion per month in the fourth quarter of 2019.

In 2019, the dramatic reversal of interest rate policies and money supply catalyzed the stock market forward. P/E (price-to-earnings) multiples of the S&P 500 Index expanded from 14.52x to 17.67x (a 22% jump) driving the bulk of equity performance, rather than strong earnings growth. Lower interest rates, benign inflation readings and the cooling of international trade disputes were all factors that drove equity markets to new highs despite flat-“ish” earnings when compared to 2018’s tax-cut fueled expansion. Based on the work we and others have done, it appears that there is an 80% correlation to the amount of new money in the global system and stock prices. It seems clear to us that there will be no appetite anywhere to raise rates or shrink central bank balance sheets in the future.

Two large trends, the shift from active to passive strategies in public equities and the migration of public to private vehicles for equity investment, continued in 2019. It is likely that more than half of all the money committed to publicly traded stocks is in index funds or exchange traded funds (ETFs). This continues to create some interesting unintentional consequences. The most prominent index funds are market-capitalization weighted, which causes a greater concentration of investment in the already largest companies. Currently, the top six stocks are approaching 20% of the entire market cap of the S&P 500 Index. This concentration was only exceeded in early 2000 (about 21%) according to Carter Worth of Cornerstone Macro. This is hardly the diversification one expects when investing in a 500 stock portfolio, and it did not end well the last time it occurred. The popularity of private equity, now at roughly $5 trillion, is also creating some interesting side effects. While it is certainly a positive for public equities that $1.5 of this $5 trillion has yet to be invested, there are some growing questions about what the previously invested portion is worth. Private equity investments are priced privately, often, at the level of the most recent investment. Who is to say that is a valid valuation, especially when it may involve unprofitable unicorns? What fun it would be to price our portfolio in such a manner.

In 2019, we discovered, in several examples, that the public markets view toward valuing large unicorns was far more conservative than the private accounting. There were several initial public offering (IPO) flops and in one high profile instance, WeWork, a $50 billion IPO expectation turned into a massive private bailout to prevent bankruptcy. Certainly, the fees are far more robust in the private world but one has to wonder with so much money now chasing a once niche market, what the ultimate investor returns will be. A final development in 2019 we would like to mention was the rise in the popularity in all things ESG (environmental, social and governance). With so much of global investment now passively invested, we find ourselves needing new regulators to guide corporate investment and behavior. Guidance that historically came from shareholders, the ultimate business owners, must now be provided by new bureaucrats. We have outsourced our stock selection to a team at Standard & Poor’s. We have outsourced the decision making in voting our proxies for the companies we own and now, we are preparing to outsource the conduct of all elements of running a business to policymakers remote from daily operations. It would seem that capitalism is being profoundly challenged with the rise of “passive aggressive” investing.

Activity

Throughout 2019, trading activity in Sprott Focus Trust was consistent with historical averages, with portfolio turnover at 30%. Surprisingly, after a pick-up in 2018, we had no merger and acquisition (M&A) activity in our portfolio last year. Given our focus on high-quality businesses and our discipline of buying based on compelling valuations, we would have expected a few visits to our portfolio from private equity investors. There was some activity in the mining sector but those deals were either announced in 2018 (Barrick Gold-Randgold), or consummated in 2020 (Detour Gold-Kirkland Lake) and known before our purchase of the holding.

During the year, we added three new positions (one of consequence) and divested three holdings. The one addition worth highlighting was Biogen Inc., which we purchased in March after its shares declined sharply due to poor trial results for an Alzheimer’s drug it was testing. We discussed the rationale for this purchase in our semi-annual letter. We were delighted in the fourth quarter when Biogen reported strong results from its existing portfolio of neurological drugs and a second trial for its Alzheimer’s treatment put it back on track for a potential FDA approval. A favorable court ruling affirming Biogen’s patents on an important existing product helped drive the company up to our number one holding in 2020. While its stock can be volatile, Biogen is a great company and in our judgment offers wonderful risk-reward potential. Our two other additions were in the mining sector. Detour Gold has recently become Kirkland Lake as a result of an acquisition; it is part of our much diversified collection of precious metals miners which collectively aggregate to 15% of our portfolio. Gemfields Limited, a miner of rubies and emeralds and the owner of the Fabergé brand name, is a fascinating collection of assets, trading at one half of its break-up value, but it will never likely exceed 1% of its portfolio due to geology risks.

We eliminated three positions in 2020, all in the first half of the year and detailed in our semi-annual report. While MKS Instruments and Williams-Sonoma were both winners for the portfolio, I don’t think we need to belabor my disappointing value trap for the ages, GameStop.

Our top-five winning holdings in 2019 were Cirrus Logic, Lam Research, Western Digital, Apple and Gentex. It is interesting to note that four of our five best performers are technology companies and three were on last year’s list of biggest losers. In the fourth quarter of 2018, news of the escalating U.S.-China trade war was a big value creator and we took full advantage of the opportunities in companies perceived to be most “at risk.” Cirrus Logic, Lam Research and Western Digital are all long-time holdings in which we have high conviction in their management and business models. Clearly 2018’s pain became 2019’s gain. Apple began the year on a weak note and then enjoyed a re-rating by the market as 2019 progressed. As investors began to focus on Apple’s rapidly growing and higher margin service businesses, the tech-giant’s shares advanced through the year, rising 88.97% for the 12 months. Apple’s share buybacks, increased dividends and leading weighting in the indices all contributed to a wonderful year for its shareholders. For the first time since we have owned Apple (2011), we feel that it is fully valued. Finally, despite trade wars and an overall sluggish auto industry in 2019, Gentex proved its resiliency and the market recognized this best-in-class auto parts supplier. Gentex continued to repurchase its shares and advance its dividend while appreciating 46.30% in 2019.

At this writing, all five of our largest contributors in 2019 have been reduced to less prominent weightings in the Fund’s portfolio, reflective of their more robust valuations. We will eagerly await an opportunity to reinvest in any or all of these fantastic businesses.

Figure 1

The largest sinners in our portfolio last year were Pason Systems, GameStop, Fresnillo plc, Franklin Resources and PolarityTE. I predict that this will be the last time you will read about GameStop or PolarityTE in our reports. Both were mistakes, the former a long-term value trap, the latter a small quickly recognized error. We continued to add to our position in Pason, an important technology provider to the energy drilling industry that boasts a pristine balance sheet, industryleading margins, dominant market share and a current dividend yield north of 5%. The same can be said for our continued commitment to Franklin Resources. Franklin, like many of its active asset management peers, continues to suffer from investor outflows. However, Franklin trades at less than four times (4x) its depressed operating income when one nets out the $7 billion of free cash on its balance sheet. Significant family ownership, a robust buyback program and a 4% plus dividend yield, not counting the occasional special dividend, keep us hopeful that better times are ahead, and to surmise that perhaps this company should be private. We continue to hold Fresnillo in our basket of precious metals miners.

In summary, during 2019 our losses were minor and combined, did not cost us more than our second best winner achieved. Our biggest losses were incurred in what we view as some of our best opportunities looking forward.

Last year’s performance was dominated by our large initial weighting in Information Technology which contributed 13.86%, Materials 6.13%, Consumer Discretionary 3.92% and Financials 3.20%. The only negative sector contribution came from Energy, down 0.94%. As you will see, when we get to a discussion of our current positioning, we were buyers of Energy and sellers of Information Technology, especially in the fourth quarter. Our contrarian approach will always dictate that we’ll try and sell high and buy low, but we always run the risk of being too early. Thus far in 2020, we seem to be premature in our rotation.

Figure 2

Positioning

The Fund started 2020 with 43 equity investments and 6.3% cash. Finding new investments has become more challenging and our cash position has expanded since the start of the year. Given the current market structure and its potential for rapid drawdowns, we think it is prudent to allow cash to build at this stage. Materials (24.3% of the portfolio) remains our largest sector which includes a collection of precious metals miners, a steel distributor and a chemical company. Beyond our activities in Sprott Focus Trust, Sprott Inc. has established itself as a global leader in the precious metals industry and this is a sector which has enormous potential given last year’s reawakening of gold prices, and the resultant fundamental improvements in this unloved and under-owned sector. Mergers and acquisitions (M&A) are frequent given the historic valuation discrepancies between the largest companies and their smaller competitors. Precious metals supplies are constrained and managements are disciplined after nearly 10 years of difficult conditions. Finally, this sector has earnings growth momentum, something which most other sectors currently lack.

Materials (24.3%), Financials (16.0%), Energy (12.5%) and Information Technology (12.4%) were our most prominent sector investments at the end of the year. Our financial services holdings, as outlined in prior reports, are comprised of a collection of asset managers, our favorite business. Information Technology, as mentioned, has become our main source of funds and Energy is of greater focus. Difficult commodity pricing and a new and rapidly spreading focus on ESG have created an improved risk-reward set up in the Energy sector. While the energy industry is increasingly viewed as the next tobacco industry (i.e., unpopular but highly profitable), we are focused on some important fundamentals. Low-cost natural gas development is likely the best pathway to transitioning to the green energy sources of the future. It is not likely that any other industry is investing in green energy faster than the major oil companies.

And finally, most are unaware of how environmentally impactful the current favored clean technologies are. Mining for lithium and cobalt for making electric vehicle batteries is not clean by anyone’s standards, even at today’s modest production rates. Solar panels need silver. In short, beneath the populist dreams there are many practical constraints that most will find surprising. In the meantime, the need to generate electricity to power our technology advancements will continue to grow. We can’t continue to add services to our smartphones without powering the rapidly expanding cloud infrastructure and we can’t fix our bridges and roads without steel produced from metallurgical coal.

The current list of our top 10 positions at the end of 2019 contains six of the same companies as last year with some movement in the weightings. Gentex, Lam Research, Apple and Thor Industries, are all still in the Fund’s portfolio at reduced levels due to their success. New to the list are Biogen, as discussed, Westlake Chemical, Berkshire Hathaway and Reliance Steel & Aluminum. Westlake and Berkshire have lived at the top of our portfolio for much of our Fund’s history and Reliance Steel & Aluminum is an old favorite.

Portfolio Diagnostics as of 12/31/19

Figure 3

In our portfolio diagnostic chart, we attempt to give investors a composite look at our weighted average holdings. A comparison of this year’s portfolio to a year ago will show our weighted average market cap is $4.32 billion, an increase of about 26% from last year. Our investments in U.S. companies have increased to 72% from 70% at the expense of foreign holdings. Our portfolio appears more expensive based on its P/E (price-to-earnings) ratio, P/B (price-tobook value) and dividend yield, which is now 2.27% down from 2.99% last year. The price to book comparison is 1.9x versus 1.8x which is not significant. Our weighted average P/E comparison is 18.8x versus 12.2x at the end of 2018, but this is a trailing number and may mislead about the future prospects. Finally, our quality metrics of ROIC (return on invested capital) and leverage weakened from 19.58% to 15.97% and 1.86 to 2.19, respectively. This occurred because ROIC is another trailing calculation and the leverage ratio is showing the effects of large scale buybacks. Nevertheless, the overall statistical quality of Sprott Focus Trust’s portfolio is very compelling when compared to any benchmark of U.S. equities. Strong balance sheets and high returns on capital at sensible prices continue to be our investment goal, and we are very positive about our current portfolio.

Outlook

As we begin a new year, we wish we could claim to have 20/20 vision. There are as many factors to make us optimistic as there are to scare us. We are in a U.S. presidential election year when our country must decide between a “Commander in Tweet” who has produced many achievements in support of our capitalist economy, and a collection of Democrats proposing policies that would certainly require higher taxes. Taxes are the single largest expense for corporations and investors and so any perceived increases would be market unfriendly. Conversely, with 90% of market activity now driven by algorithmic trading and ETFs, and much more based on liquidity than fundamentals, we are one random tweet away from a very sharp correction.

As mentioned earlier, every central bank in the world is providing liquidity and seems prepared to do more. If possible, rates are more likely to go down nominally and new economic concepts like MMT (Modern Monetary Theory = money printing) and fixed interest rates (as done after World War II) may be tested. Here in the U.S., we may have reached a tipping point in terms of funding our debt and deficits. Foreign central banks have ceased or dramatically reduced their purchase of U.S. Treasuries just as our deficit spending accelerates. The last time this occurred was in the 1960s, which caused President Nixon to close the Gold Window. When we do see a return of inflation, it will likely be higher than most would forecast. In real terms (adjusted for inflation), the markets peaked in the mid-to-late 1960s and did not exceed their inflation-adjusted highs until the mid-1990s. The point is that stocks can continue to do well in nominal terms while currencies are debased to solve for the over commitments that have been made.

We don’t believe that the U.S. will experience negative interest rates because when one factors in the cost of hedging currency, our own rates are on par with the $17 trillion-plus negative yielding bonds globally. Our base case is that the combination of ample liquidity, modest global growth and an abundance of dry powder in the private equity world will produce supportive conditions for equities in 2020. We are prepared for any opportunities that can quickly arrive with our growing cash balance. Finally, we at Sprott will continue to accumulate shares of the Fund both through distribution reinvestment and open market purchases. The closed-end structure of the Fund allows us to capitalize on opportunities while others run for liquidity. We are optimistic, therefore, that the discount-to-NAV will go away in the not too distant future.

I want to take this opportunity to welcome Matt Haynes, CFA, who became an official member of the Sprott Focus Trust team at the beginning of the year. Matt is a seasoned value investor with many years of experience at Dean Witter (now Morgan Stanley), Mutual Beacon (Franklin Resources), Lazard Freres & Co., and then at his firm, 1949 Investment Partners. As you may recall, I have relied on Matt for research assistance and sanity checks since the summer of 2015. Matt has been running a sizeable personal portfolio for my family for almost five years and will now assist me in managing Sprott Focus Trust. In addition to sharing many value principles with me, Matt adds a great deal more expertise in foreign investing and in some important sectors where I have less experience. I am excited to have a partner in Matt and happy to have the backup and continuity he will provide. As always, many thanks for your support and we look forward to hearing from you.