Manager Commentary December 31, 2023

Whitney George

The following commentary covers the 12-month period from January 1 - December 31, 2023, and is an excerpt from the Sprott Focus Trust 2023 Annual Report.

January 30, 2023

Dear Fellow Shareholders,

We are pleased to report that for the 12 months ended December 31, 2023, Sprott Focus Trust (FUND) appreciated 11.84% on a net asset value (NAV) basis and 6.96% on a market total return basis. FUND’s performance for 2023, while positive and in line with its own long-term averages, was disappointing on a short-term basis relative to the Russell 3000 Index benchmark’s 25.96% return. At this time last year, we were pleased with a flat annual return for 2022. Ironically, we find ourselves a bit disappointed with FUND’s double-digit positive performance this year. We should remind ourselves that ours is a long-term approach (with a three- to five-year investment horizon) as the general equity markets are just now recovering to the peaks last seen in very early 2022. On January 30, 2024, the S&P 500 Index finally surpassed its January 4, 2022, high. The day before, the Russell 3000 Index matched its two-year-old peak but the average performance of all its constituents was still down by 7.05% with the median stock down 14.70%. Our three-year returns remain very competitive at 11.22% versus 8.54% for the Russell 3000 benchmark, as do FUND’s 5-year returns at 14.28% versus 15.16% for the benchmark. Overall, we are pleased with our absolute results and our current portfolio positioning.

As expected, 2023 was a notably volatile year for all markets as investors adjusted to a significantly higher interest rate environment. The Federal Reserve’s (Fed) final interest rate increase in this inflation-fighting cycle was in July and by the fourth quarter, markets were aggressively pricing in dramatic rate cuts in 2024. The Fed made 11 rate hikes (or 5.25%) during this cycle as it combatted inflation, which declined from a high of 9% in June 2022 to 3% at year-end 2023, not quite the Fed’s 2% target inflation rate. Fixed income markets ended the year roughly where they started, and equity markets recorded historic returns. What was unexpected was the emergence of Artificial Intelligence (AI) as a dominant investment theme and its surprisingly positive impact on a handful of large-capitalization technology companies with dominant weightings in all the broad equity indices. We believe the market may have gotten a bit ahead of itself in 2023 on both interest rate projections and AI fundamentals expectations. As we begin to reach the anniversary of more benign inflation, data readings may become more difficult and price-earnings multiple expansion more elusive. In contradiction to what markets have already priced in, this may support the Fed policy of sticking with “higher for longer” interest rates.

Throughout 2023, commodities markets and China continued to face challenges, the latter being a critically important market in recent decades. Energy, the most relevant sector for FUND, produced the greatest headwinds to performance after a stellar contribution in 2022. This was especially surprising given the recent turmoil in the Middle East with the outbreak of the Gaza-Israeli conflict. On the other hand, gold continued to do its job as a portfolio diversifier and a safe haven asset, climbing 13.10% for the year, soundly outperforming “safe” fixed income assets. While we did not participate in gold’s performance through our ownership of gold mining equities, which lagged the metal in performance, we are optimistic that gold mining equities will re-link themselves to the physical metal in 2024 after a historic bout of relative underperformance.

Finally, global liquidity stood out as the number one driver for markets in 2023. Continued massive fiscal deficits competed for capital with private markets in all developed markets. A strong U.S. dollar (USD) makes things worse, and a weaker USD lightens the burden on all. We would expect more of the same in 2024 while noting the world is now moving away from the USD as a reserve currency in earnest. Last year, 20% of the world’s oil trading was conducted with currencies other than USD. This bodes well for FUND’s hard asset themes in the long run.

Positioning & Portfolio Activity

Portfolio turnover was very low for FUND in 2023, 14.64% as shown in Figure 3. By comparison, FUND’s turnover was 19.65% in 2022 and 22.00% in 2021. Last year’s low turnover ratio reflects our strong conviction for FUND’s positions. It also reflects the challenges of harvesting portfolio positions in a rising U.S. equity market and then identifying equally attractive new purchases that meet our valuation criteria.

FUND had 36 equity investments at year-end, up from 34 a year ago, as we liquidated one position and initiated three new positions during 2023. Cash was 2.6%, down from 4.0% at mid-year, which we consider relatively fully invested. As shown in Figure 2, the Materials sector was FUND’s greatest exposure at 39.4%. Our long-term investment thesis for mining stocks in both precious and critical metals continues. However, we are mindful of changing dynamics that could necessitate repositioning. Financial Services at 14.8% and Energy at 13.2% comprised the next-largest sector exposures. Eight of the previous period’s 10 largest positions remain, with the current top 10 holdings comprising 45% of net assets, unchanged from mid-year, June 30, 2023, as shown in Figure 1.

At mid-year, we discussed liquidating a small position in Lam Research Corporation and purchasing a starter position in CF Industries Holdings, Inc. In the second half of 2023, the rising equity markets offered relatively few additional opportunities to buy quality at a discount. One portfolio holding, DDH1 Ltd. in Australia, was acquired at a material premium by a larger and more diversified Australian mining services company named Perenti Ltd., paying a combination of cash and shares. While we were disappointed in the low implied price paid to acquire DDH1 Ltd., we cannot argue with the strategic rationale of the acquiror. The enlarged Perenti offers expanded global contract mining services, greater scale with possible ASX 200 Index inclusion and re-weights its business back to the more attractive Australian market, accelerating utilization of Perenti’s accumulated tax losses. The share-for-share exchange enables FUND’s continued ownership of the resulting combined entity, which we believe dramatically undervalues the business.

We initiated new starter positions in two companies toward the end of 2023. The first is a well-known French consumer products company, Société BIC SA (BIC), which derived only 8% of its revenues in France (and 29% in Europe) in 2022. Many of its products will be familiar since 42.7% of sales were in North America. BIC has long been a world leader in stationery lighters and shavers, with well-recognized brands known for quality products at low prices. After reaching a high of €160 per share in August 2015, BIC shares declined to a low of €40 per share during 2020 due to a stale product portfolio, poor acquisitions, declining revenues and operating margins that peaked at 22% in 2015, and then fell to less than 10% in 2020. BIC is controlled by the Bich family, who collectively own more than 63% of voting rights and 47% of shares outstanding. In November 2020, BIC embarked on its new five-year Horizon Strategic Plan to return the business to prominence by becoming more consumer-centric without eroding the strong manufacturing and distribution-led competencies BIC is known for. Early signs of successful execution of specific growth initiatives are reassuring. With BIC’s strong net cash balance sheet and its shares trading at a material discount to our assessment of fair value, risk-reward appears to be very attractive.

Another opportunity came after corporate governance-related issues led to a shake-up of Osisko Gold Royalties’ management and Board of Directors, driving its shares down by more than 30%. Osisko’s gold royalty portfolio was previously highly valued in the market for its high quality, solid growth prospects, concentration in safe mining jurisdictions and strong ESG (environmental, social and governance) performance. Disagreements with the board led Osisko’s CEO to leave the company and led to the eventual resignation of its Chairman. Uncertainty about further shoes to drop prompted investors to sell Osisko and seek gold royalty exposure elsewhere until things settled further. Sprott’s team of gold mining specialists is very familiar with the assets within Osisko’s portfolio and the nuances of its corporate governance challenges and possible resolution, enabling a more measured assessment of risk and reward. This assessment showed Osisko’s valuation near 1.0x estimated net asset value as an attractive opportunity. In relatively short order, board member Norm MacDonald was elevated to Chairman and new CEO Jason Attew was hired. Osisko is now firmly back on track with its growth plans intact and a new management team to drive the return to its premium valuation.

Figure 3

Portfolio Diagnostics

Performance Contributors and Detractors

Figure 4 shows which positions contributed and detracted the most from FUND’s aggregate performance in 2023. Once again, strength during the first half of the year was sustained during the second half as four positions remained as top five contributors.

Figure 4

Top Contributors in 2023

It is interesting to note that our two best performers in 2023 (Artisan Partners and THOR), were our two worst performers in 2022. Artisan Partners Asset Management, Inc. was FUND’s biggest contributor to performance in 2023, adding 2.29% as the continued strength in equity markets helped drive higher average assets under management (AUM) versus mid-year. During Artisan Partners’ first-ever Investor Day held in New York in September, management shared its recipe for success in hiring and developing new investment teams. According to CEO Eric Colson, “The common components are differentiated talent, alignment of interests, customized business support, minimal distractions and patience.” While certain traits may be considered unexceptional in isolation, Artisan’s dogged adherence to each and keen sense of where future market opportunities lie amid a changing investment landscape has driven exceptional business results. Management believes its fixed income business is poised for success next, given this past year’s higher interest rate regime.

THOR Industries contributed 1.81% to FUND’s performance in 2023. European demand for recreational vehicles (RVs) strengthened further during the second half of 2023, partially offsetting ongoing weakness in North American sales. While the macroeconomic environment for manufacturers like THOR is relatively consistent across the globe – higher interest rates, higher inflation, supply chain constraints, geopolitics/war and the myriad of uncertainties they foster – THOR’s flexible business model allows for speedy adaptation to changing market conditions during periods like this. THOR’s excellent management team has performed well through the challenges of previous cycles in similar ways – controlling costs, inventory, pricing and other variables within its control.

FUND’s steel investments contributed meaningfully to its performance results in 2023 as Reliance Steel & Aluminum Co. and Nucor Corporation shares were strong performers, adding 1.77% and 1.53%, respectively. Nucor is the largest steel producer in the United States and has benefited from its large scale and dominant market position serving very large end markets such as non-residential construction and infrastructure. Favorable U.S. government policy initiatives such as the Inflation Reduction Act (IRA), the Bipartisan Infrastructure Law (BIL) and the CHIPS and Science Act have bolstered structural demand drivers that were already underway, leading to abnormally high and sustained steel pricing and profits. Nucor’s cash-rich balance sheet and value-driven capital allocation record should ensure that Nucor shareholders will likely continue to benefit from this prolonged steel upcycle.

Operating a very different business model than Nucor, Reliance Steel & Aluminum is a metals service center company, processing (i.e., changing the shape, size and/or form) and distributing steel and aluminum products to smaller end-market consumers with quick delivery. As a result, Reliance realizes higher through-cycle margins, more stable realized pricing and counter-cyclical free cash flow (FCF) generation. The localized nature of Reliance’s business creates opportunities for it to acquire established regional (typically family-owned) businesses periodically. Reliance has completed 70 such acquisitions since 1974. We spent a day on site researching Reliance subsidiary Yarde Metals in Southington, CT, in November 2023. The tour of its operating facilities and meetings with various levels of Yarde Metals management provided a comprehensive understanding of its business model and competitive advantages in that locale.

Lastly, Westlake Corporation contributed 1.68% and was FUND’s fourth-ranked performer for the twelve months. Westlake compared favorably against its commodity chemical-oriented peers due to its more diverse business. Westlake’s Performance and Essential Materials segment (64% of revenues in Q3 2023) was negatively impacted along with its peers by higher interest rates weighing on demand and lowering global industrial activity. Mitigating this somewhat was Westlake’s structural feedstock and energy cost advantage. The greatest offsetting impact, however, came from its growing Housing and Infrastructure Products (HIP) business, which has much higher and more stable operating margins through the cycle. This diversity in Westlake’s business helped drive its business and share price performance this year.

Top Detractors in 2023

Not all positions impacted performance positively in 2023. Little changed on that side of the ledger since mid-year as Helmerich & Payne, Inc. remained FUND’s top detractor for the full year after its shares fell; it detracted 1.08% from FUND’s performance. It is worth noting that Helmerich & Payne has been a long-term holding of FUND and was its top-performing holding in 2022. As the largest provider of super-spec drilling rigs to the oil and gas industry in the U.S., cyclically depressed drill rig activity and lower oil and gas prices in 2023 proved too great to overcome, given the difficult energy investing climate. While the short-term outlook is unclear, Helmerich & Payne remains disciplined on rig pricing amid lower industry rig utilization. This should serve margins and returns well in the medium term when the cycle turns upward again, which company management expressed confidence in during its most recent quarterly results call. We share this optimism and maintain faith in Helmerich & Payne’s demonstrated track record of doing what is best for shareholders.

Kennedy-Wilson Holdings, Inc. detracted 0.75% from FUND’s 2023 results, as it was a casualty from the general malaise impacting commercial real estate in general — higher interest rates and increased vacancies in certain sub-segments. The impact of higher interest rates on the net asset values of real estate projects has been universally negative. But for Kennedy-Wilson, there is more to the story. Kennedy-Wilson’s primary exposure is to the healthier multi-family home segment, where demand remains robust. Household formation continues apace and demand for housing exceeds supply growth, mitigating the damage experienced by real estate companies more geared to struggling commercial high-rise and retail property investments. In addition, Kennedy-Wilson has historically invested opportunistically amid previous periods of disruption with great success. Last spring, the mini-banking crisis affecting several California regional banks created one such opportunity. During the third fiscal quarter of 2023, Kennedy-Wilson acquired a $4.1 billion construction loan portfolio from PacWest Bank at a material discount, representing the largest single transaction in its history. This deal is similar to the opportunity in 2011 when Kennedy-Wilson bought a $2.2 billion high-quality loan portfolio secured by 23 assets in London at a discount. With estimated fair values across the sector being negatively impacted in the short term by higher capitalization rates, Kennedy-Wilson is playing the long game by creating opportunities for substantial long-term capital appreciation amid the current disruption.

In our semi-annual shareholder letter, we discussed the underperformance of aviation aftermarket services and sales company AerSale Corporation. Unfortunately, the song remained the same at year-end and this holding detracted 0.66% from FUND’s performance in 2023. Despite achieving key milestones during the year’s second half, AerSale’s share price continued to suffer. Aftermarket flight equipment sales significantly improved, and the Federal Aviation Administration (FAA) finally approved the company’s revolutionary Enhanced Flight Vision System, AerAware. These two positive developments were offset by the sale of a large tranche of 4 million shares by its concentrated private equity shareholder Leonard Green & Partners, which continues to liquidate its holding into each increment of good news. While its sizable stake nearly halved during 2023, Leonard Green & Partners’ remaining approximately 19% ownership stake remains an overhang. The long-term growth opportunity from AerAware could transform its business, unlocking significant value as the technology is deployed.

There were few places to hide in the energy space in 2023 and one of the oil and gas industry’s largest producers, Exxon Mobil Corporation, was a modest detractor, subtracting 0.30% from FUND’s performance in 2023. Growing fears of recession and its impact on demand have kept the price of oil range-bound. At the same time, calls for increased renewable energy over fossil fuels continue to dampen longer-term sentiment. Exxon Mobil has several initiatives in its traditional business and future-facing solutions, such as carbon capture and storage that exemplify its status as an industry leader. Exxon Mobil’s upstream offshore oil development projects in Guyana are key growth assets. They are among the best performing in the world with respect to emissions intensity, outpacing 75% of oil-producing assets globally, according to independent energy consultant Rystad Energy. Other low carbon business initiatives include its recent $5 billion all-stock purchase of Denbury, Inc., which expanded carbon capture and storage opportunities through access to the largest CO2 pipeline network in the U.S. Other investments in lithium, hydrogen, biofuel, and carbon capture and storage will help address climate change and closely align with Exxon Mobil’s competitive advantages and core capabilities.

During the California Gold Rush of the mid-nineteenth century, prospectors needed to buy a pick and a shovel to break rocks in their search for a golden fortune. Often, these efforts went unrewarded, while the companies that sold picks and shovels were more consistently profitable and less risky. The concept still applies in today’s modern mining industry despite great technological advancement in exploration techniques. Drilling services companies such as Major Drilling Group International, Inc. are the modern-day sellers of picks and shovels and are as integral to mineral discovery and production as ever. Its shares languished last year and the holding detracted 0.26% from FUND’s results, as investor interest in mining-related investments paled compared to capital-light technology companies focused on AI. The irony in this comparison is that mining has been the lifeblood of all technological improvements since the beginning of time. Without exaggeration, modern civilization has increasingly relied upon metals and minerals extracted from the earth to provide food, shelter, energy, transportation, and countless industrial and electronic products that make life comfortable. Recent shorter-term movements in the prices of mined materials have driven current investor apathy toward “picks and shovel” plays like Major Drilling. With a slightly longer investment time horizon, we believe an extremely attractive opportunity awaits patient investors to benefit from a strong multi-year upcycle in demand for metals and high-quality drilling services.

Outlook

As 2024 represents a U.S. presidential election year, we assume there will be little appetite for any fiscal restraint in the American political establishment. Record deficits will continue, and a larger government debt pile will need to be financed at higher interest rates. Concurrently, the global appetite for USD, and therefore U.S. Treasury bonds, will likely continue to diminish. Irrespective of what the Fed decides to do with interest rates, new pools of liquidity will be required to prevent further bouts of Treasury market dysfunction. We believe that the Fed’s quantitative tightening program is ending and will likely be replaced with new policies and programs that will have the effect of quantitative easing in all forms but the name. If we are correct, the USD will weaken and inflation will persist above desirable targets. Commodities should do better as the long-term supply-demand fundamentals of the developed world overcome weakened commodity demand from China. We expect that precious metals will once again gain a level of interest from Western investors that already exists in the developing world, particularly Asia. While much of the U.S. economy will continue to struggle if not recede, there will be pockets of strength in industries related to infrastructure and clean energy. The process of de-globalization and de-carbonization will continue to provide attractive opportunities.

FUND remains well-positioned to capitalize on several well-entrenched yet under-appreciated themes. Our heavy exposure to clean steel, domestic natural gas and precious metals mining should benefit even if we are only partially correct in our economic assessments. FUND’s portfolio, as always, contains a collection of high-quality companies at very attractive absolute valuations and bargain basement prices on a relative basis. Our shares, trading at a 9.74% discount to Net Asset Value at this writing, appear to be a bargain, so we will continue our daily share repurchase program. In 2023, we retired 1,211,710 shares at an average price of $7.97. 

Many thanks to the Sprott Team for its daily support, particularly Matt Haynes’ contributions to this letter. And mostly, thank you to all our loyal and patient fellow shareholders. We welcome any questions or comments at any time. 

Sincerely,

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.