Manager Commentary June 30, 2023

Whitney George

The following commentary covers the six-month period from January 1 - June 30, 2023, and is an excerpt from the Sprott Focus Trust 2023 Semi-Annual Report.

July 27, 2023

Dear Fellow Shareholders,

During the first half of 2023, Sprott Focus Trust (FUND) appreciated 3.30% on a Net Asset Value (NAV) basis and 2.92% on a market total return basis. While FUND’s performance was in the range of what we expected as we entered 2023, it compares poorly to the 16.17% appreciation for the benchmark Russell 3000 Total Return Index. We were surprised by the equity market’s rapid, yet very narrow rise in the face of rising interest rates, sticky inflation and unsettling political and financial headlines.

The equity market’s rise occurred predominately in the second quarter and was sparked by the promise of all things AI (artificial intelligence). In our view, the rush into just a few AI-focused technology companies has left the market generals dangerously ahead of their troops and given investors a distorted picture of the stock market’s general health. As of this writing, five companies comprise 24% of the entire S&P 500 Index: Apple, Microsoft, Google, Amazon and NVIDIA. These top five companies drove market performance, leaving 495 companies behind with relatively flat returns for the first half. If one looks further into the market’s concentration, the top 1% of all stocks in the Russell 3000 Index (30 names) comprise more than 40% of its weight. For reference, while there is no equal weight calculation for the Russell 3000 Index, the Russell 2000 Index equal weight return was 3.11% and the Russell 1000 equal weight return was 5.28% in the first half of 2023. It has been 50 years since so few securities have been so dominant. In the spring of 1973, five stocks also made up 24% of the S&P 500 Index. AT&T, Eastman Kodak, Exxon, General Motors and IBM were one decision investments by the end of an era known as the Nifty Fifty. What followed soon after was a vicious bear market in 1973 through 1974. While we are hopeful that the current imbalances will work themselves out through a broadening of the equity bull market, we are mindful of the less pleasant lessons of history.

In my annual letter to Sprott Inc. (the parent company of FUND’S investment advisor) shareholders, I expressed our view that the Federal Reserve (“Fed”) would keep interest rates higher for longer as it continues to fight inflation. I also noted that the Fed’s medicine would ultimately be more toxic than the disease because the forces driving inflation are structural and not easily defeated. Since March 2023, we have witnessed several examples of what we were expecting. Steadily rising interest rates and tightening liquidity conditions caused the collapse of Silicon Valley Bank and Signature Bank, the emergency UBS buyout of Credit Suisse Group AG and the FDIC regulator seizure of First Republic Bank and subsequent sale to JPMorgan Chase & Co. Together, these developments offered the clearest signs that one year into the Fed’s quantitative tightening program, the financial system is struggling to deal with higher interest rates. In response to the banking crisis, the Fed implemented new programs to insure deposits beyond the $250,000 level and allow banks to pledge their holdings in government bonds at maturity value rather than market value. The net effect was to reverse most of the quantitative tightening accomplished while creating a form of yield curve control.

Finally, we averted a first-ever default by the U.S. government in June by lifting the debt ceiling limit, which allows the government to continue borrowing to pay its bills until January 1, 2025. We expect this may turn Whitney George out to be permanent. Fiscal spending continues to ramp up to the point where government spending now represents 27% of the total economy (as measured by GDP, gross domestic product). Tax receipts continue to decline as deficits widen. In summary, we found little in 2023’s first half to justify the price earnings multiple expansion among a select group of mega-capitalization stocks that have been driving markets. While equity and fixed-income markets broadly shrugged off the banking stress and posted gains during the period, we believe leveraged commercial real estate and pension funding are two obvious areas that bear watching.

Portfolio Activity

The first half of 2023 was not a great environment for value-oriented stock buyers like us, as the rising share prices of many higher-quality companies propelled valuations above our disciplined buy targets. During the six months, we added only one new position and liquidated one small position. In May, we initiated an R&D (research and development) position in CF Industries Holdings, Inc. following a 45% decline from its August 2022 share price high due to the precipitous fall in the nitrogen fertilizer price CF Industries produces. Although there were fundamental reasons for the spike in nitrogen fertilizer prices before Russia invaded Ukraine in February 2022, the war’s impact on natural gas prices and the diminished supply availability made nitrogen fertilizer prices unsustainable. Extreme highs in commodity prices are sometimes followed by dramatic declines after supply and demand dynamics reverse the discrepancy. Market volatility related to short-term extreme situations can create wonderful buying opportunities in quality companies for disciplined value investors, as we believe is the case with CF Industries.

In short, fertilizers enhance plant growth, providing nutrients to supplement those found naturally in soil. There are three main types: nitrogen, which enhances leaf growth; phosphate, which helps root growth; and potash, which fosters stem growth and plant water movement. In terms of crop inputs, which also include seed and insecticide, nitrogen is by far the most important input to farmers, followed by seed and insecticide (phosphate and potash are least important when farm budgets are constrained by low crop prices). Nitrogen fertilizer is made using the Haber-Bosch process, developed over a century ago to create ammonia by heating and pressurizing nitrogen from the air combined with natural gas (methane). The resulting ammonia is processed further into nitrogen fertilizer in both liquid and granular forms. Urea is the most produced and consumed nitrogen fertilizer globally and a key product for CF Industries. Founded in 1946 as the Central Farmers Fertilizer Company, CF Industries today is the largest producer of ammonia in the world and among the largest nitrogen fertilizer producers, with nine manufacturing plants in the U.S., Canada and the UK. CF Industries achieves the lowest delivered cost per ton by leveraging its industry-leading asset utilization and productivity alongside an extensive multimode distribution network to lower logistics costs.

While low-cost producers like CF Industries typically mitigate the risk of a permanent capital loss during inevitable market downturns, profitability through the cycle is also greater than competitors, allowing for opportunities to gain market share and increase sustainable competitive advantages. With limited spare capacity for nitrogen supply and consistent and high-priority demand from farmers, we expect the price of nitrogen to remain well supported for at least the next three years. We believe CF Industries is best placed among industry players to reap the benefits of this multi-year setup. Furthermore, the company’s depressed valuation, significant free cash generation and nearly debt-free balance sheet should enable it to create significant shareholder value.

A small position in Lam Research Corporation, which we indicated a year ago that we had begun to nibble on, was sold as the share price rocketed away from our buy target amid the ebullience surrounding AI technology stocks in the first half of 2023.

Figure 1

Figure 1 shows which positions contributed and detracted the most from FUND’s aggregate performance in the first half of 2023. Vishay Intertechnology was FUND’s top contributor for the six-month period, with the company share price gaining 37% despite a challenging near-term operating environment. Significant change is afoot as longtime CEO Dr. Gerald Paul retired and 32-year company veteran Joel Smejkal took the reins. Smejkal didn’t waste time articulating his vision for the new Vishay, explaining on the recent Q1 results call, “Under my leadership, we’re going to reorient Vishay from an operations-focused company to a customer and market-focused company, from a cash flow management business to a P&L-driven company, while upholding our capital return policy, from a company that fulfills company orders to one that anticipates customer need and is ready to support, from a company focused on the present to one that is forward looking, and from a proficient organization to one that’s dynamic and rewards risk taking.” This describes about as abrupt a change in corporate culture as any we have witnessed over the years. Smejkal’s long and varied experience with Vishay, from engineering, marketing, sales, operations and business development, gives him a broad understanding of Vishay’s entire business from which to drive such a shift in orientation. While it will take time for tangible evidence of progress, the market seems to have rewarded Vishay’s shares with at least a modicum of expected future benefit. In addition, FUND’s steel holdings in Reliance Steel & Aluminum and Nucor contributed meaningfully to performance in the first half, with company share prices gaining 35% and 25%, respectively. Reliance Steel & Aluminum, the largest metals service center and steel product distributor in North America, reported significantly stronger-than-normal recovery in shipments for the first quarter, especially in its largest end-market of non-residential construction. The company cited growing demand from new projects in public infrastructure, manufacturing and renewable energy as drivers of the strong recovery in shipments. We believe capital allocation has been equally stellar, as the company has eliminated nearly all its $2.1 billion in net debt since 12/31/2018 and repurchased more than 22% of its outstanding shares over the same period. These shareholder-friendly moves illustrate our confidence in Reliance Steel’s management and board to continue to prioritize shareholder value creation in the years to come. Nucor shares benefited from similar policy-driven dynamics present across the steel industry in non-residential construction, including infrastructure (e.g., Bipartisan Infrastructure Law), onshoring of manufacturing (e.g., CHIPS Act) and the energy transition (e.g., Inflation Reduction Act). While Nucor has not deleveraged to the same extent as others, it has built up a nearly $5 billion war chest of cash and has repurchased approximately 20% of its shares outstanding in the last five years, illustrating its proficiency in capital allocation and shareholder value creation.

Shares in Artisan Partners Asset Management returned 37% during the first six months of the year on the back of strong equity markets since more than 90% of its assets under management (AUM) are in equity strategies. Artisan Partners’ first quarter ending AUM of $138.5 billion was an 8% net improvement versus the end of the fourth quarter of 2022, primarily from market-related gains, offset slightly by modest net outflows of $1.2 billion. With the significant increase in interest rates, Artisan Partners’ management is excited about its nascent fixed-income strategies, which have been quietly building a peer-leading track record. The Artisan High Income Fund ranked fifth out of 338 in its Lipper High-Yield Category as of year-end 2022. Given the new interest rate regime globally, management believes its fixed-income business is at an inflection point, perhaps partially explaining the strength in its shares this year. Lastly, THOR Industries’ share price gained more than 37% in the first half, as strength in its European business offset weakness in North America. Recreational Vehicle (RV) sales in Europe increased 20% during the most recent quarter versus the same period one year ago, driven by a 22% increase in net price per unit, while unit shipments declined by a modest 2.5%. This resilient demand compared favorably to the North American segment, where Towable RV net sales were down 57% and Motorized RV net sales were down 24% over the same period. Shares in THOR Industries had already discounted the challenging environment, following a 50% decline from its March 2021 peak, while increased activity on RV dealer lots gave investors cause for optimism. In addition, Thor’s flexible business model enables it to quickly adapt to changing market conditions, which has helped THOR preserve margins in previous cyclical downturns in RV demand.

Helmerich & Payne was FUND’s top detractor during the period as HP shares fell more than 26%, detracting 1.17% from FUND’s overall performance. As the largest provider of super-spec drilling rigs to the oil and gas industry in the U.S., shares in Helmerich & Payne are often driven by the nearterm outlook for drilling activity, which is influenced by the price of crude oil. Against the backdrop of tepid drill rig activity and lower oil and gas prices in 2023, Helmerich & Payne shares struggled to buck this trend. The company’s most recent financial results showed the strength of its business as Helmerich & Payne was able to generate prodigious free cash flow, pay both its regular and a special dividend, in addition to repurchasing more than 3% of its shares outstanding so far this fiscal year. Another of our energy-related service providers, Pason Systems, detracted from FUND’s performance as its shares declined more than 26% in the first half. This decline contradicts Pason Systems’ strong operating performance, as revenue per industry day hit a new record during the period due to increased adoption and pricing. While overall drilling activity in the U.S. has softened in recent months, the outlook for continued growth in drilling, based on basic supply and demand principles, is positive, according to company management. Factors influencing this optimism include significant draws from storage and the inventory of drilled but uncompleted wells (DUCs) below sustainable levels. These conditions cannot persist in perpetuity while oil demand exceeds pre-COVID-pandemic levels.

Shares in high-end casual and denim apparel retailer The Buckle, Inc. declined 17% in the first half of 2023, given the deteriorating outlook for consumer spending as fears of a recession drove shares of most retailers lower. Buckle’s most recent results showed a modest 8.5% decline in revenues and an associated 14% rise in inventories versus one year ago. However, the company’s large net cash balance sheet and deeply discounted valuation bolstered our confidence in Buckle’s management to navigate any potential slowdown. Shares in leading fresh shell egg producer CalMaine Foods, Inc. declined 11% as the extremely elevated price of eggs for much of 2022 continued to resume more normal levels, impacting analyst expectations for Cal-Maine’s operating results this year. Furthermore, as feed costs have remained elevated, the impact on operating margins could be quite negative. Cal-Maine’s net cash balance sheet should provide the company with the financial resources to consolidate smaller privately owned egg producers during the unfolding down cycle, as it has done very well over the years. Finally, shares in aviation aftermarket services and sales company AerSale Corporation detracted slightly from FUND’s performance as investors grew frustrated by the company’s pace of feedstock acquisitions, asset sales and the ongoing delay of Federal Aviation Administration (FAA) approval of its AerAware product. We believe that AerSale’s experienced and disciplined management is smart to exercise patience by not overpaying for feedstock acquisitions. Asset sales should pick up in the second half, and FAA approval of AerAware is expected imminently. The long-term growth opportunity from AerAware could transform its business, unlocking significant value as the technology is deployed.

Positioning

Figure 2

As of June 30, 2023, FUND was invested in 34 equity positions and held 4.0% 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 securities we own. As shown in Figure 2, the Materials sector was FUND’s greatest exposure at 36.3%. The long-term case for mining stocks in both precious and base metals continues. However, we are closely watching economic activity and the impact an unfolding slowdown will have on miners and drilling contractors. Energy and Financial Services, both at 15.3%, comprised the next-largest sector exposures. Eight of the previous period’s 10 largest positions remain, with the current top 10 holdings comprising 45.1% of net assets, slightly less than six months ago (46.2%).

Figure 3

Portfolio Diagnostics as of 6/30/2023

Outlook

As of this writing, we are encouraged to see the general equity markets broadening out to benefit many of our holdings, but we remain cautious in the medium term. Inflation is moderating with some easy comparisons against last year’s numbers. Following the Fed’s most recent 0.25% rate hike (July 26), markets are likely convinced that we are at the end of the Fed’s rate hiking campaign. As mentioned in prior reports, we believe the current deflationary trend might be transitory due to inflation’s structural roots in deglobalization and decarbonization. But, we do agree that short-term interest rates may be peaking. Potential accidents beyond banks in commercial real estate and pension funding will continue to factor into monetary decisions. The higher interest costs on the U.S. government debt burden alone should be factored into future decisions as they significantly contribute to mounting deficits.

We are equally interested in the path of the U.S. dollar, which has been declining for nine months. For years, some have predicted the decline of the U.S. dollar’s global reserve status with nothing to prove the theory. There is now proof, given that more international trade deals are being conducted using non-U.S. dollar domestic currencies among the competing countries or trade blocks. A cheaper U.S. dollar will provide some debt relief for much of the world, including the U.S. However, it will keep inflation elevated, providing a tailwind for hard assets investments, an outcome we will welcome.

Despite the relatively sluggish start to 2023, we are very comfortable with FUND’s positioning at midyear. Our investments are financially secure with high operating leverage and many are trading at discounts to what we believe are their absolute values and significant bargains to market averages.

As always, many thanks to the Sprott Team for its daily support, particularly Matt Haynes for his contributions to this letter. And mostly, thank you to all our loyal and patient fellow shareholders.

Sincerely,

W. Whitney George,

Senior Portfolio Manager