Sprott Focus Trust: An Incredibly Well-Managed Cyclical Fund (NASDAQ:FUND)

Thesis – Discovering An Overlooked CEF

This analysis covers Sprott Focus Trust (NASDAQ:FUND), which is an overlooked closed-end fund with spectacular managerial attributes. The fund is managed by Whitney George and Matt Haynes with the purpose of discovering value stocks within the Russell 2000. Furthermore, George and Haynes invest with conviction, generally holding less than 50 assets. By implementing passive rebalancing, Sprott Focus Trust has outperformed the Russell 3000 since its inception.

Before delving into the fund’s key features, I wanted to highlight that this analysis is about finding a hidden gem that could give investors an advantage in the equity markets. My assessment of the fund is from a quantitative vantage point, providing a parsimonious overview of the asset.

Without further ado, let’s get into it.

Allocation

The diagram below shows that the fund’s average market cap exposure is $2.96 billion, which is borderline to the small-cap territory. Thus, one could argue that the CEF is a hybrid small to mid-cap vehicle.

Eugene Fama made an interesting case for small-cap value a few decades ago, stating that small-cap value stocks consistently outperform the broader market in the long term. Fama’s basis is that such assets are often underestimated and that market participants can beat the market by betting on mean reversion. Despite various counterarguments, Fama’s case provides tangible evidence that this closed-end fund’s prospects are backed-up by solid financial literature.

Sprott Focus Trust is exposed to highly cyclical sectors, namely basic materials, financials, energy, and real estate. Thus, it’s clear that this is a risky bet as the fund’s speculating on highly volatile stocks.

Nevertheless, as discussed later, the vehicle’s risk attribution and valuation metrics support a bullish case for this closed-end fund.

Despite the fund’s substantial allocation to Warren Buffett’s Berkshire Hathaway Class B (BRK.B) and oil giant Nucor Corporation (NUE), its primary holdings are mostly low-volume securities. Many of these are trading at low valuations with significant earnings growth rates (see the succeeding chart).

Stock	PB Ratio	Earnings Yield
Reliance Steel (RS)	1.74	15.18%
Westlake Corporation (WLK)	1.31	20.71%
Helmerich & Payne (HP)	1.76	0.11%
Pason Systems (OTCPK:PSYTF)	3.56	7%
THOR Industries (THO)	1.11	24.90%
Federal Hermes (FHI)	3.26	7.35%

Click to enlarge

Source: Seeking Alpha; YCharts

Performance Metrics

In my opinion, the fund’s most encouraging metrics are its Sharpe Ratio of 0.59 and its Sortino Ratio of 0.92, which illustrates its management’s ability to manage upside and downside risk. In a utopian universe, Sharpe and Sortino Ratios above 1.00 is desired. However, they rarely exist.

Furthermore, the closed-end fund has a positive information ratio, indicating that its active return exceeds its active risk, meaning its managerial skill is high.

Although Sprott’s risk attribution is mainly positive, I’d like to warn investors that its negative skewness and excess kurtosis mean that its returns are often negatively distributed, leaving the vehicle exposed to market downturns.

Valuation & Dividends

As briefly mentioned before, the fund’s valuation prospects are solid. In fact, its price-to-book and price-to-earnings ratios are significantly lower than the S&P 500’s. Moreover, the fund’s weighted average ROIC (return on invested capital) of 29.28% signals that most of the portfolio’s constituents utilize their working capital with extreme efficiency.

Sprott’s Focus Trust pays a quarterly dividend with a current annual yield of 6.69%. Furthermore, the fund’s average dividend yield has historically been high, providing much surety to investors seeking dividend consistency.

Risks

I’ve mentioned a few risks throughout the article. However, I want to reiterate the fund’s exposure to cyclical stocks. Although it is geographically diversified, Sprott’s Focus Trust is value-centric and seemingly ignores sector risk.

The 2023 recession rhetoric could spook investors, in turn causing a cyclical stock sell-off. The financial, basic materials, and real estate sectors are inherently fragile to macroeconomic downturns, which could leave this fund at risk if economic variables don’t shift anytime soon.

In addition, this closed-end fund hosts a substantial amount of value-at-risk, meaning it could suffer from excess drawdowns if 2022’s bearish market trajectory resumes.

Final Word

Sprott’s Focus Trust is an overlooked closed-end fund with sublime risk-return utility. The fund’s emphasis on small-to-mid-cap stocks that trade below their intrinsic values is a recipe for long-term success. Moreover, the fund’s constituents typically host high earnings yields and impressive ROIC metrics, which phases out a “value trap” counterargument.

Lastly, the Sprott Focus Trust possesses a history of lucrative dividend yields, adding to its investors’ total return prospects.