Cowan Asset Management letter for the second quarter ended June 30, 2016.

Dear Unitholder,

We’re going to start by giving you a test. During the 12 weeks of the second quarter, which of these three indices posted the worst performance: (a) Britain’s FTSE 100 Index, (b) Canada’s S&P/TSX Composite Index, or (0) America’s S&P 500 Index? Go ahead, take a minute to recall the major financial and economic news since April and think it over. We’ll wait right here.

While you’re taking a minute to mull it over, let’s chat soccer. Thinking back to major news from the quarter, how crazy was it that England lited the Euro 2016 championship so early? Really thought they would have remained in the tournament longer than they did. Oh well, I suppose the consequences are for them and them alone to live with.

OK, got your answer? You didn’t cheat, did you?

Odds are that while you were debating an answer, you recalled the fallout from the Brexit referendum, but had trouble recalling any other major financial and economic news from earlier in the quarter. We feel confident in predicting that Brexit was in the forefront of your mind because it is human nature for it to be there. It is a tendency called “recency’ (or “availability”) bias and it is something that professional investors have to be aware of at all times.

Recency bias means that when evaluating a topic, newer examples of that topic come to mind more easily than older ones. This bias is a mental shortcut that, time and time again, humans have been shown to rely upon when making decisions. For example, this bias is the reason why some people become more afraid of flying immediately after a plane crash is reported in the news, even though these crashes remain extremely rare.

This bias becomes a problem for investors when they forecast that recent events will continue to occur in the future. For instance, a recent bull market leads many people to think that stock prices will continue to increase with each passing day; this type of behavior was witnessed during the tech bubble. Alternatively, a recent bear market leads some people to think stocks will continue to decrease indefinitely; think back to the widespread fear during the global financial crisis.

Back to our original test. As it turns out, the S&P 500 was the worst-performing index of the three during the quarter. Britain’s main index returned 6.5% while Canada’s returned 5.1% and America’s returned 2.4% from the beginning of April until the end of June.” Where the recency bias can do even more damage, however, is with respect to predicting future returns. lf investors are unaware of this bias when trying to gauge how markets will move in the future, the Brexit result is apt to weigh more heavily in investors’ minds than older information like the movement in oil prices or improving U.S. employment data.

We began this letter with a discussion of recency bias because we figured it was going to be counterintuitive to tell anybody who has been reading in the press about the Brexit doom-and-gloom that our funds actually had a pretty good quarter. During the quarter the Cowan Absolute Return Fund generated a 4.7% return while the Cowan Income Opportunities Fund generated a 3.8% return. Year-to-date, the Absolute Return Fund is up 6.9% and the Income Opportunities Fund is up 9.5%.

Cowan Asset Management

Cowan Asset Management – Active Management or Closet Indexing?

The difference in returns between the Absolute Return Fund and two of the three major indices highlights the fact that we are truly active managers whose portfolios don’t simply mirror the securities within an index. As the following chart shows, this holds not just for the last quarter: the Absolute Return Fund has not shown significant long-term correlation with any of these indices.

Cowan Asset Management

Mutual funds that claim to be managed actively but essentially just mirror the holdings of an index are referred to as “closet indexers”. Closet indexing has been a topical subject in Canada lately. The Ontario Securities Commission recently began reviewing whether mutual funds that are being advertised as actively managed actually hold securities that are sufficiently dissimilar to the holdings of a benchmark index. Also, a recent paper in the Journal of Financial Economics found that closet indexing is more prevalent in Canada than any other country in the world.2

Closet indexing is important to regulators – and should be important to the investing public as a whole – because active managers tend to charge higher fees than passive ETFs (which are actually built to mirror the holdings of a benchmark index). Thus, investors who are paying more for active management have a right to expect that they are getting more for their money.

Besides showing little historic correlation with major indices’ returns, the Absolute Return Fund’s holdings bear little resemblance to any major index. Geographically speaking, 53% of the securities are listed in Canada, 23% in the US, 12% in the U.K., and the rest are split between Australia, Italy, and Singapore. Furthermore, our Canadian holdings include no bank, oil & gas producer, or mining equities; these three industries are among the most widely represented in the TSX Index.3

This is all by design. Since we bill ourselves as active managers, we want to be sure that you get what you pay for. But as a portfolio manager, standing out from the crowd by ignoring the composition of an index is a difficult thing to do. If a closet indexer makes money, he or she can take all the credit for it. Whereas if a closet indexer loses money, he or she can avoid blame by pointing out that the index lost roughly the same amount of money. It’s a win-win. It reminds us of John Maynard Keynes’ observation, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”.

The Math Behind Patient Investing

Speaking of conventional thinking, there is an undoubted appeal to making money quickly. The allure of short-term profits escapes almost no one, investors, executives, and gamblers included. But lost alongside the emotional high of getting rich quickly is some simple math that makes a compelling argument for being patient while waiting for profits to appear over the long-term.

The following table shows the annual rate of return generated by asset price appreciation that occurs over a variety of years. For instance, the table shows that if the price of an asset doubles in one year, an annual return of 100% is generated. Similarly, if the asset price triples over a span of 10 years, an annual return of 12% is generated.

Cowan Asset Management

It is math like this that reinforces our long-term approach to owning investments. Sure, doubling your money in one year is great. But even if it takes five years for that money to eventually double, an impressive 15% annual return is still generated.

This concept represents the flip-side of a phrase that gets thrown around too often among active traders: dead money. Barring an upcoming catalyst, so the wisdom goes, the price of a stock is unlikely to change anytime soon, meaning any money invested in the stock is unlikely to increase and will remain “dead” for quite some time.

While owning a stock that benefits from a near-term catalyst is an envious situation to be in, buying a stock solely with a near-term catalyst as the investment thesis is too short-sighted, in our opinion. It is hard enough to successfully identify a stock to buy that will eventually appreciate in value, let alone trying to successfully identify one that will appreciate in mere months. As we see it, the longer we are prepared to hold a security, the more opportunities we will encounter for positive share price catalysts.

Belmond Ltd. (BEL-NYSE) is an example of where we are putting this math to work as part of our investment thesis. We first talked about this luxury travel provider 18 months ago in our fourth quarter 2014 client letter. When we described our thesis for Belmond at that time, we noted that the company’s dual-class share structure had caused previous takeover attempts to be rejected. We surmised that if this structure was to be eliminated, the shares could appreciate meaningfully, since owners of the public shares may be more amenable to a takeover offer than the owners of the voting shares.

Since discussing our original thoughts on Belmond with you, the stock has fallen to approximately US$10.00 from US$12.00.4 As you may have guessed, the dual-class share structure has remained in place. None of this concerns us. We recently attended an investor meeting where the company’s board continued to receive vocal criticism about the share structure – this matter has not been forgotten by shareholders. We remain comfortable in our view that continued pressure from shareholders will cause the board to eliminate the dual-class structure at some point over the next five years. We are not, however, comfortable in predicting that the structure will be fixed any more quickly than that. Fortunately, our patient client base gives us the flexibility to wait and potentially realize some of the annual rate of return calculations highlighted above.

Because our strategy is to be patient, we hold a number of positions in companies like Belmond. While we believe this will lead to good returns over the long-term, it can lead to choppy results from one year to the next. In any one specific year, we could have one, ten, or zero holdings realize a positive catalyst. This is by design: we have the ability to tolerate this choppiness from year-to-year whereas some other institutional investors do not. This results in more attractive buying opportunities being made available to us than to those investors who cannot tolerate the volatility.

Catalysts: Good & Bad

Belmond’s shareholders are not alone in pushing their company to be welcoming of takeover attempts, and there is a good reason why. For takeovers that were announced in 2015, the average premium for the proposed acquisition price was 28%. In the same year, simply announcing a proposed deal caused the share prices of the targets to increase by an average of 16% the next day.5 Few catalysts rival the ability of a takeover announcement to cause rapid share price appreciation.

Conversely, the historic share price performance of companies doing the acquiring has been poor. Typically, acquirers’ share prices fall in the wake of a takeover announcement. This is because the market knows that between 70% and 90% of mergers and acquisitions (“M&A”) are failures.6 Despite this, CEOs and investment bankers continue to tout the benefits of their latest acquisition proposal, suggesting that their idea is different (and, presumably, better) than historic acquisitions. So why does M&A continue to be a regular occurrence among public companies, despite their questionable economic value?

To understand why, we need to look no further than the different incentives among stakeholders. For investors, the incentives are straightforward: they want their companies to become more profitable, generate greater returns on invested capital, and realize higher share prices.

Managements’ incentives are more opaque. Synergies are usually touted as a justification for offering a premium price to acquire a target company. These synergies theoretically take the form of eliminated redundancies between the two companies. For example, two merged companies no longer need two head offices. Unfortunately for management, this also means the new company doesn’t need two CEOs, two CFOs, nor two COOs. It also means that some well-paid board of director seats will disappear.

Thus, M&A often leads to executives losing their jobs at the target company. And while it would be wonderful to live in a world full of altruistic executives, we are of the belief that this does not describe the mindset of many management teams. Instead, incentives generally reward executives to grow their companies such that they resemble empires over which they can preside.

Investment bankers certainly aren’t dumb, they know that this is how management teams think. Thus, bankers spend a great deal of time pitching M&A ideas to company executives. Bankers, being much more altruistic than executives, will gladly pitch these ideas for free. They will just kindly ask for a multi-million dollar commission fee if the transaction actually goes through.

Investment bankers certainly aren’t dumb, they know that this is how management teams think. Thus, bankers spend a great deal of time pitching M&A ideas to company executives. Bankers, being much more altruistic than executives, will gladly pitch these ideas for free. They will just kindly ask for a multi-million dollar commission fee if the transaction actually goes through.

Combine these bankers’ fees with legal fees, employee severance charges, plant decommissioning expenses, and friction from culture clashes and you can see how quickly the costs of an acquisition could dwarf the benefits gained from the synergies. This is why we tend to avoid any company that bills itself as a “market consolidator” or “roll-up story”. In our opinion, roll-ups should be limited to two just uses: fruit and rims.

Investment Team News

Patience is a virtue at Cowan Asset Management, and a long-term mindset permeates many of our team’s decisions. This mentality was most recently demonstrated by Ian’s decision to propose to his girlfriend of seven years. Fortunately, his patience paid off as she happily said, “Yes!” We couldn’t be more pleased for the couple and hope you’ll join us in wishing them many more years of happiness together!

Sincerely,

Cowan Asset Management Investment Team