Cowan Asset Management client letter for the third quarter ended September 30, 2016.
It’s times like the third quarter that make professional investing look easy. From the start of July until the end of September the Cowan Absolute Return Fund was up 5.0% and the Cowan Income Opportunities Fund was up 4.3%. Year-to-date, the Absolute Return Fund is up 12.3% and the Income Opportunities Fund is up 14.2%.
Furthermore, there were no shocking referendum results, no surprise central bank rate cuts, and no bombshell commodity price collapses. Rather, numerous markets realized consistent price increases throughout the third quarter and that helped our funds do well. When some people say that professional asset managers are no better than dart-throwing monkeys, it is markets like these to which the detractors are referring. We – in our 100% unbiased opinion believe this criticism to be impolite, malicious, and degrading to monkeys.
The flip side of this strong price performance – and the justification for hiring us instead of a monkey – is that many security valuations are now elevated to prices that look precariously high. Because of this, we have been realizing some of the returns generated over the summer. Unfortunately, this also means it is now quite difficult to find attractively-priced securities to add to the portfolios.
During the quarter the TSX Composite was up 5.5% and the S&P 500 was up 3.9%. The FTSE 100, up 7.1%, continued to shake-off Brexit concerns.1 The one hiccup was on September 9th when these same indices fell by as much as 2.5%. Driving this slide were comments from a US. central bank official. His comments simply suggested that he was more willing to raise interest rates than he had been in the past. Note that ten Federal Reserve officials vote on rate movements, not just this one individual.
Market movements like what we witnessed on September 9th reinforce our view about the significant role interest rates have been playing in security valuations. If an index as large as the S&P 500 can lose 2.5% of its value – which is equal to almost US$500 billion in market capitalization – simply because of one man’s vague musings about interest rates rising, then imagine what will happen once rates eventually do increase.
We’ve discussed this issue before, so we are cognizant of sounding like a broken record.2 But our concern remains that all-time low interest rates have artificially inflated a broad array of asset prices.
And since it is your money that is invested in our funds, we believe that it is our ongoing responsibility to share these concerns.
Like most of this year’s economic worries, the markets quickly forgot about the September 9th selloff. Each of the three aforementioned indices had recouped almost all of their losses within two weeks. This illustrates a problem faced by investors who, like us, are aware of the risks posed by rising rates. Trying to trade securities around the latest monetary policy rumour is a dangerous game to play. Getting the timing wrong by a few days means the difference between making profits and taking losses.
Instead of attempting to trade on short-term macroeconomic data, we endeavor to protect against the risk of rising rates by taking a longer-term view of how rates will move. Whether rates rise in September 2016, December 2016, or July 2017 doesn’t have a material impact on our view of what an individual security is worth. lnstead, when valuing an equity security, we estimate what rates will be 10 years from now, and use those estimates when building our financial models. Unlike other, more visual, types of modelling, we are less concerned about how attractive things look right now and more concerned about how attractive things will look in the future.
Cowan Asset Management – What Does The Market Know?
Let’s assume that the Federal Reserve raises the interest rate at its meeting in December. Finance 101 tells us that asset prices should decrease because the present values of their future cash flows will decrease. If it isn’t immediately clear to you why present values of future cash flows decrease as interest rates rise, ask yourself whether you would rather have $1 today or $1 a year from now. Hint: if you had $1 today you could invest it and end up with more than $1 in one year. Thus, receiving $1 today is worth more than waiting to receive $1 a year from now. In other words, the present value of $1 received in one year is lower than the value of $1 received today.
But how much less is that future $1 worth? That depends on the investment returns you can generate by investing the $1 received today. And these investment returns depend on the interest rate at which your dollar was invested. Thus, the higher the interest rate, the higher the investment returns you can generate on $1 received today, and the less valuable the $1 received in the future becomes by comparison. It is this mechanism – rising rates causing the present value of future cash flows to decrease – that cause the prices of assets to fall.
The Federal Reserve’s December meeting is on Wednesday the 14th. 80 if the Fed decides to raise rates on that day, does it mean asset prices will plummet immediately once the news is announced? At the time of the writing of this letter, the answer we’d give you is “probably not”.
When investing, it is not enough to know just the facts about a company before deciding to buy its securities. A good analyst must go one step further to determine what information is factored into the security’s current market price. For example, we could hire any financially-competent intern fresh out of university to research Royal Bank of Canada for us. The new hire would likely to a good job of describing the company’s operating segments, identifying credit risks, and pinpointing the bank’s growth opportunities. But every investor with an interest in RBC would already know all of these simple facts. So the intern would have brought our understanding up to only the most basic level.
A good analyst would continue on to the next level by estimating whether or not other investors are underappreciating facts such as the bank’s credit risks or its growth opportunities. By analyzing what the market may misunderstand about RBC’s future prospects, the analyst can form an opinion about what facts are already baked into the stock’s current price and what facts aren’t.
If you ever found yourself on a date that was going swimmingly, only to catch yourself thinking, “Why is this person single?” then you have already practiced this type of next-level analysis.
How Are We Different?
This next-level analysis represents an important part of our investment process. After learning everything we can about a company and forming an opinion about its future, we then ask ourselves if we have an edge. By “edge” we mean some sort of leg-up on all other investors who have access to the exact same information as us.
In the cases where we do have an edge, it frequently comes down