Cowan Asset Management client letter for the third quarter ended September 30, 2016.

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Dear Unitholder,

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.


Cowan Asset Management

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 to behavioural aspects such as: (1) being more patient than others while waiting for a security to realize its intrinsic value, (2) embracing a stock after its price has fallen so drastically that it feels painful to buy, or (3) focusing on a key piece of information that others have ignored. Part of identifying our edge requires being honest with ourselves. Therefore, places where we don’t have an edge include: (1) trading at a higher frequency than others, (2) an ability to create a superior financial model, or (3) access to information that other investors don’t have. Reasons for these respective deficiencies include: (1) we don’t think this will be profitable over the long-term, (2) we don’t think it’s worth the additional time investment, and (3) it’s illegal. Let’s go back to the original question: what impact will the Fed’s actions have on asset prices? The markets currently think that there is a 56% chance that the Fed will raise rates at the December meeting.3 This means most asset prices have already accounted for a 56% chance of higher rates post-December. If we were going to try to profit from the Fed’s decision in December, we would have to be confident that there is either a much greater or a much lower chance of a rate hike.

In our opinion, the Fed will hike rates in December. In other words, we think that there is a much greater than 56% chance. But we also have to ask ourselves if we have an edge when forming this opinion. And the honest answer is “no”. We are no better than the average investor when it comes to predicting what the Federal Reserve will do in December. The federal funds rate is one of the most visible financial numbers in the world. Anyone who invests professionally is familiar with it. If we were to start betting on the Fed’s rate movements, our bets would be placed in one of the largest, most competitive pots in the world.

We consider ourselves to be smart. We consider ourselves to be diligent. But there are a lot of professional investors in the world. So when it comes, specifically, to forecasting US. interest rates, we will readily admit we are not among the smartest, nor among the most diligent in the world.

Instead of partaking in one of the world’s most competitive bets, we prefer to look for investment ideas in places where other portfolio managers either can’t or won’t look. Small-capitalization companies are a prime example. Many portfolio managers will limit their investable universe to mid- and large-cap companies solely because it takes too long to build a sizeable portfolio position when buying the shares of small companies in the open market.

We are also flexible with respect to the geography of a company’s publicly-traded shares. Whereas some portfolio managers have a mandate to focus only on, say, Canadian or American companies, we are free to scour the entire world for the best investments we can find. With fewer restrictions on what competition we have to face when placing bets, we believe our ability to make smart investment decisions is enhanced.

What to Watch For in Q Four

The Federal Reserve’s actions, or lack thereof, won’t be the only thing we’ll be watching for as we head into year-end. The Bank of Canada will also decide whether to make changes to the overnight rate. With the markets currently placing just a 12% chance of a cut and a 0% chance of a hike by year-end, we aren’t interested in hearing whether rates will change so much as hearing about what risks the Bank currently sees in the economy.

We have our own views about Canadian economic risks so we are intrigued to see whether the Bank is thinking along the same lines. One of the risks that has been getting a lot of attention in the press lately is housing. Vancouver’s foreign-buyers’ tax, tighter regulations imposed by Ottawa, and record levels of household debt are causing many to wonder how much longer the housing market will demonstrate its unprecedented resilience.

In the wake of Vancouver implementing its new tax, residential property sales fell off a cliff, decreasing 26% year-over-year in August.4 With so much of the Canadian economy being reliant on the real estate industry, we’re worried about what will happen if other areas of the country experience this kind of decreased enthusiasm for housing. For a reminder of why this risk bothers us so much, have a look at the following chart. lt illustrates just how important real estate has become with respect to propping-up the Canadian economy.

Cowan Asset Management

But we don’t just sit around worrying! We’re also eagerly anticipating what would happen if a negative catalyst was to hit the Canadian markets. Take Brexit for example: during the short-lived fear that gripped many investors after the referendum’s result was announced, we were happily buying the shares of our favourite U.K.-based companies. If a catalyst of similar magnitude was to hit the Canadian markets, there are many high-quality companies – such as the big banks – that we would happily buy at lower prices. If and when such a widespread sale may occur is anyone’s guess, but we do have our shopping list readyjust in case.


Cowan Asset Management Investment Team

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