Cowan Absolute Return & Income Opportunities Fundletter to clients for the first quarter ended March 31, 2016.

Dear Unitholder,

The Cowan Absolute Return Fund returned 2.1% in the first quarter, a period that saw Canada making global headlines for both the attractive returns of its equity markets and the return of a Prime Minister’s attractive tuxedo at a White House state dinner. While it was nice to see our country feted in Washington, Canadian investors were more focused on having a few extra dollars in their pockets. Commodities rebounded during the quarter, with gold leading the way. The Absolute Return Fund doesn’t invest heavily in the commodity sector, so it didn’t participate in this rally. We focus more on picking individual stocks and not industry sectors. Nor do we pay much attention to what particular securities are in an index. Consequently, our holdings tend to have a low correlation with major indices’ movements. But this doesn’t bother us; if our investment theses prove correct, the gaps between market prices and intrinsic values will close, and the Fund will eventually produce healthy returns.

We launched the Cowan Income Opportunities Fund on January 1st of this year. The performance of a newly-launched fund can be a bit like the performance of a newly-walking toddler: unsteady. It takes some time to put cash to work and fulfill the investment mandate. This means that short-term results are not often indicative of what long-term performance will be. As it applies to the Income Opportunities Fund, our toddler started walking as if it was Usain Bolt accelerating out of the starting blocks. A return of 5.4% was generated in the quarter. It’s foolish to put predictions to paper, but here’s one we’re comfortable making: there is no way the new fund will sustain this high level of performance!1 It benefited from some fortunate timing when credit spreads were wide and the market  was overcome with fear. We will accept some praise for identifying these opportunities and aggressively allocating capital to them, but we want to be clear in saying that these types of opportunities don’t come along too often. If they do present themselves once more, we will again be ready to act.

Cowan Absolute Return & Income Opportunities Fund

Cowan Absolute Return & Income Opportunities Fund – First Quarter Review

The first quarter provided a perfect example of why we, unlike many others in the financial industry, do not equate increased price volatility with increased risk. Over the last three months, the TSX returned 4.5%, the S&P 500 returned 1.3%, and global equities returned 04%.2 If you were to know nothing else about the quarter’s performance, you would probably think that it was a pretty good, albeit unremarkable period.

Contrast this understanding with how many short-term focused investors were feeling in mid-January when the TSX was down 8.9%, the S&P 500 was down 9.0%, and global equities were down 11.3% year-to-date. To many people it felt like a roller-coaster ride on a track that only ever plunges straight down to the ground. Looking back even further, the last five quarters have seen the S&P 500 move a total of 4,735 points, yet the net change from start to finish was an inconsequential 0.8 points.

As we’ve said many times before, we genuinely believe that an ability to remain calm and focused on the big picture during volatile times is what separates good investors from bad. But we also acknowledge that it is easier said than done. Whether it’s for emotional reasons (watching savings dwindle day after day would rattle just about anyone) or for institutional reasons (portfolio managers are forced to sell quickly when they have clients who are apt to withdraw during market pullbacks) there will always be reasons why many investors are short-term focused. But just like a roller coaster, it’s best not to get out in the middle of a steep plunge.

Canadian investors who benefited from the weak loonie in 2015 by owning assets abroad saw their fortunes reverse in the first quarter of 2016. A rally in oil prices, combined with comments from both Canadian and US. central bankers on interest rates, saw the Canadian dollar appreciate 6.4% versus the US. dollar. To put this move in perspective, if a Canadian investor owned the S&P 500 during the quarter, the 1.3% gain in US. dollar terms would have translated into a 4.9% loss in Canadian dollar terms.

Since we first mentioned it in our second quarter 2015 letter, pharmaceutical company Valeant has not disappointed when it comes to making headlines worth discussing. If you don’t recall, when we first talked about Valeant, it was on fire, having returned almost 70% through the first half of 2015. At that point it had grown to become the largest company on the TSX. This meant that portfolio managers with a mandate to beat the TSX on a relative basis were forced to own the stock or suffer from underperformance. As we concluded at that time, “This means that there have been buyers of Valeant equity who don’t have even a basic understanding about the company’s extremely-complicated business model”.

As the first quarter of this year has shown, calling Valeant’s business “extremely-complicated” was putting it mildly. It now seems that not the CEO, nor the board, nor the auditors knew how much revenue the company had actually generated. Valeant announced in February that $58 million in net revenue was recognized incorrectly in 2014’s audited financial statements. Subsequently, the company announced that the CEO was leaving, a number of board members were being replaced, and the CFO was asked to resign, but “has not done so”.

We mention this now to highlight the importance of a certain investment conclusion that doesn’t get enough traction in the mainstream media. Headlines are often made by portfolio managers who think a specific stock is a “strong buy” or a “strong sell”. But often it is more appropriate to hold an opinion of, “I honestly don’t knoW’ and move on to another idea.

Additionally, the Valeant saga highlights the important and overlooked role that individuals play in asset allocation. While individuals who purchase mutual funds often think that they are outsourcing all of their investment decision-making to a professional money manager, the reality of the situation is often quite different. By purchasing a sector- or country-specific mutual fund, individuals are doing a great deal of the asset allocation work themselves. A portfolio manager running one of these funds has a mandate to remain fully invested in the specific sector or country in which the fund specializes. The portfolio manager does not have the flexibility to increase the proportion of cash held if securities can’t be bought at attractive prices, nor can other sectors or geographies be examined for better deals. This is why so many portfolios with a specific mandate all end up holding the same stocks, regardless of the fundamental attractiveness of each individual security: their clients told them what to buy, albeit indirectly. Thus, if you’re a portfolio manager with a Canadian mandate in early-2015, your limited options included (1) the declining oil & gas industry, (2) the beat-up mining industry, and (3) the high-flying Valeant.

Fortunately, we feel no such pressure

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