Value Investing

Cowan Absolute Return & Income Q1 Letter: The Valeant Saga

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 to own whatever stock is the flavour of the month. Nor would we change our investment approach just to gather more assets simply because a sector, geography, or style was suddenly popular. We will always allocate your capital with long-term performance being our principal consideration, unconcerned about increasing our marketability to new clients. As investor Jean-Marie Eveillard said, “I’d rather lose half my clients than half my clients’ money”.

Cowan Absolute Return & Income Opportunities Fund – What Not to Read

These days, it’s difficult to open a newspaper, turn on the TV, or re-watch WrestleMania 233 without coming across the name of a certain real estate developer who is in the running to become the next President of the United States. In Canada, a great deal of this attention is decidedly negative; we need to look no further than our Facebook news feeds to realize that many of our social-media-savvy friends have a strong distaste for the idea of a “President Trump”.

But after scrolling through a dozen posts chronicling people’s preference for anyone but Trump, we find ourselves questioning the benefits to be gained by evaluating these political views. Firstly, we’re Canadian, we can’t even vote in the U.S. election. Whether we agree with a candidate’s views or not is irrelevant because, frankly, nobody in an official capacity cares what we think. Secondly, history has shown that election outcomes in developed countries have no impact on the capital markets. So trying to predict a winner doesn’t do us much good either. Thirdly and finally, there are only so many hours in the day, so they must be used wisely. Time spent reading about outlandish foreign politics is time deducted from analyzing annual reports, reading erudite books, or watching the Blue Jays game.

This last point highlights a problem that all portfolio managers must confront: there is an unlimited amount of information available for investors to digest, but there is only a limited amount of resources available with which to analyze it. This means that determining what not to read is often more important than determining what to read. Research on this topic paints an even bleaker picture of the downfalls of too much information. Papers examining the predictive power of individuals have shown that as people receive more judgment-relevant information, confidence in their predictions increased faster than the accuracy of their predictions. In some cases, prediction accuracy actually decreased as the amount of information increased.

This temptation to gather more and more information when analyzing an investment is a dangerous one for analysts. Not only is it an inefficient use of time, but it often leads to portfolio managers getting “married” to some ideas. That is to say, analysts gain comfort from the sheer amount of time they have spent analyzing a security, rather than in the validity of the conclusions drawn from the analysis.

To avoid having this bias affect our work, we strive to be ruthless when questioning whether tracking down an incremental piece of information is worth our time. This approach manifests itself in a few ways that are unique among investment managers.

Unlike most asset managers, we rarely meet with the management teams of the companies we’re evaluating. If you were to ask just about any portfolio manager whether these meetings are part of their investment process, odds are they would say something like, “Yes, I want to look a CEO in the eye before investing”. We believe that taking the time to arrange meetings with company management is a waste. In general, CEOs rise to the top of their companies because they are exceptionally-good at persuading their superiors that they are valuable employees, whether or not that’s actually true. Therefore, we often find CEOs to be charismatic leaders with extraordinary salesmanship skills. This is not the type of person you should strive to meet when trying to form an objective opinion about a company. Far too often, portfolio managers are swayed about a company’s prospects by an overly-optimistic and likeable chief executive.

We also rarely partake in site tours to view a company’s equipment, facilities, or production processes. The one exception is if it allows us to learn, for the first time, about the inner workings of an industry we know little about. We get a kick out of investment firms that advertise the prophetic insights their portfolio managers form while donning a hard hat and visiting a factory. If, instead, these advertisements were being honest, they would tell you that the only insights being formed by a portfolio manager on a site tour are along the lines of, “Yup, this is indeed a factory. This hard hat is uncomfortable. I hope my departing flight is on time.”

Quarterly earnings reports are another capital markets ritual that we largely ignore. At many investment firms, analysts will keenly await the press release that discloses how a company performed over the last three months. From there, models will be tweaked, forecasts will be updated, and sleep will be lost. We are no more interested in how much money a company earned over a three-month period than we are in how much it earned over the last month, week, or day. Quarterly earnings represent such a minuscule time sample that they rarely provide any meaningful information about how a company will perform over the long-term. When we do become interested in quarterly reports, however, is when share prices overreact (either up or down) to their release. In cases like these we have found many attractive buying and selling opportunities created by investors who put too much weight on these short-term results.

In sum, our investment process leans heavily on the Pareto principle. Named after the economist Vilfredo Pareto, it states that in many situations, 20% of the input generates 80% of the results. For us, the input is time and the result is a sound investment thesis. We will continue to focus our most intense efforts on the 20% of our time that will generate the most impactful results.

Cowan Absolute Return & Income Opportunities Fund – Using Time Efficiently

In order to focus our efforts on the work that produces the most impactful results, we must avoid doing the unnecessary busy work that plagues nearly every organization. As it applies to our investing process, we eliminate any steps that don’t help us reach a conclusion about whether or not a security is priced attractively. We don’t get bogged-down in the minutia, trying to attain a level of precision that is pointless.

One of the ways this approach manifests itself is in our financial models. We use discounted cash flow valuations in order to estimate the intrinsic value of the securities we analyze. To create these valuation models, we use a Microsoft Excel spreadsheet that allows us to project a company’s cash flow five years into the future. Once these cash flows are projected, Excel spits out a single number that tells us the security’s intrinsic value, down to two decimal places of precision.

However, this level of precision can give a false sense of security about the accuracy of the intrinsic value computation. As they say in the computing world, garbage in equals garbage out. In other words, the accuracy of the output is only as good as the quality of the inputs used. To solve this problem, we could spend countless more hours tweaking the inputs used in the model, as many investment managers do. Indeed, if we were to take this approach, our estimated intrinsic value (with two decimal places of precision) may move a few cents, or even a few dollars closer to the security’s true intrinsic value.

We could spend our time doing this, or we could take a moment and remind ourselves of the Pareto principle. The time spent nitpicking over whether the company’s cash flows will grow by 5% or 7% from 2019 to 2020 just isn’t worth it. Some investment managers take this view to an extreme. Warren Buffett doesn’t even use Excel (or a computer for that matter). Instead, he calculates how much he’s willing to pay for a company in just a few minutes using pen and paper. Other respected value investors have said that if an analyst even has to open Excel, he’s doing a valuation wrong. While we do think that these are extreme views, there is some truth to them. Many times we have seen analysts spend days crafting complex spreadsheet valuations, only to have their conclusions negated by a single, hard-to-find calculation error.

Instead of spending more time increasing the precision of our estimates, we insist on a healthy margin of safety in our analysis. We recognize that there are many unknowns when projecting the future, and that we need a cushion to protect us from estimate deviations. So even though our detailed valuation work is important, it is only one part of the analysis we perform, not the sole determinant of whether we buy a security. We should be able to tell if an investment is potentially cheap by doing a brief, first-pass examination. We’ll then dive into the details to confirm whether or not this observation is correct.

Client-Only Website Section

Our website, www.cowanasset.com, now features a section accessible only by you, a Cowan Asset Management client. It will contain detailed monthly commentary on fund performance, including how individual securities within the funds have performed. In addition, detailed research reports about securities we have evaluated will be available on this section of the site so that you can gain a better understanding of what we look for when deciding whether to add holdings to the portfolio. Contact any member of the investment team to obtain your login credentials and access this new section of the site.

Our first research report available in the new client-only section is on a company that has been making headlines lately. When we initially evaluated the company in 2014, we chose to pass on buying the equity; however, it now looks like we will end up owning it anyway. As will you. And your neighbours. And your relatives. The company is Bombardier, who looks to be on the verge of receiving a capital injection courtesy of the federal government. Soto find out more about the latest company that will likely be added to the list of investments you own, get in touch and we’ll send you a username and password. Spoiler alert: we’re not that keen on Bombardier as an investment. We-Haul

Cowan Asset Management’s Toronto office has migrated south! Our new location at the corner of King and Yonge streets replaces our previous office in North York. As we always have an eye to managing our time and costs efficiently, we decided to do some team building on a recent Saturday morning by borrowing a truck and hauling our office equipment downtown ourselves. The total cost of the move was $97.56 and three hours of our time. Pictured below are Ian and Alexander doing some rare field research (in this case, research on AMERCO, ticker “UHAL” on the Nasdaq).

If you find yourself in our new neighbourhood, drop us a line and come visit the new space. The decorations are a little sparse, so if you have any interior design experience, your input would be most welcome! There are still a few boxes lying around here, but we promise that we won’t put you to work unpacking when you stop by.

Sincerely,

Cowan Asset Management Investment Team