Second Quarter 2017 Client Letter July 1, 2017

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Harvey Hood
5 years ago
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1 July 1, 2017 Dear Client, There are a few things that terrify us. Spiders, obviously. Turbulent flights. Needles, ugh, needles are the worst. Realizing mid-day that our belt doesn t match our shoes. But something that doesn t terrify us is the prospect of central banks beginning to raise interest rates. There have been rumours that a number of banks the Bank of Canada, the Federal Reserve, and the Bank of England included are finally comfortable with embarking on a path of steady rate hikes over the coming years. The math of bond pricing is such that as interest rates increase, prices decrease. The magnitude of the price decrease is the biggest for the bonds with the longest time to maturity. Because of this, we have deliberately focused on holding shorter-term bonds in the Income Opportunities Fund. So we aren t too worried about the impact rising rates will have on our bond holdings. Equity valuations are also affected by interest rate movements. When rates are high, the value of future cash flows to shareholders are discounted more heavily. This can push down the price of a stock. Because of this, we have deliberately focused on reducing the Absolute Return Fund s net equity market exposure. So we are also comfortable with our equity holdings in a rising rate environment. The Absolute Return Fund returned 3.6% in the quarter and 7.9% year-to-date. 1 For the quarter, the Fund generated all of its positive return in April. The appreciation of the Canadian dollar versus many currencies in May and June offset the underlying holdings price increases. During the quarter we increased the Fund s inverse ETF positions to help reduce the aforementioned net equity market exposure. The Income Opportunities Fund returned 1.4% in the quarter and 5.8% year-to-date. Like its sister fund, the Income Opportunities Fund is positioned conservatively. It currently holds a healthy cash balance and its interest-rate exposure is conservative. As interest rates remain unattractive when compared to inflation, we continue to be patient when allocating capital. Gross Performance Summary Year-to-Date Q Absolute Return Fund 3.6% Income Opportunities Fund 1.4% Since Inception (annualized) 7.9% 9.4% 5.8% 16.7% The Absolute Return Fund was established in January The Income Opportunities Fund was established in January All fund return data is on a gross basis.

2 Page 2 Things and Fun Say you want to buy something but are short on the cash to do so. You have a couple of options. First, you could not buy the thing. But that s no fun! Buying stuff is more fun! So you don t choose that option. Second, you could increase your income by getting a part-time job at the local coal mine. But that s no fun! Spending leisure time in the sun is more fun! So you don t choose that option either. Third, you could borrow money for the thing. And let s imagine that the person who will lend you the money is a very generous fellow: he doesn t even charge you interest! Now that sounds fun! So you choose this option and you buy the thing. Turns out, your friend is even more generous than you first expected. He tells you that if you want to buy even more things he ll lend you even more money. Interest free! Since you still like fun, you take this money and buy even more things! One day your generous friend knocks on your door. He tells you that it s not a big deal, but he needs to start charging you just 1% interest on your loans. No problem, you reckon, 1% is still practically nothing! So you continue to borrow from your friend and you continue to buy more things. A little while later your friend knocks on your door again. This time he looks concerned. He says that he needs to start charging you 10% interest. Uh oh, you observe astutely, 10% is not nothing! So not only do you stop buying things, but you also use a big chunk of your income to pay down your loans. Now imagine that everyone in your city/province/country also likes things. And they also know your previouslygenerous friend. This means they are all now faced with the same problem as you. So they all stop buying things and all start paying down their loans at the same time. This is bad news for your city/province/country. Nobody is buying things anymore. So all of the thing-makers have to start firing employees. Now all of these fired employees have no income to repay their own loans. So they start selling their second-hand things. This increased supply pushes down the price for things. This makes it even harder to generate income by selling things. So more people working at thing-makers are fired. And so on. And so on. What we have roughly described here is called a balance sheet recession. The term was coined by economist Richard Koo based on what he observed from the Japanese economy in the 1990s. We are worried that the same situation may be observed from the Canadian economy in the coming years. Our website s market commentary this month discusses the particulars of why we are worried about a Canadian balance sheet recession: But in a nutshell, it s the combination of elevated household debt, rising interest rates, and historic levels of consumer spending. In the past few years the Canadian economy has become overly-reliant on consumers buying things, in our opinion. We believe that a great deal of this increased spending was financed by increased borrowing. So

3 Page 3 imagine what would happen if this borrowing was to stop. The following chart shows how important consumption and residential investment has become in recent years. If consumer spending was to revert to historical levels, it would likely pull GDP down with it. What We ve Been Buying In previous letters we ve discussed why our broad investment mandate is important to our investment process. Since we don t have to care whether a company s market capitalization, geography, or industry fits within arbitrarily-defined limits, we can search for value anywhere in the world. That flexibility has proven to be a big advantage when it came to one of our newest holdings, Murgitroyd Group PLC (MUR-LON). The Glasgow-headquartered company had a market capitalization of just 35 million at the time of our original analysis. Because it is so small, few investors would even consider looking at the company in the first place. This meant there was less competition for us. In January, the company announced weaker-than-expected first-half fiscal 2017 results. This caused the stock to plummet almost 25% in just one day. That caught our attention. We decided spend some time researching the company. MUR provides intellectual property services within the European Union and employs 65 patent attorneys to do so. Patent registration didn t strike us as the type of volatile business that justified 25% stock selloffs. So we did some more digging. We even made an exception to our rule of not talking to management. As it turned out, nearly all of the weak first-half results were attributable to one-time costs related to a recent acquisition. It seemed like many of those costs could be reigned-in quickly by management.

4 Page 4 So we learned that a company that had increased its dividend in 15 of the last 16 years while maintaining consistent margins and steady revenue growth was suddenly valued at 25% less than it was just one day earlier. Oh, and the company had almost no debt. We have a highly-technical name for situations like this: we call them buying opportunities. But the Markets are Efficient, Right? We wrote the previous section in mid-june. At that point we were willing to be patient with our MUR holding. We had simply hoped that the company would release earnings reports that showed gradual improvement over the coming years. However, at the end of June there was news that caused the stock to appreciate 23% in one day. And we use the term news loosely. The Telegraph featured an interview with a U.K.-based portfolio manager who said that MUR was an attractive investment at the current price. 2 That was it. He had access to the same public information as everyone else. And this wasn t Warren Buffett talking; we had never heard of this portfolio manager before the interview. Nothing fundamental changed about the company. A newspaper simply published an article basically echoing what we said above. And the stock increased substantially. There is a widely-held belief among academics (and even many investors) that the markets are efficient. What this means is that current stock prices accurately reflect all available information. The consequence of this hypothesis is that it would be impossible to beat the market by analyzing this information. As a result (so its proponents would say), investors would be better served by simply buying a passive index fund, or by employing a cheap, dart-throwing monkey. We will admit that the market is mostly efficient. Most of the time it does a very good job of pricing securities accurately, based on public information. This is the main reason why we end up passing on most of the investments we analyze. We aren t logicians, but we re pretty sure that all it takes is one example like MUR to disprove the theory that markets are efficient all the time. Yet the efficient market hypothesis persists. Appreciating Possible Price Appreciation The focus of the Income Opportunities Fund is to invest in securities that offer an attractive income stream. But we also look for income-producing securities that could appreciate in price. The Capstone Infrastructure Corp. fixed-rate reset preferred shares (CSE.PR.A-TSX) that we have held for some time offer an example of this. Capstone develops, owns, and operates power generating facilities in Canada. Many of these facilities have long-term power purchase agreements with provincial utilities. The company was publicly traded until May 2016 when a private equity firm purchased all the outstanding equity and retired the debt. Oddly enough, the buyer didn t choose to redeem 2

5 Page 5 the $75 million in preferred shares. Despite the public reporting burden, the new owners decided to leave the preferred shares outstanding because they viewed them as inexpensive financing. The last time we added to our position was at a price around $13, well below the shares par price of $25. This represented an attractive current yield of 6.4%. What may be overlooked by the market, however, is that these shares will be redeemable by the issuer on their next dividend reset date in mid We think that these shares could be redeemed at par and, even if not, they could still appreciate towards their par price in the market. If these shares are redeemed at par, it would be almost a double from current levels. Whether or not the shares are redeemed, we believe that earning a 6.4% yield is a good risk-adjusted opportunity for the Fund. Canadian Interest Rates The Bank of Canada caught the market off guard when it suggested that it could raise rates as early as July. Up to that point, many currency traders had been short the Canadian dollar. As they rushed to cover their positions, the loonie appreciated strongly, gaining over 2 versus the U.S. dollar. The Bank s reasoning for the change of heart was the strong economic data the Canadian economy has generated recently. Furthermore, they now believe that the negative shock from the decline in oil prices has worked its way through the economy. Recall that in 2015 the Bank lowered rates by 0.5% to soften the impact of the oil price collapse. While the economy did suffer from falling profits in the energy sector since then, the lower rates stimulated Canadian consumers to increase their spending by taking on more debt. As we mentioned earlier, the real estate and consumer discretionary sectors were key to offsetting the oil s waning contribution. The Bank now finds itself in a tricky spot. It recognizes that real estate asset prices and consumer debt levels are high. On the other hand, these are what have been driving the economy s strong performance. The Bank will have to walk a fine line by reducing debt accumulation without raising rates so much that it would send the economy into a recession. If the Bank was to increase rates steadily, it is likely that the Canadian dollar would appreciate further. A rising Canadian dollar acts as a headwind for exports. It will be interesting theatre to watch how the Bank and the Canadian economy transition to this new environment. With cheap money being taken away, strong economic growth will be necessary to maintain current asset valuations. In other words, we will have to wait and see whether people will continue to buy things even though their previously-generous friend is now charging them not-nothing. Sincerely, Cowan Asset Management Investment Team

ECO155L19.doc 1 OKAY SO WHAT WE WANT TO DO IS WE WANT TO DISTINGUISH BETWEEN NOMINAL AND REAL GROSS DOMESTIC PRODUCT. WE SORT OF

ECO155L19.doc 1 OKAY SO WHAT WE WANT TO DO IS WE WANT TO DISTINGUISH BETWEEN NOMINAL AND REAL GROSS DOMESTIC PRODUCT. WE SORT OF GOT A LITTLE BIT OF A MATHEMATICAL CALCULATION TO GO THROUGH HERE. THESE