Second Quarter 2019 Client Letter July 1, 2019

Dear Client,

In the second quarter the Cowan Absolute Return Fund reversed some of the gains it generated at the start of the year. It was down 4.2% gross from April through June and is now up 5.0% gross so far in 2019. The month of May was the difference maker for equity markets, with major indices falling anywhere from 3.3% (S&P/TSX Composite) to 7.9% (NASDAQ Composite).1 The Cowan Income Opportunities Fund was basically flat during the quarter, with a -0.7% gross return; it is now up 1.9% gross for the year.

We mention the short-term returns of indices because broad market movements influence the performance of the Absolute Return Fund in periods of less than one year. Last quarter we said we were happy with how the Absolute Return Fund performed during the full-cycle of ups and downs in the markets from the start of October to the end of March. Extending this evaluation period to capture the second quarter, we remain pleased with how the Absolute Return Fund has held in: it is up 2.3% gross over the last nine months. While it hasn’t participated fully in the euphoric rally some indices have so far enjoyed in 2019 (the S&P/TSX Composite is up 14% year-to-date), it also didn’t fall as far as these same indices did during market selloffs (the Absolute Return Fund was down 2.0% gross in May).

This is by design. Long-time readers will know that we have been cautious about equity valuations for some time. To guard against these potentially-frothy markets, we have held inverse ETF positions that help to cushion the Fund’s fall during market selloffs. We are happy to continue to hold these inverse ETFs as equity valuations continue to look rich. This approach is such a core part of our investment philosophy that it has been on the front page of our website for as long as we’ve been hanging a shingle on the internet:

SOURCE: COWANASSET.COM

1 All index return data is on a price basis and provided by Bloomberg.

Q2 2019 Year-to-Date 3-Years 5-Years InceptionCowan Absolute Return Fund -4.2% 5.0% 4.0% 5.1% 5.4%Cowan Income Opportunities Fund -0.7% 1.9% 6.4% — 8.3%

AnnualizedGross Performance Summary

The Cowan Absolute Return Fund was established in January 2014. The Cowan Income Opportunities Fund was established in January 2016.

Cowan Asset Management10 King St. E, Suite 401

Toronto, ON M5C 1C3www.cowanasset.com

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With all that in mind, the past few years have been a frustrating and perplexing environment for value investors. We’ve been trained that the crucial part of the investment process is to be disciplined when buying. In other words, if we overpay for an asset, the ultimate result may be a permanent loss of capital.

It seems that few other investors have been as concerned about overpaying lately. With the benefit of hindsight, it seems that we would have been better off simply allocating capital to the most expensive assets we could find. For an example, let’s look at fixed-income. Some people (yours truly included) said it was crazy to invest in bonds with negative real returns. A year ago on July 1st, an investor could buy a 10-year U.S. government bond that was yielding 2.87%. At that time CPI was 2.95%, resulting in a negative real yield. However, as central banks were expected to get aggressive with monetary policy to keep the economy afloat, the downward pressure on interest rates meant an investor who bought the bond at $100 could sell it on July 1, 2019 for $107 while also pocketing $2.87 in interest over that time. This would have generated a total return of 9.87%.2

For an example from the equity markets, we need to look no further than recent IPO headlines. Beyond Meat (BYND-NASDAQ), best known for its meatless burgers, debuted with a US$3.8 billion market capitalization in early May. Less than one month later the market cap grew to US$10.1 billion. Oh, and the company has never once turned a profit. That means the company is trading at a *double checks math* negative price-to-earnings ratio (“P/E”). In fact, BYND is not the only high-profile, profitless company to IPO this year: Lyft (LYFT-NASDAQ), Uber Technologies (UBER-NYSE), Pinterest (PINS-NYSE), and Slack Technologies (WORK-NYSE) all made their public market debuts in 2019. And this follows a year, 2018, that saw only 16% of tech IPOs come from profitable companies. This 16% figure represents the lowest percentage since the heyday of the dot-com bubble in 2000.

Investor euphoria has helped equity markets rebound quickly from the selloff in the fourth quarter. If we look at the S&P 500 specifically, it is telling what has driven this rebound. The following chart shows that an increase in the index’s P/E – not an increase in earnings – is responsible for nearly all of 2019’s returns. In other words, fundamentals haven’t improved, but investors have been willing to pay more for $1.00 of these companies’ earnings.

2 All bond price and CPI data provided by Bloomberg.

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Not all of the stocks within the S&P 500 have benefited from a higher P/E. In fact, it’s just that the expensive stocks have been getting more expensive. The next chart shows the P/E of stocks with a top quintile valuation has expanded to its highest level since the dot-com bubble (are references to this time period beginning to sound familiar?) Adding to value investors’ frustrations is that the cheapest stocks have seen their P/E decline over the past few years. Thus, the investors who have been rewarded with higher returns in recent periods have been the investors chasing the returns from previous periods, not those investors who have tried to buy low and sell high.

While this has been a trying period, it has not altered our investment approach. We still firmly believe that chasing returns by allocating capital to expensive assets is a recipe for disaster over the long-term. Granted, we have been wrong about this for some time.

Why have we been wrong? It seems that we underestimated how much fuel low interest rates would supply the markets. For starters, a big part of this has been TINA’s fault. An acronym for “there is no alternative”, it refers to the fact that with bonds yielding next-to-nothing (or less than nothing in some cases), investors have not been able to generate sufficient returns from fixed-income. Thus, the only alternative has been equities, which has pushed up demand and prices. This supposition is supported by the following chart which shows that U.S. households recently had their highest allocation to equities since the dot-com bubble (there’s that reference again).

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SOURCE: BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM (US)

We believe this ongoing asset price inflation has created a wealth effect; i.e., people spend more money as the value of their assets rise. Thus, it is likely that broader economic growth has benefited from people feeling richer and consuming more.

What now? But the past is the past. What matters now is what the future holds for the economy and the markets. With respect to the global economy, it looks like things are beginning to slow. With threats of a trade war looming, central bankers seem to be wasting no time in providing more monetary stimulus to keep this party going: as of the time of this writing, the market-implied odds of a late-July rate cut by the Federal Reserve were 100%.

But things are different this time. Compared to when widespread monetary stimulus was provided just before the financial crisis, interest rates are already quite low. In 2007 the effective federal funds rate was 5.25%; today it’s less than half of that. And in Europe, rates are so low it’s hard to make sense of them: there is now more than USD$13 trillion of debt with negative yields.3 Stop and think about what a negative interest rate would actually mean: a borrower would be paid to go into debt.

We believe that TINA has pushed investors into riskier assets over the last decade – a period that has been one of the longest economic expansions on record. But what if this expansion comes to a halt? How would these high-priced assets perform? The tailwind from falling interest rates will be much weaker this time around. Equity valuations can’t go

3 https://www.bnnbloomberg.ca/the-world-now-has-13-trillion-of-debt-with-below-zero-yields-1.1276547

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up forever; even the most bullish investor has a limit on how much he or she is willing to pay for $1.00 of future earnings.

What if these valuations actually fell for a prolonged period of time; a scenario that hasn’t been tested in a decade? The next chart illustrates why we are concerned about what the next bear market will look like. It shows that the percentage of companies in the S&P 500 owned by passive funds (which includes ETFs) has doubled since the end of 2010. Why is this noteworthy? Widespread ETF ownership has never been tested in a bear market. If investors rush for the ETF exits, liquidity issues may arise, compounding the effects of a selloff.4

What is an investor to do in today’s environment? Jump on the bull-market bandwagon and hope it doesn’t drive off a cliff? Start trying to get cute by anticipating central bank decisions?

You probably know what our answer is going to be, but it’s not a no-brainer. As disciplined investors, we won’t overpay for assets. But this discipline has left us feeling like the neighbours are hosting a party and we weren’t invited. Expressed more formally, there has been an opportunity cost for us not partaking fully in the market’s recent euphoria. Unlike some major indices, we have not generated a 15% return so far in 2019. This can make us look pretty stupid over the short-term.

4 We previously wrote about this here: https://www.cowanasset.com/blog/etfs-in-a-bear-market/

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But looking stupid isn’t something we’re afraid of. Losing money is. We would rather return 0% if it also meant avoiding a market crash. While investors may benefit from emotional safety by following the crowd, this doesn’t mean they also benefit from financial safety.

Back home We talked a lot about the U.S. in this letter, mainly because the Federal Reserve is making headlines with its probable rate cut at month-end. It seems like the Bank of Canada is much less likely to slash rates (market-implied odds of a cut by year-end are less than 25%), but that doesn’t mean things are materially better here. We’ve raised our concerns about Canadian household debt many times in the past, so we won’t rehash those here. But a risk we’d like to bring to your attention is just how closely our economy is tied to the U.S. economy.

The next chart shows the strong correlation between the U.S. ISM Manufacturing Index (which shows the proportion of U.S. businesses that increased activity during the month) and earnings growth of the S&P/TSX Composite index. As has been said many times before, when the U.S. sneezes, Canada catches a cold. Here’s hoping Canadian businesses have been loading-up on vitamin C as a preventative measure.

Currency markets have also taken note of the perceived rate move differences between Canadian and U.S. central banks. Year-to-date the Canadian dollar appreciated 4.2% versus the U.S. dollar, as traders anticipated that Canadian bond yields would become more attractive compared to U.S. yields after a Federal Reserve rate cut. Since both of our Funds are priced in Canadian dollars, this appreciation of the loonie has caused the Canadian-dollar-denominated value of our U.S. investments to be a drag on performance. If exchange rates were the same at the end of Q2 as they were at the end of Q4, the Canadian-dollar-denominated market value of the investments in the Absolute Return Fund would be 2.6% higher; in the Income Opportunity Fund, they would be 0.9% higher.

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On the bright side Yikes. We just proofread everything above and, wow, this is one of our gloomier letters. So we should probably end on a happier note. Six years ago the Toronto Raptors had missed the playoffs for their fifth-straight season, and at that point in their 18-year existence had won a grand total of one playoff series. Fast forward to June 2019 and we found ourselves taking this picture of Kyle Lowry and the Larry O’Brien Trophy at the Raptors’ first-ever championship parade.

There’s a tendency in sports to assume that the future will look just like the recent past. This same tendency exists among investors. But as the Raptors demonstrated, things can and do change. And we are confident that valuations will eventually change in the markets. It may take some patience and discipline, but we believe that our mindset will be rewarded over the long-term.

Sincerely, Cowan Asset Management investment team