Grey Owl Capital Management letter for the first quarter ended March 31, 2016.

“And that’s why we keep the hedges… Because the day we take them off, the game is over.” – Prem Watsa, CEO Fairfax Financial Holdings (at the 2016 shareholder’s meeting)

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Dear Client,

Over the almost nine years we have run the Grey Owl Opportunity Strategy, we have achieved equity-like returns with approximately half the volatility and drawdowns of various equity indices. While the returns have been far smoother than various equity indices, they have not always been smooth in an absolute sense. In addition, our Opportunity Strategy has demonstrated significant “tracking error” compared to just about any index one might choose – i.e. we might go through periods (weeks, months, quarters, years) where the index is up and our strategy is down and vice versa. We are very willing to miss the last leg of a bull market in order to protect capital over the full cycle, and that is what we are doing now – our positioning is the most defensive it has been since 2008. When a market experiences a topping process, perfectly timing an exit is impossible and not our objective. Nonetheless, danger signs that were prevalent in 2000 and 2007 are visible today. The table below summarizes the long-term performance of our “Opportunity Strategy.”

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The first quarter of 2016 and the trailing twelve months were both challenging periods as this performance table for the Grey Owl Opportunity Strategy as of March 31, 20164 indicates:

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Today, the Grey Owl Opportunity Strategy represents approximately 48% of assets under management (AUM) for Grey Owl Capital Management, LLC. Grey Owl Partners, LP (our hedged partnership) represents 25% of AUM, fixed income 21% of AUM, and third-party managed investments represent 6% of AUM. Despite the challenging quarter for our Opportunity Strategy, our fixed income accounts were up approximately 3.5% from January 1 through March 31, 2016. Grey Owl Partners was down less than one percent. Across all of our different accounts, we performed “OK” in a challenging environment.

The biggest culprit hurting performance during both the quarter and the trailing twelve months was Valeant (VRX). At $36/share the stock is down 86% from its August 2015 peak of $264/share. In our Opportunity Strategy, Valeant represents half of our loss over the past twelve months. Despite this, Valeant has been a successful investment historically and as we wrote in our third quarter 2015 letter and we discuss in further detail below, it will be a positive performer over the entire period of our investment even if our current position goes to zero (i.e. we sold more than our entire cost basis at higher prices).

We manage risk and seek return at the asset allocation level, at the portfolio level within each asset allocation bucket, and at the individual security level within each strategy. Despite our most defensive positioning since 2009 at the asset allocation and strategy levels, an individual position can still cause modest damage – as Valeant proves. Going forward, Valeant is a small position and we see upside from the current level.

At the asset allocation and portfolio level, we are prepared for a storm. Fewer than 50% of our assets are in our equity/risk strategy (i.e. the “Opportunity Strategy”) and within that strategy more than 50% of assets are now in cash or cash equivalents. Grey Owl Partners is currently market-neutral and we have very little credit risk in our fixed income portfolios. Which leads us to a brief discussion of philosophy and a parable.

Grey Owl – Philosophy

Fairfax Financial Holdings is a $17 billion market capitalization holding company with a record of compounding book value at 20% annualized for 30 years. To achieve this record, the Chairman and CEO, Prem Watsa has demonstrated a willingness to patiently sit out periods of market overvaluation and risk in order to preserve dry-powder for a day with better opportunities. Since 2010, Fairfax has spent $3.6 billion hedging against the risk of an equity correction and global deflation.

At the annual meeting in Toronto on April 14, Mr. Watsa kicked off the event by addressing the elephant in the room. Parable was the rhetorical method: A barber asks one of his customers if he would like to see the stupidest kid in the world. The customer says yes, the barber puts one dollar in one hand and two quarters in another, then calls over a small boy. The barber then shows the boy what is in each hand and tells the boy he can take the money from either hand. The boy chooses the quarters and walks out leaving the barber to say to his customer, “see, isn’t he the stupidest boy in the world?” Later, the customer sees the boy on the street and asks him why he choose the two quarters over the dollar. The boy responded, “because the day I choose the dollar, the game is over!” Mr. Watsa concluded his story, “and that’s why we keep the hedges… because the day we take them off, the game is over.”

Between 2003 and 2006, Fairfax spent approximately $500 billion on equity and credit hedges before reaping over $4.5 billion in gains on the hedges in 2007 and 2008.5 We concur with Mr. Watsa’s outlook concerning equity valuations and systemic stress across the global economic system. We also concur with his willingness to patiently protect capital when necessary.

Volatility Increases, Large-Cap Equity Indices Move Sideways

The first quarter of 2016 was an extreme version of a tale of two periods. From January 1 through February 11, risk assets collapsed. Then, from February 11 through March 31 (and continuing through the end of April as we write) risk assets violently rebounded.

The following table highlights how this volatility manifested across multiple asset classes.

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The rapid drop and equally forceful rebound to start 2016 mirrored the experience in the summer of 2015.

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Sideways movement of indices coupled with bouts of significant volatility is a common feature of a market top.

A similarly volatile, yet sideways pattern developed in late 2006 into mid-2008.

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Most readers will remember how that story ended, but it is worth revisiting the chart to emphasize the point. From January 2008 through March 2009, the S&P 500 was down 41%.

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Grey Owl – Classic Bear Market Rally

“The Markets Have a Message: Don’t Believe This Rally” was the headline from a March 28, 2016 Wall Street Journal article arguing this is a classic bear market rally, not an all clear sign:

“Traders talk of ‘risk on’ times, and the past six weeks rank as one of the biggest risk-on rallies since the global financial crisis.

Yet the picture isn’t one of wild risk-taking, whatever the headlines appear to suggest. Three of the traditional safe assets to which investors fled in January and early February haven’t fallen back as risky assets gained.

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