Turtle Creek manager’s commentary for the fourth quarter ended December 31, 2015.

The net asset value of Turtle Creek Equity Fund increased 7.0%1 in the fourth quarter, significantly better than the S&P/TSX Composite index which was down 1.4%. As a result of the strong relative results this quarter, Turtle Creek outperformed the broader Canadian market for the whole of 2015, finishing the year down 1.4% versus the index which was down 8.3%. The U.S. markets had similarly flat results, with the S&P 500, S&P MidCap 400 and Russell 2000 indices posting total returns of +1.4%, -2.2% and -4.4%, respectively, for 20152. However, U.S. market returns were much better in Canadian dollar terms due to the 16% decline in the Loonie over the course of 2015.

Turtle Creek

Turtle Creek’s Portfolio

During the quarter we added two new companies and removed two, bringing the total company changes for the year to four – a rate of change consistent with previous years. The changes to the portfolio this quarter were prompted by relative valuation: two companies that we have been following for a few years had recently become more attractively priced (with no change to their long term prospects) and, as a consequence, had become more compelling as potential additions to the portfolio. At the same time, the share prices of two of our long time holdings (one that we have held in varying amounts since 1999) had risen to such levels that both offered relatively poor long term expected returns. In both cases, we had been reducing the holdings over time as the share prices of each company rose to all-time highs, with the final share sales occurring this quarter.

They are both exceptional companies and we will not hesitate to add them back to the portfolio in the future if they become more attractively priced. However, in each case, they are ‘risky’ in that the market seems to be pricing them for perfection (and beyond?). We don’t mean to suggest that the businesses are risky – there are very few scenarios we can envision where either of these companies is making less money in five or ten years. The risk is that the stock price is no higher, or even lower, in five or ten years.

Turtle Creek – Valuation Risk

As we wrote in one of our earliest annual letters, risk isn’t simply the likelihood of losing money; it is also the prospect of underperforming the market over extended periods. You can pay too much for a great company and suffer years of disappointing investment returns. Think of this as Valuation Risk.

One can gain a better understanding of Valuation Risk by looking at a case study: Fairfax Financial Holdings Limited. Fairfax, with operations spanning the globe, is engaged in property and casualty insurance and reinsurance, and investment management. Fairfax seeks to achieve superior long term investment returns, primarily through the management of its insurance float. It is a terrific company and definitely meets our criterion of being a highly intelligent organization. Since the current management team took over in 1985 (30 years ago) the company has compounded its book value at an annualized rate of 21% – a truly remarkable achievement. And the stock price hasn’t been far behind, rising at an annualized rate of 20% (including reinvested dividends) over the same period of time: $1 invested in 1985 is worth $246 today. For sure, Fairfax’s shareholders from day one are a happy group!

However, let’s look at a subset of Fairfax shareholders: those who invested in early 1999 when the shares traded at $600 per share. Owning Fairfax at that point was risky, from a valuation standpoint. Shareholders who invested in early 1999 would have first seen the price of their investment decline over time and then would have had to wait over 15 years, to mid 2014, before breaking even (including dividends)! As you can see, it’s risky buying into even extraordinary companies, which compound shareholder value at powerful rates over decades, if you don’t pay close attention to valuation.

To be clear, this is not a criticism of Fairfax. Good companies focus on operating their businesses to the best of their ability and communicating with their shareholders as clearly and fairly as possible. They don’t control the price at which investors buy and sell their shares in the open market. During the 15 year period – from 1999 to 2014 – where shareholder stock market returns were zero, the company continued to increase shareholder value, almost tripling its book value.

To be even clearer, we don’t believe owning Fairfax shares today is risky, from a valuation standpoint. We think it is a remarkable company that continues to build a global specialty insurance company, combining strong insurance underwriting results with a superior ability to invest the ‘float’ that arises from the insurance operations. Owning Fairfax Financial at its current valuation levels is low risk compared to most public companies.

The point is, the public market often becomes enamoured with evidently great companies such that the share price rises and rises to levels where being an owner is risky, in the sense that there is a high likelihood of poor investment returns in the future. While part of our job at Turtle Creek is to identify remarkable companies who will compound value for their shareholders over the long term, an equally important part of our job is to make sure we own more and more of these companies when the Valuation Risk becomes lower (i.e., when they are cheap and the long term expected return is high) and own less and less of these companies when the Valuation Risk becomes higher (i.e., when they become more expensively priced and the long term expected return is low). Taken to the extreme, this includes having the discipline to sell positions to zero. That is precisely what we have done this quarter – reduced a couple of our companies to zero, purely as a result of high valuation levels.

The launch of Turtle Creek Canadian Equity Fund

Turning to Turtle Creek itself, in Q1, 2016 we are launching Turtle Creek Canadian Equity Fund (“TCCF”). TCCF will follow the same investment strategy as our flagship fund, Turtle Creek Equity Fund (“TCEF”), except that it will own only Canadian companies. Today, TCEF owns 21 Canadian companies and 4 U.S. companies. TCCF will own the same 21 companies as TCEF as well as an additional 4 Canadian companies in place of the U.S. companies.

We are creating the Canadian fund for some of our existing and prospective investors who allocate to Turtle Creek as their ‘Canadian equity’ manager. It is correct to think of Turtle Creek, to date, as a Canadian equity manager: during Turtle Creek’s 17 years, 98% of the fund, on average, has been invested in TSX-listed Canadian companies. Today, 94% of the fund is invested in TSX-listed Canadian companies and 6% is invested in U.S. companies. We don’t know for sure if the number of U.S. companies and their weightings in TCEF will increase, but if we had to guess we think they may over time. We also may, at some point, own companies whose head offices are domiciled overseas. By forming Turtle Creek Canadian

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