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ORBE BRAZIL FUND

Quarterly Report - December/2012

Doubt is not a pleasant condition, but certainty is absurd." - Voltaire Stocks arent cheap and popular at the same time. Unknown
What worked in the stock market in 2012 in Brazil was focusing on liquid stocks, many of them traded at already quite high valuations (and still rising, and rising more), and being heavily themed, making macroeconomic choices and focusing almost exclusively on domestic consumption. We do not do either of these things. As such, this has been a somewhat frustrating year for us, with mediocre returns, although still positive (+6.6% in local currency). To buy a stock that is already trading at the equivalent of 50 times the annual profits that the company generates, and expect it to continue rising because that company will continue to grow, can work at certain times as was seen recently but this is not value investing at all. We also do not focus, as we never have, on liquid stocks, which allow short-term trading, and were the almost exclusive destination of investors in recent periods. Also as a risk management tool and due to self-knowledge (we know what we understand well and what we do not) we are not theme-oriented in any moment, focusing our capital exclusively on consumption, commodities or in any sector whatsoever. We prefer to be sector and macro diversified, bringing different risks to our equity portfolio. This may seem bad in years like the last one with so much dispersion amongst industries in the market, but in our view is an important tool for managing downside risk. It appeared that there were two markets in 2012, one of liquid stocks strongly linked to domestic consumption, and another for the rest. See in the graph below the huge dispersion of movements between different groups of stocks, one containing the companies with high multiples linked to domestic consumption and the other group containing the rest, mainly real estate, industries, banks and exporters.
27,40%

7% 2%

jan

fev

mar

abr Other

mai

jun

jul

ago

set Ibovespa

out

nov

dez

Domestic consumption

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Shares of companies linked to domestic consumption, such as retail, consumer goods and shopping malls, had a bull year with large volumes. Several reached their historical highs, and many are trading at extremes that represent 60 or 80 times their 2012 earnings. Meanwhile industrial or B2B companies, for example, such as our Schulz, Magnesita and ALL in some cases trade at 6 or 8 times their earnings, but are still far from the preference list of most investors. As we know well, everything in the market is temporary. Liquidity has also made a big difference. Our Indusval, for example, despite doing its homework perfectly, advancing on the market that has been left available and entering into several new businesses with great potential, such as in the niche of agribusiness finance, is still totally forgotten and trading at a ridiculous 0.7 times its solid NAV, while other medium banks that are more liquid and well known saw their shares recover well throughout 2012. In the specific case of Indusval, a part of the strategic plan is to address the issue of liquidity of the shares, and in late December the company announced the hiring of a market maker (XP broker) for the first time. In this way, 2012 was a year with a lot of variability among equity funds. And ours, unfortunately, but largely due to its characteristics and the environment, was among those that suffered from results lower than desired, although still positive in Brazilian R$, due to the mismatch between what we do and what particularly worked during this period. This is normal and we have experienced it many times in our existence. Doing something different is often uncomfortable. In the long term, we are convinced of the value generated by avoiding the consensus. In the short term, it is not easy and requires patience.

Expectations, changes and triggers To challenge the theory of market efficiency, and its premise of rational expectations, would implicitly assume that we are not as intelligent and balanced as we like to believe. If the market is not efficient, its agents - including each of us - make mistakes that cause defects in asset pricing. Since it is not much the way of human beings to admit to incapability, it was very much insisted that the group of investors in the market did not make mistakes (or that the sum of their mistakes and successes neutralized each other), and therefore it was not possible to obtain extraordinary gains (or losses) in the stock market consistently and over a long period of time. Given the abundant evidence and new behavioral theories that helped undermine the pillars of the efficient market hypothesis , the perspective has been adapted: there is some inefficiency, sporadic and difficult to capture consistently, such that only a few players can obtain extraordinary returns. That is, most of us make mistakes, but some are more capable than the great mass. This argument is more easily digested since everyone may think they are part of the select talented group and in this way throw the stigma of incompetence to the next investor. In our last report, we showed with the example of ALL (ALLL3) how implied expectations modeled in the price of a stock in the market sometimes contains exaggerations that are incoherent with reality. These are ideal situations for the purchase of a stake in a company, with its solid cash flows poorly reflected in its price. However, in investing, it is not enough to find companies whose prices are incompatible with their economic reality. For real profits to occur, a trigger is needed, something that sets off a movement to correct the market perception regarding the company. There are several types of triggers that can start this movement of re-pricing, but sometimes the best medicine is time - and operating results that come with it. This is the case of our Minerva (BEEF3), the stock in our portfolio that showed the best performance in 2012, which we will explain in details below - and of which we expect a similar strong performance in 2013. When we presented the investment thesis on Minerva almost 2 years ago, in the report for the 1st quarter of 2011, we mentioned how the bovine protein sector works in long cycles of greater or lesser supply, which affect the profitability of the whole chain. At the time, we indicated how the cycles moment was reversing to a phase of sharp increase in the availability of cattle in Brazil, which should improve Minervas operating margins. We also mentioned that a more concentrated market, on which the top 3 companies dominate 80% of beef exports - totally opposite to the historical
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scenario - would create a more conducive environment for negotiating with producers and customers, allowing the company to obtain higher spreads on the volume sold. None of these considerations were based on projections, but only on in-depth analyses of demographic data (cattle herd, in this case) and qualitative analysis of the market, competitive positioning and Minervas management. There is no magic or esotericism. So as not to say that we have no credit, we had energy to delve into a complex industry without "pre-conceptions". But the honest truth is that the future improvement of results was quite obvious, ridiculously poorly priced and ripe to be exploited by anyone who was not eternally perpetuating the results at the time of our initial investment. The triggers for moving the stock price were missing. Normally listed as the potential levers of unlocking value are events such as an acquisition or sale of material assets, a liquidity event (change of control, stock offering), or regulatory changes. In the case of Minerva, there was nothing so drastic, but a sequence of beneficial events of a smaller scale pushed the company's stock in an uptrend throughout 2012 until the announcement of the follow-on offer in November.

Several events have improved market perception regarding the company's ability to deleverage the main risk factor associated with Minerva , the margin levels that can be achieved in this industry, and, consequently, the real value of the company. We believe that the positive results will continue to appear as the cycle of increased cattle supply reaches its most acute moment, giving sequence to the correction of the price-value distortion that still exists in the companys stocks. As Minerva works with high leverage, it is natural that the largest share of its future expected cash flows be directed to pay the company's creditors, with the residual flows composing the shareholders return. When expectations regarding the companys margins and debt servicing capacity improves, the whole additional cash is captured by the shareholders. A one percentage point improvement in the EBITDA margin on revenues as high as Minervas (about R$ 4 billion) creates R$ 30 million (after tax) of additional flow per year for an equity value assessed at the beginning of 2012 at R$ 500 million. If we perpetuate this additional flow, each point of the EBITDA margin earned and carried to the market valuation models would increase the theoretical value of the equity at the beginning of 2012 by 67%. As the market incorporates these expectations of better margins to mathematical models, the natural dynamics takes

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the stock to a price that reflects more accurately the new set of expectations. It is no surprise, therefore, that there was an appreciation of 122% for the stock throughout 2012. The graph below illustrates the percentage of the enterprise value (market value of the company plus its net debt) belonging to shareholders of Minerva, as market value of equity. It shows clearly how the improvement of future performance expectations reflected directly in the value appropriated by the equity holders.

Oferta Follow-On: R$ 412.5 MM

Obviously triggers can work both ways. Some changes destroy enormous shareholder value, and are almost instantly reflected in stock prices (invariably with some exaggeration). A good example is the recent case of the Brazilian government's proposal for compensation of non-amortized assets of energy companies with concessions near end, far below the most conservative expectations from most stakeholders and generating such a large uncertainty about the future of the companies that it is practically impossible to evaluate them. For Minerva, the greatest risk that can unlock a negative trigger is sanitary. This is a risk inherent in the food business, and for this reason we constantly monitor it. In the last weeks of December there was an unfounded news story, poorly transmitted by the local press, about the existence of a case of "mad cow disease" in Brazil. This "fact" was magnified with certain irresponsibility by several media outlets, leading to the block of some peripheral markets for our beef exports. All the facts show that there was no reason for such a stir: it was an old case, a cow of advanced age that did not die or even express the BSE disease. It just had the proteins associated with the disorder. Similar cases occurred in Europe and the USA 60 times in recent years, without any impact to local agents. The stock market, however, mixed things up and in yet another failure of rationality, took the senile cow for a mad cow, penalizing the shares of Minerva severely in the last month of the year. As we are fully convinced that there is no real risk in the event, we did not hesitate to increase our exposure again, and we are convinced that we will continue bringing large returns in 2013. The Follow-On Offer We have already complimented the quality of Minervas management several times in our reports. The decision to sell additional shares in November, although it temporarily stopped the strong appreciation cycle of its shares, was correct. In addition to strengthening the capital structure of the company, the offer goes in line with the proposed change in the level of liquidity of the shares and the ambition of the future plans of the company. Still, the recent stock rise cycle allows the offer - though in a market still very restricted - to be attractive to new investors, and also generates value for current shareholders. The dilution of value imposed by an issue price still below the fair value of the stock is opposed by the obvious value creation possibilities opened by the new capital due to the positive cycle the sector is in and the
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value of deleveraging in the perception of the companys risk and financial cost. These potential gains are also open to new investors, who still had strong incentives to subscribe to the offer, as indeed happened. It is the optimal use of the capital market in order to create value for all parties.

Portfolio Triggers - other The same phenomenon that could be observed with Minerva has a high likelihood of occurring with ALL, whose prices reflect implicit assumptions of stagnant revenues and margins severely worse than those actually delivered by the company, as we discussed in the last report. The truth is that CONAB (Brazils Food Supply Agency) estimates of an increased crop for 2012/13 (+9,5%) paint a positive outlook for demand, and the freight conditions in the competing trucking market (more regulation, less supply with Euro V restrictions) create strong pricing power and should greatly boost the company's results. Furthermore, the startup of Eldorado Celulose, a new large client in take-or-pay contracts, and the entry into full operation of the big rail extension to Rondonpolis, will bring new relevant cash flows. There are also specific triggers, such as capitalization events for Brado or Vetria projects, or signs by the government of greater respect for signed contracts. Finally, even the completion of the negotiation of Cosan's entry into the control group (at R$23/share, in the original proposal, compared to a current R$ 9 market price) can function as a clear signal of the actual value - and of a new alignment in the control/management of the company. Triggers of events usually have an immediate impact on share price, especially when they show a hidden value in the company's balance sheet. In Magnesita (MAGG3), a capitalization through a strategic partner in the graphite project should remove the short-term concerns of the market with the business of refractories for the steel industry. This project, one among many potential ones across a broad range of mining rights owned by the company, has enormous potential value for the company, but is largely ignored in the assumptions embedded in its current market value, which already badly represents its current operations. Suzano (SUZB5), which despite the emotions caused by the stock offering in mid 2012, ended the year with a slight appreciation (+4.2%), without generating us losses, should also have a good period of triggers going forward, with the evolution of the Maranho and Suzano Renewable Energy projects. On the last day of the year in 2012, after the market had closed, there was the announcement of the sale of its stake in the hydroelectric plant Capim Santo for the good amount of R$ 320 million. To understand what are the possible mechanisms that will unlock the value that seems not to be perceived - and thus also to understand what are the assumptions made by the market for the company in question - is as important as finding an asset with great potential returns. After all, a potential that is not exploited eventually becomes just a waste of allocated capital. In an environment as we have seen in the market in 2011 and 2012, the extraction of value and changes in expectations regarding companies take longer. There is a lack of investor interest for more complex cases, as well as liquidity in the shares of smaller companies. Yet nothing in the market lasts forever, and while companies are creating value in their daily operations, and that value is not recognized in the share price, the larger becomes the gap between price and fair value that we seek.

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ORBE BRAZIL FUND


Fund Summary
Value Investing fund with long-only equity strategy focused on identifying undervalued assets in the mid cap universe in the Brazilian stock market.

Quarterly Report - December/2012


Characteristics
Up to 15 holdings Management Fee: 2% a year Performance Fee: 20% above Libor + 6% a year Minimum Subscription: US$ 100k Additional Subscription: US$ 50k Lockup: 1 year Redemptions: quarterly Redemption notice: 90 days

Struture
Manager: Orbe Management Co. Administrator: CACEIS Custodian: Banco Bradesco (Brazil) Auditor: KPMG Domicile: Bermuda

300

3000

Orbe Brazil Fund Ibovespa R$/US$


2500

Ibovespa CDI FGV-100 2000 Value

250

200

150

1500

100

1000

50

500

out-03

out-04

out-05

out-06

out-07

out-08

out-09

out-10

out-11

Jan-08

Jan-09

Jan-10

Jan-12

Jul-07

Jul-08

Jul-09

Jul-10

Oct-07

Oct-08

Oct-09

Oct-10

Jul-12

Jan-11

Apr-11

Apr-07

Apr-08

Apr-09

Apr-10

US$ return
Dez/2012 2012 Last 6 months Last 12 months Last 24 months Last 60 months Since Inception

Orbe Brazil Fund


5.46% -2.14% 10.93% -2.14% -30.24% (Apr/2007) 7.71%

Apr-12

Oct-12

Jul-11

Oct-11

Orbe Value FIA


6.14% -1.08% 12.17% -1.08% -28.89% -0.65% (Feb/2003) 1729.83%

Ibovespa
-3.03% -1.42% 10.92% -1.42% -28.29% -17.30% (feb/2003) 854.96%

100% 80% 60% 40% 20% 0% 2007

Corporate Governance

100% 80% 60% 40% 20% 0%

Market Cap

2008

2009 Level 1

2010 Level 2

2011 Traditional

2012

2007 Above R$ 3 bi

2008

2009

2010

2011

2012

New Market

Between R$ 1 bi and 3 bi

Up to R$ 1 bi

100% 80% 60% 40% 20% 0% 2007

Board of Director Nomination


100% 80% 60% 40% 20% 0% 2008 2009 Yes No 2010 2011 2012

Avarage Daily Liquidity of Assets

2007 Above R$ 3 MM

2008

2009

2010

2011

2012

Between R$ 3 MM and R$ 2 MM

Up to R$ 1 MM

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fev-03

fev-04

fev-05

fev-06

fev-07

fev-08

fev-09

fev-10

fev-11

jun-03

jun-04

jun-05

jun-06

jun-07

jun-08

jun-09

jun-10

jun-11

fev-12

jun-12

ORBE BRAZIL FUND

Quarterly Report - December/2012

Indexes The Fund is compared against the Ibovespa, FGV-100 and CDI. The Ibovespa, which is the official index from Brazilian Bovespa exchange, is composed of over 40 companies, mainly of large caps with a combined market capitalization exceeding US$1.2 trillion. The index is very concentrated in 4 sectors: Oil, Mining, Steel and Banks. FGV-100 is an index calculated using the Stockholders equity of the 100 largest companies listed, except banks and governmentcontrolled businesses. CDI is the Brazilian interbank rate, used as reference for fixed-income instruments. There are major differences between the stocks selected by Orbe and Ibovespa and FGV-100 including that Orbe actively manages very concentrated portfolios typically investing in only 8 to 12 companies, from the 450 listed. The Ibovespa& FGV-100 are unmanaged and there may be differences in other features including liquidity and volatility. Disclosure
The contents of this message are intended for informational purposes only and are not for distribution to and does not constitute an offer to sell or the solicitation of any offer to buy or sell any securities to any person in any jurisdiction. While Orbe Investimentos has done its best to verify the accuracy of all information contained herein, no reliance should be placed on the information or opinions in this communication or their accuracy or completeness, for the purpose of making any investment or any other purpose. No representation, warranty or undertaking, express or implied, is given as to the information or opinions in this communication or their accuracy or completeness, by Orbe Investimentos or by their respective directors, officers, partners, employees, affiliates or agents, and no liability is accepted by any of the foregoing as to the information or opinions in this communication or their accuracy or completeness. Any investment information is intended for use by professional investors only. Under US Law, an offer to buy or sell any securities may only be made through offering documents in compliance with the Securities Act of 1933 or exemptive provisions there under. Past performance is not a guarantee of future returns. All investment strategies entail some risk. When an investment involves a transaction denominated in a foreign currency, it may be subject to currency fluctuations that will have an impact on the value of the investment in another currency. In addition complex tax structures and delays in distributing important tax information, differences in regulatory requirements and fees. Investments in the emerging markets involve risks not normally associated with investments in more developed and economically stable jurisdictions with more sophisticated capital markets and regulatory regimes. Such risks include political, economic and currency risks and the risk associated with investing in underdeveloped legal, regulatory and accounting environments. In addition, investments are volatile, and have limited liquidity, transparency and depth, which may make it difficult to achieve a desired purchase or sale price for investments or to purchase or sell investments at any particular time. Any investment should not be made without careful reference to the relevant Prospectus. Nothing herein shall constitute an investment recommendation or investment, accounting, tax or legal advice. All content is for informational purposes only. Under US IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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