ORBE BRAZIL FUND

Quarterly Report - September/2012

If I were given one hour to save the planet, I would spend 59 minutes defining the problem, and one minute resolving it. - Albert Einstein

We closed the quarter viewing a market in somewhat better spirits. Orbe Values NAV increased in value by 10% during the quarter (up 4.13% in September alone). We began to see a slight recovery in interest in Brazilian equities, albeit somewhat less for those with less liquidity or that represent not so obvious choices. We will see how things go over the coming reporting periods, but if this trend continues it could mark a return to higher volumes following a significant drop since 2011 for less liquid shares. That would bring a significant recovery in the prices of these stocks, which remain inadequately priced. We have repeated, perhaps excessively, that the current prices for some stocks poorly reflect the values of the companies themselves. Part of that repetition comes as a function of the persistence of the down cycle in the market, which, despite having shown a bit of recovery this year, continues to penalize a slew of good companies as a function of specific concerns or macroeconomic uncertainty. Another reason comes from our experience of over a decade looking for short-term inefficiencies that generate incorrect pricing, and the way that we enthusiastically exploit such opportunities. This enthusiasm, in evidence at times when shares are undervalued, sometimes makes us seem optimistic when we advocate the separation of fair value from share prices. Now, prices should be reflections of the current expectations about future cash flows to be generated by an invested asset, discounted by a reasonable required rate of return and adjusted to risk. Imagine a normal investor. For each BRL 1 that he puts into equities, he expects tomorrow the same amount, plus a return above that of an alternative investment (for example, a savings account that would generate BRL 0.06 on the year in this example), plus something for the risk that he took by investing in the shares of a company (if hes conservative, we can say that this investor might want BRL 0.14 more to make him indifferent between the savings account and the stock market). That means BRL 1.20 invested in shares a year from now is worth BRL 1 in the hands of this investor today. The greater your propensity for risk, the smaller the required rate of return a less conservative investor might only require BRL 1.10 as sufficient to justify placing his savings in an asset with less predictable returns. From this, one might then imagine that we merely have above average expectations compared to most people about the projected future cash flows of the companies, or that we have a higher propensity for risk (and thus a lower required rate of return) than the customary investor who makes up the market, therefore increasing our appetite for shares when others are not inclined to place chips in variable income instruments. The truth is that we continually perform in-depth analysis to determine the amount of risk involved in the future cash flows of each of our companies. We also look at the rates of return that we can expect should the money be reinvested instead of distributed. Companies increase their value to their investors when they employ their capital at rates that are greater than the opportunity cost, and our analytical process tries to examine as closely as possible the procedures, projects and people that will define the use of the

Page 1 out of 10 Sep/2012

cash flow that is generated for each of the companies in which we have invested. Therefore, we always feel very comfortable when we say that one of our assets is cheap (or, conversely, when we sell an asset that we believe to be expensive or already appropriately priced). And, also, like all good value investors, we are in many cases investors in balance sheets, taking what a company has today at a discount, and placing less importance on its future cash flows, which are often not very predictable. Our high comfort level is derived not only from the amount of work we put in and the conservative nature of our projections and evaluations. A significant part of the equation comes from understanding which principles the market assumes implicitly in relation to the prices in the daily stock markets. Which assumptions will need to prove true for current market prices to make sense? We can firmly defend all of the investment criteria we use for each of our companies, and by adding them up we can arrive at a valuation that is considerably higher than that seen in the market. But one of most compelling exercises (and one that is easier than defending our own future expectations) involves reverse engineering: which future cash flows would justify the current price of a share on Bovespa? And how realistic do these principles seem when confronted with the real world? Below we will present this analysis, in simplified form, for ALL (ALLL3).

ALL Current Price and Implicit Expectations

An interesting example for this exercise is ALL. We have already discussed its competitive advantages and potential to generate value several times in our qualitative reports. Here are the main data from ALLs results over the last five years:

1 Capital expenditures

Page 2 out of 10 Sep/2012

We should highlight a few items: the companys monopolistic business model guarantees that it almost always works at fullcapacity, leaving very little variation in revenues, which grow as the company invests in infrastructure, greater capacity and the elimination of bottlenecks (productivity).
Margins are also pretty healthy, and, with a short-lived exception in 2009, when the global economic crisis had a strong effect on Brazilian grain exports, they have been fairly stable. The company works with a healthy cash cycle, with little or no allocation of working capital as revenues grow. Finally, its high level of investment in recent years is derived from a strong effort to increase capacity (principally via the Rondonpolis project and productivity) and due to required investments in maintenance of BRL 325 million a year. Finally, it is important to note that we are not taking into consideration the way the company finances its operations. Therefore, we do not look at financial costs (the cost of its debt), nor at dividends (the remuneration of shareholders), as part of the equation at this point. Free cash flow to firm (FCFF) is all cash generated by operations (less investment) to remunerate the creditors and shareholders who finance the company. In the last five years, the companys revenues have grown (8.5% a year), and its ROIC (return on invested capital) was about the same as its cost of capital (about 10% a year), which means that the companys value did not suffer, despite its intense investment scheme, a challenging macroeconomic climate, and growing cost pressures that all Brazilian businesses faced during the period in question. Before we look at the projections, or expectations, we need to set a discount rate for the uncertainty of future cash flows. As we illustrated in the beginning of this report, we need to discount for those flows at a rate adjusted for risk in order to find the current value. The most common way is to use the weighted average cost of capital (WACC) , which looks at the cost of the two sources of financing for the company: creditors (capital from third parties) and shareholders (in-house capital). The table below shows a simplified calculation of this average taking into consideration ALLs capital structure. The interest rate it pays on its debt currently stands at about 7,5% a year, in real terms. Since financial costs can be deducted from taxes, we need to adjust this rate in light of those tax benefits. In terms of the cost of equity, instead of using the CAPM model, which we have often criticized, we can use third-party of capital (debt cost) as a parameter, adding an equity risk premium of 5%, thus arriving at 12.5% a year. With these assumptions we would have a real WACC of 7.7%.

2 The railroad business is normally a natural monopoly, given that there is no competitive parallel railway and no interest in creating one, since the outlays required would not bring sufficient return on investment
Page 3 out of 10 Sep/2012

Now we can finally look at ALLs future. As an exercise, we will ignore any growth, new projects and new business. There are only two events that are certain and that would cause any alteration in the companys cash flow in this example: the conclusion by the end of 2012 of the Rondonpolis project (about 2,600 additional TKUs of cargo per year, which represents a 5% increase in the companys capacity) and the beginning in 2013 of the contract with Eldorado Celulose (about one million tons per year on a take-or-pay basis). The table below shows the companys future results, which already include the projected margins that would be necessary to simulate the expectations contained in the market price of its shares (that is, the only thing different below from the companys current scenario are profit margins that are significantly below its current and historical performance; we will explain why in a moment).

There will be a small increase in revenues in 2013 because of the two projects mentioned above. As for the rest, we adopted a conservative scenario of totally stagnant revenue. With the exception of new projects like Rondonpolis, the company tends to reinvest an amount roughly equivalent to the depreciation of its asset base, without causing major distortions operational cash flow generation. The projections are real - that is, they do not take into account inflation (even though the companys contracts and tariffs are linked to inflation). Applying the discount rate to the estimated cash flows, we arrive at the value of the company. To determine its equity value, or the value of the companys shares, we still need to remove the part of the value that is owed to creditors, equivalent to the current total net debt that the company carries. The calculation is shown below. The estimated value per share is almost equal to the share price at the end of September:

Page 4 out of 10 Sep/2012

We can now question the assumptions that led to this number that is, what would need to happen to justify in objective terms the current prices (leaving out fear and uncertainty). The most striking of the assumptions is the margins, which are below anything ever observed. We would need to remove one-fourth of the gross margin we saw in 2011, and a similar amount from the average margins for the last five years. We need to perpetuate the scenario in which ALL operates, forever, with less profitability than that it experienced in its worst recent year 2009, the year that the 2008 financial crisis hit the real world. The justifiable fear stemming from the possible effects of the governments revision of tariffs has already dissipated with the announcement of the new tariff ceilings (which, in the end, will only slightly affect the company - and now should last for a new 5 years cycle). This reduces even more any real prospects that would justify such a permanent deterioration of margins to be modeled.). This reduces even more any real prospects that would justify such a permanent deterioration of margins to be modeled. Secondly, we should note the absence of any real growth, which runs contrary to the results presented by the company throughout its history (9% per year over the last five years). It is worth nothing as well that we did not include any growth in the perpetuity; in other words, it is as if ALL were frozen in time forever, while generating cash flows 25% below the current level. This scenario is bizarre for a firm with an excellent management team like the one ALL has, and even more so in the logistics business, which is so needed in Brazil and which has such great potential.

Page 5 out of 10 Sep/2012

This is like saying that the additional cash flow generated by the Rondonpolis project will not compensate for the capital invested, and that all of the other on-going projects Ritmo, Brado, Vetria and others will generate absolutely no value, and that its current operations are incapable of generating additional income for its shareholders, even though all of the recent developments at ALL have shown otherwise. Or it might be that the governments proposed reforms will impact negatively on any value that can be generated until the end of the concessions. Even so, at the current market prices, if will assume that bizarre future, this asset can still generate a rate of return of 12.5%, beyond inflation, for its shareholders every year! ALL might be emblematic case, but it is certainly not alone. The same thing happens with Schulz, where hiccups in the first semester results, caused by a change in the regulations for truck engines (the so-called Euro 5 adoption), which affected and should continue to affect the entire industry through mid-2013, seem to have been taken as the normal condition for the company. Schulz, for its part, has just completed a significant capacity expansion program and continues to maintain its number one position in the compressors business not to mention the enviable work it has done to reduce costs by taking advantage of a more delicate environment, which will guarantee very healthy margins despite a significant drop in volumes in its automotive division, and which will make way for its best margins ever as the market improves. A similar story unfolded with Minerva through mid-2012, as its shares suffered the consequences of a difficult period in the cattle cycle. As the cycle started to reverse itself (something that should continue throughout 2013) and as these results became evident, the expectations of the market rapidly readjusted themselves to a scenario more in line with reality, leading to an appreciation in share value of over 120% this year. Anyone who does not expect the end of the world with the end of the Mayan calendar in 2012 (and that includes us) can clearly see the huge opportunities that these assets offer at these prices. There are serious recent studies that demonstrate that the implicit estimates in marhet share prices usually correspond to only a small fraction of the cash flows that are actually generated by the companies in subsequent years that is, independent of who might be more or less optimistic, the customary market reality, in its non-euphoric moments, errs on the side of excessive pessimism in terms of what it thinks companies can do. In our vision, we doubt that most of the market is always cheap. That is not the point. But in times of considerable uncertainly like now, the market with its shared excesses winds up giving strong support to companies that are better known, whose shares enjoy liquidity and whose performance is predictable, leaving aside true opportunities. In any case, little exercises like the one with ALL tend to demonstrate how excess can lead to opportunity. We make it our business to find cases where these distortions are latent, and we take advantage of them to make investments where the likelihood of success is best. So what justifies the fact that these shares are traded at todays prices? Here is where the shared distortions of the stock market come into play, both as a question of the expectations outlined above and because of something we always like to highlight: the esoteric and unfounded vision that something is falling because it is bad, and therefore will fall further, or vice-versa, which implicitly suggests a continuation of things as they are. The human mind is naturally like that, and we have to struggle against this instinct. It is impossible for most to imagine that next year will be different

3 Platt, H., Platt, M., Demirkan S. (2010). Free Cash Flow, Enterprise Value, and Investor Caution. Journal of Private Equity, 13(4), 42-50.

Page 6 out of 10 Sep/2012

than this one. Investment decisions, which should be for the very long term, are more distorted by recent events and less affected by what the fundamentals say about future prospects.

Repurchases vs. IPOs vs. Expectations

The financial market, like others with a high concentration of established suppliers, offers a rare case where price trends are fed back into the process by participants, which impedes reversing direction, rather than helping them along. In a normal industry sector, when assets fall in price, people are driven to buy them (or sell as prices rise), thus creating resistance to brusque shifts in price. In highly concentrated markets, a competitor who raises prices (probably at the expense of market share) tends to create similar movements by others, increasing the profits of the industry as a whole (a phenomenon that can be clearly viewed in the mining industry over the last decade, for example). In the financial market, where there are widespread actors, the feedback phenomenon is especially extraordinary, albeit understandable: as share prices are based on intangible expectations, a drop indicates a change in the expected outcome for someone. Since the future is uncertain, a sell-off by someone who holds a stock (and who therefore is believed to understand the asset he owns) tends to influence the opinions of other actors, driving the movement. Thus speculative bubbles are born, as are downward spirals. The reverse engineering idea outlined above in the case of ALL offers an excellent tool to help understand how shares are priced by actors in the market, and, therefore, to separate the wheat from the chaff: to understand what the fundamentals are as opposed to what is merely fear and uncertainty. In our next report we will address the moment when the expectations of actors reverse themselves, and the huge impact this usually has on share prices, using an example of our successful investment in Minerva, noted briefly above. The fact is that market exaggerations, in their absolute extremes, are easier to identify than they are when we are in the middle of the road, between one extreme and the other, or when we look at isolated cases, individual companies, because these examinations are full of specific opinions about a firms future. Therefore, on the whole, observing trends, it becomes easier to understand what happens in markets, and to understand what traditional market phase we are in. An IPO boom traditionally indicates that things are going too well: the more inelastic the demand of investors for assets, the greater the incentive for a private owner to let go of his part of a company . On the other hand, in times of excessive fear, clear-headed companies with smart, straight-thinking executives repurchase their own shares at huge discounts, in their view, since they know best about their assets and true prospects. This generates more long-term value to an even greater extent if the price drop is more accentuated. The chart below clearly illustrates this trend: with each abrupt market drop, the volume of IPOs disappears, while the number of repurchases increases. As trends move the market upwards, IPOs once again increase until the next drop. Repurchase programs are obviously more common than new offerings, but the correlation of the frequency of these events with market movements clearly represents a thermometer to help figure out where we are in the cycle.

Page 7 out of 10 Sep/2012

Orbe Investimentos is very enthusiastic about company repurchase programs, when for the right reasons. Repurchased shares that are sufficiently cheap increase our share of the value in a company at very low cost, and this has proven to be a good way for companies to use cash flow to increase shareholder value. As we have a habit (or mandate) to buy shares at very discounted values, it is common for companies in which we invest to have repurchasing programs in place. Currently, Embraer ( since January 2012), ALL (August 2011), Minerva (December 2011), Schulz (February 2012), Indusval (October 2011), and Magnesita (August 2012) all have significant programs in progress. This represents more than half of our current portfolio! The number of repurchase programs (which would be the sum of the points in the above chart during the last year) for us offers a great indicator of the level of disparity between market expectations and the vision of business owners about their future cash flows. With an adequate dose of skepticism, we prefer to believe in the opinions, and the decisions, of the executives and owners. The extended drought in IPOs and the increase in on-going repurchase programs are clear indications for us of what the reverse engineering exercise with ALL tried to demonstrate: there are bargains in the market, created by uncertainty and lower liquidity in the smaller companies that we work with, which creates a great deal of volatility, little direction and enormous distortions. In-depth analysis of investment cases not of short-term market behavior in general will leave a clear image of the loss of correlation between fundamentals and price. Some look at this as risk. We look at it as opportunity.

Page 8 out of 10 Sep/2012

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 - September/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

Orbe Brazil Fund Ibovespa R$/US$

3000 Ibovespa 2500 CDI FGV-100

250

200

2000

Value

150

1500

100

1000

50

500

Jan-11

Jul-11

Oct-11

out-03

out-04

out-05

out-06

out-07

out-08

out-09

out-10

out-11

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

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

Orbe Brazil Fund

4.35% -3.52% -15.51% -6.26% -23.57% (Apr/2007) 6.19%

Orbe Value FIA

4.47% -3.43% -15.37% -5.99% -21.04% 0,85% (Feb/2003) 1703.16%

Ibovespa
4.04% -3.68% -17.69% 3.28% -28.89% -11.37% (feb/2003) 839.11%

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

Corporate Governance

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

Market Cap

2008

2009 Level 1

2010 Level 2

2012 Tradicional

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$ 2 MM

2008

2009

2010

2011

2012

Between R$ 2 MM and R$ 1 MM

Up to R$ 1 MM

jun-12

Apr-07

Apr-08

Apr-09

Apr-10

Apr-12

Jan-08

Jan-09

Jan-10

Jan-12

Jul-07

Jul-08

Jul-09

Jul-10

Jul-12

Oct-07

Oct-08

Oct-09

Oct-10

Apr-11

ORBE BRAZIL FUND

Quarterly Report - September/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.

Page 10 out of 10 Sep/2012