Orbe Brazil Fund- Sep2012

7/31/2019 Orbe Brazil Fund- Sep2012

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ORBE BRAZIL FUNDQuarterly Report - September/2012

Page 1 out o 10Sep/2012

I I were given one hour to save the planet, I would spend 59 minutes defning 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 or those

with less liquidity or that represent not so obvious choices. We will see how things go over the coming reporting periods, but i this

trend continues it could mark a return to higher volumes ollowing a signicant drop since 2011 or less liquid shares. That would

bring a signicant recovery in the prices o these stocks, which remain inadequately priced.

We have repeated, perhaps excessively, that the current prices or some stocks poorly reect the values o the companies themselves.

Part o that repetition comes as a unction o the persistence o the down cycle in the market, which, despite having shown a

bit o recovery this year, continues to penalize a slew o good companies as a unction o specic concerns or macroeconomic

uncertainty. Another reason comes rom our experience o over a decade looking or short-term ineciencies 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 theseparation o air value rom share prices. Now, prices should be reections o the current expectations about uture cash ows

to be generated by an invested asset, discounted by a reasonable required rate o 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 o an alternative

investment (or example, a savings account that would generate BRL 0.06 on the year in this example), plus something or the risk

that he took by investing in the shares o a company (i hes conservative, we can say that this investor might want BRL 0.14 more to

make him indiferent between the savings account and the stock market). That means BRL 1.20 invested in shares a year rom now

is worth BRL 1 in the hands o this investor today. The greater your propensity or risk, the smaller the required rate o return a less

conservative investor might only require BRL 1.10 as sucient to justiy 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

uture cash ows o the companies, or that we have a higher propensity or risk (and thus a lower required rate o return) than the

customary investor who makes up the market, thereore increasing our appetite or shares when others are not inclined to place

chips in variable income instruments.

The truth is that we continually perorm in-depth analysis to determine the amount o risk involved in the uture cash ows o each

o our companies. We also look at the rates o return that we can expect should the money be reinvested instead o 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 dene the use o the


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We should highlight a ew items: the companys monopolistic business model guarantees that it almost always works at ull-

capacity, leaving very little variation in revenues, which grow as the company invests in inrastructure, greater capacity and theelimination o bottlenecks (productivity).

Margins are also pretty healthy, and, with a short-lived exception in 2009, when the global economic crisis had a strong efect on

Brazilian grain exports, they have been airly stable. The company works with a healthy cash cycle, with little or no allocation o

working capital as revenues grow. Finally, its high level o investment in recent years is derived rom a strong efort to increase

capacity (principally via the Rondonpolis project and productivity) and due to required investments in maintenance o BRL 325

million a year.

Finally, it is important to note that we are not taking into consideration the way the company nances its operations. Thereore,

we do not look at nancial costs (the cost o its debt), nor at dividends (the remuneration o shareholders), as part o the equation

at this point. Free cash ow to rm (FCFF) is all cash generated by operations (less investment) to remunerate the creditors and

shareholders who nance the company.

In the last ve years, the companys revenues have grown (8.5% a year), and its ROIC (return on invested capital) was about the

same as its cost o capital (about 10% a year), which means that the companys value did not sufer, despite its intense investment

scheme, a challenging macroeconomic climate, and growing cost pressures that all Brazilian businesses aced during the period

in question.

Beore we look at the projections, or expectations, we need to set a discount rate or the uncertainty o uture cash ows. As we

illustrated in the beginning o this report, we need to discount or those ows at a rate adjusted or risk in order to nd the current

value. The most common way is to use the weighted average cost o capital (WACC) , which looks at the cost o the two sources o

nancing or the company: creditors (capital rom third parties) and shareholders (in-house capital).

The table below shows a simplied calculation o 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 nancial costs can be deducted rom taxes, we need to

adjust this rate in light o those tax benets. In terms o the cost o equity, instead o using the CAPM model, which we have oten

criticized, we can use third-party o capital (debt cost) as a parameter, adding an equity risk premium o 5%, thus arriving at 12.5%

a year. With these assumptions we would have a real WACC o 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 sucientreturn on investment


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Now we can nally look at ALLs uture. 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 ow in this example: the conclusion by

the end o 2012 o the Rondonpolis project (about 2,600 additional TKUs o cargo per year, which represents a 5% increase in

the companys capacity) and the beginning in 2013 o the contract with Eldorado Celulose (about one million tons per year on a

take-or-pay basis). The table below shows the companys uture results, which already include the projected margins that would be

necessary to simulate the expectations contained in the market price o its shares (that is, the only thing diferent below rom the

companys current scenario are prot margins that are signicantly below its current and historical perormance; we will explain

why in a moment).

There will be a small increase in revenues in 2013 because o the two projects mentioned above. As or the rest, we adopted a

conservative scenario o totally stagnant revenue. With the exception o new projects like Rondonpolis, the company tends to

reinvest an amount roughly equivalent to the depreciation o its asset base, without causing major distortions operational cash

ow generation. The projections are real - that is, they do not take into account ination (even though the companys contracts

and tarifs are linked to ination).

Applying the discount rate to the estimated cash ows, we arrive at the value o the company. To determine its equity value, or

the value o the companys shares, we still need to remove the part o 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 o September:



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We can now question the assumptions that led to this number that is, what would need to happen to justiy in objective terms

the current prices (leaving out ear and uncertainty). The most striking o the assumptions is the margins, which are below anything

ever observed. We would need to remove one-ourth o the gross margin we saw in 2011, and a similar amount rom the average

margins or the last ve years.

We need to perpetuate the scenario in which ALL operates, orever, with less protability than that it experienced in its worst recent

year 2009, the year that the 2008 nancial crisis hit the real world. The justiable ear stemming rom the possible efects o the

governments revision o tarifs has already dissipated with the announcement o the new tarif ceilings (which, in the end, will only

slightly afect the company - and now should last or a new 5 years cycle). This reduces even more any real prospects that would

justiy such a permanent deterioration o margins to be modeled.). This reduces even more any real prospects that would justiy

such a permanent deterioration o margins to be modeled.

Secondly, we should note the absence o any real growth, which runs contrary to the results presented by the company throughout

its history (9% per year over the last ve years). It is worth nothing as well that we did not include any growth in the perpetuity;

in other words, it is as i ALL were rozen in time orever, while generating cash ows 25% below the current level. This scenario is

bizarre or a rm 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.



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This is like saying that the additional cash ow generated by the Rondonpolis project will not compensate or the capital invested,

and that all o the other on-going projects Ritmo, Brado, Vetria and others will generate absolutely no value, and that its current

operations are incapable o generating additional income or its shareholders, even though all o the recent developments at ALL

have shown otherwise. Or it might be that the governments proposed reorms will impact negatively on any value that can be

generated until the end o the concessions. Even so, at the current market prices, i will assume that bizarre uture, this asset can

still generate a rate o return o 12.5%, beyond ination, or 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 rst

semester results, caused by a change in the regulations or truck engines (the so-called Euro 5 adoption), which afected and

should continue to afect the entire industry through mid-2013, seem to have been taken as the normal condition or the company.

Schulz, or its part, has just completed a signicant 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 o a more delicate

environment, which will guarantee very healthy margins despite a signicant drop in volumes in its automotive division, and

which will make way or its best margins ever as the market improves.

A similar story unolded with Minerva through mid-2012, as its shares sufered the consequences o a dicult period in the cattle

cycle. As the cycle started to reverse itsel (something that should continue throughout 2013) and as these results became evident,

the expectations o the market rapidly readjusted themselves to a scenario more in line with reality, leading to an appreciation in

share value o over 120% this year.

Anyone who does not expect the end o the world with the end o the Mayan calendar in 2012 (and that includes us) can clearly

see the huge opportunities that these assets ofer at these prices. There are serious recent studies that demonstrate that the

implicit estimates in marhet share prices usually correspond to only a small raction o the cash ows that are actually generated by

the companies in subsequent years that is, independent o who might be more or less optimistic, the customary market reality,

in its non-euphoric moments, errs on the side o excessive pessimism in terms o what it thinks companies can do. In our vision,

we doubt that most o the market is always cheap. That is not the point. But in times o 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 perormance 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 nd cases where these distortions are latent, and we

take advantage o them to make investments where the likelihood o success is best.

So what justies the act that these shares are traded at todays prices?

Here is where the shared distortions o the stock market come into play, both as a question o the expectations outlined above

and because o something we always like to highlight: the esoteric and unounded vision that something is alling because it is

bad, and thereore will all urther, or vice-versa, which implicitly suggests a continuation o things as they are. The human mind is

naturally like that, and we have to struggle against this instinct. It is impossible or most to imagine that next year will be diferent

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



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than this one. Investment decisions, which should be or the very long term, are more distorted by recent events and less afected

by what the undamentals say about uture prospects.

Repurchases vs. IPOs vs. Expectations

The nancial market, like others with a high concentration o established suppliers, ofers a rare case where price trends are ed

back into the process by participants, which impedes reversing direction, rather than helping them along. In a normal industry

sector, when assets all in price, people are driven to buy them (or sell as prices rise), thus creating resistance to brusque shits in

price. In highly concentrated markets, a competitor who raises prices (probably at the expense o market share) tends to create

similar movements by others, increasing the prots o the industry as a whole (a phenomenon that can be clearly viewed in the

mining industry over the last decade, or example).

In the nancial market, where there are widespread actors, the eedback phenomenon is especially extraordinary, albeit

understandable: as share prices are based on intangible expectations, a drop indicates a change in the expected outcome or

someone. Since the uture is uncertain, a sell-of by someone who holds a stock (and who thereore is believed to understand

the asset he owns) tends to inuence the opinions o other actors, driving the movement. Thus speculative bubbles are born, as

are downward spirals. The reverse engineering idea outlined above in the case o ALL ofers an excellent tool to help understand

how shares are priced by actors in the market, and, thereore, to separate the wheat rom the chaf: to understand what the

undamentals are as opposed to what is merely ear and uncertainty. In our next report we will address the moment when the

expectations o actors reverse themselves, and the huge impact this usually has on share prices, using an example o our successul

investment in Minerva, noted briey above.

The act is that market exaggerations, in their absolute extremes, are easier to identiy than they are when we are in the middle o

the road, between one extreme and the other, or when we look at isolated cases, individual companies, because these examinations

are ull o specic opinions about a rms uture.

Thereore, 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 o investors or assets, the greater the incentive or a private owner to let go o his part o a company . On the other hand,

in times o excessive ear, 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 i the price drop is more accentuated.

The chart below clearly illustrates this trend: with each abrupt market drop, the volume o IPOs disappears, while the number o

repurchases increases. As trends move the market upwards, IPOs once again increase until the next drop. Repurchase programs are

obviously more common than new oferings, but the correlation o the requency o these events with market movements clearly

represents a thermometer to help gure out where we are in the cycle.



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Orbe Investimentos is very enthusiastic about company repurchase programs, when or the right reasons. Repurchased shares

that are suciently cheap increase our share o the value in a company at very low cost, and this has proven to be a good way

or companies to use cash ow to increase shareholder value. As we have a habit (or mandate) to buy shares at very discounted

values, it is common or 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 signicant programs in progress. This represents more than hal o our current portolio! The number o repurchase

programs (which would be the sum o the points in the above chart during the last year) or us ofers a great indicator o the level

o disparity between market expectations and the vision o business owners about their uture cash ows. With an adequate dose

o skepticism, we preer to believe in the opinions, and the decisions, o the executives and owners.

The extended drought in IPOs and the increase in on-going repurchase programs are clear indications or us o what the reverse

engineering exercise with ALL tried to demonstrate: there are bargains in the market, created by uncertainty and lower liquidity inthe smaller companies that we work with, which creates a great deal o volatility, little direction and enormous distortions.

In-depth analysis o investment cases not o short-term market behavior in general will leave a clear image o the loss o

correlation between undamentals and price. Some look at this as risk. We look at it as opportunity.



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Fund Summary Characteristics Struture

Value Investing und with long--only equity strategy ocused onidentiying undervalued assetsin the mid cap universe in theBrazilian stock market.

Up to 15 holdingsManagement Fee: 2% a yearPerormance Fee:

20% above Libor + 6% a yearMinimum Subscription: US$ 100kAdditional Subscription: US$ 50kLockup: 1 yearRedemptions: quarterlyRedemption notice: 90 days

Manager: Orbe Management Co.Administrator: CACEISCustodian: Banco Bradesco (Brazil)Auditor: KPMGDomicile: Bermuda

US$ return Orbe Brazil Fund Orbe Value FIA Ibovespa

Sep/2012 4.35% 4.47% 4.04%

2012 -3.52% -3.43% -3.68%Last 6 months -15.51% -15.37% -17.69%

Last 12 months -6.26% -5.99% 3.28%

Last 24 months -23.57% -21.04% -28.89%

Last 60 months - 0,85% -11.37%

Since Inception(Apr/2007)

6.19%(Feb/2003)1703.16%

(eb/2003)839.11%


0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012

Avarage Daily Liquidity of Assets

Above R$ 2 MM Between R$ 2 MM and R$ 1 MM Up to R$ 1 MM

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2012 2012

Corporate Governance

New Market Level 1 Level 2 Tradicional

0%

20%

40%

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80%

100%

2007 2008 2009 2010 2011 2012

Market Cap

Above R$ 3 bi Betwe en R$ 1 bi and 3 bi Up to R$ 1 bi

0%

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60%

80%

100%

2007 2008 2009 2010 2011 2012

Board of Director Nomination

Yes No

0

500

1000

1500

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3000

fev-03

jun-03

out-03

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out-04

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out-09

fev-10

jun-10

out-10

fev-11

jun-11

out-11

fev-12

jun-12

Ibovespa

CDI

FGV-100

Value

0

50

100

150

200

250

300

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

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Orbe Brazil Fund

Ibovespa

R$/US$


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IndexesThe Fund is compared against the Ibovespa, FGV-100 and CDI. The Ibovespa, which is the ocial index rom BrazilianBovespa exchange, is composed o over 40 companies, mainly o large caps with a combined market capitalizationexceeding US$1.2 trillion. The index is very concentrated in 4 sectors: Oil, Mining, Steel and Banks. FGV-100 is anindex calculated using the Stockholders equity o the 100 largest companies listed, except banks and governmen-tcontrolled businesses. CDI is the Brazilian interbank rate, used as reerence or xed-income instruments. Thereare major diferences between the stocks selected by Orbe and Ibovespa and FGV-100 including that Orbe activelymanages very concentrated portolios typically investing in only 8 to 12 companies, rom the 450 listed. The Iboves-pa& FGV-100 are unmanaged and there may be diferences in other eatures including liquidity and volatility.

Disclosure

The contents o this message are intended or inormational purposes only and are not or distribution to and doesnot constitute an ofer to sell or the solicitation o any ofer to buy or sell any securities to any person in any jurisdic-tion. While Orbe Investimentos has done its best to veriy the accuracy o all inormation contained herein, no relianceshould be placed on the inormation or opinions in this communication or their accuracy or completeness, or the pur-pose o making any investment or any other purpose. No representation, warranty or undertaking, express or im-plied, is given as to the inormation or opinions in this communication or their accuracy or completeness, by Orbe Inves-timentos or by their respective directors, ocers, partners, employees, aliates or agents, and no liability is acceptedby any o the oregoing as to the inormation or opinions in this communication or their accuracy or completeness.Any investment inormation is intended or use by proessional investors only. Under US Law, an ofer to buy or sell any securitiesmay only be made through ofering documents in compliance with the Securities Act o 1933 or exemptive provisions there under.Past perormance is not a guarantee o uture returns. All investment strategies entail some risk. When an investment involves a

transaction denominated in a oreign currency, it may be subject to currency uctuations that will have an impact on the valueo the investment in another currency. In addition complex tax structures and delays in distributing important tax inormation,diferences in regulatory requirements and ees. Investments in the emerging markets involve risks not normally associated withinvestments in more developed and economically stable jurisdictions with more sophisticated capital markets and regulatoryregimes. 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 dicult to achieve a desired purchase or sale price or investments or to purchase or sell investments at any par-ticular time. Any investment should not be made without careul reerence to the relevant Prospectus. Nothing herein shall cons-titute an investment recommendation or investment, accounting, tax or legal advice. All content is or inormational purposes only.Under US IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inormyou that any tax advice contained in this communication (including any attachments) was not intended or writ-ten to be used, and cannot be used, or the purpose o (i) avoiding tax-related penalties under ederal, state or lo-cal tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.


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Orbe Brazil Fund- Sep2012