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…it ain’t about how hard you hit. It’s about how hard you can get hit and keep moving forward…if you know

what it´s worth, then go out and get what it’s

worth, but you gotta be willing to take the hits1”

(Rocky Balboa, Character)

In this letter, we cover the

following topics:

• Challenges in the current

scenario

• Decision making capacity

under stress

• Performance and results

We will also deep dive into

Vulcabras, a new position in

our portfolio.

Enjoy the reading!

HIX Capital is an independent asset management firm focused on investing

in Brazilian Equities. We manage local (BRL) and offshore (USD) funds whose

goal is to maximize return on invested capital through a concentrated

portfolio of high quality companies. In other words, we look to invest in

companies that: have simple business models; (b) are well managed; and

(c) offer compelling potential returns. We strive to achieve the deepest

possible knowledge about the companies and sectors we invest in.

About HIX Capital

1 In fact, the original citation is, “…it ain’t about how hard you hit. It’s about how hard you can get hit and keep moving forward…if you know what you’re worth, then go out and get what you’re worth, but you gotta be willing to take the hits”. We made this jocular adaptation as a provocation on the difficulties in investing again the market.

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Dear Investors,

During the 2nd Semester of 2018, the HIX Equities 1 SP (USD offshore fund) presented a 10.9% gain, whilst the USD Ibovespa increased by 20.6%. Since the fund’s inception (September 2016), the HIX Equities 1 SP has presented a 5.3% gain versus a USD Ibovespa gain of 29.1%. Since the fund was fully allocated, at the end of November 2016, it presented net returns of 13.3% versus the USD Ibovespa of 24.0%. The HIX Capital FIA, HIX Equities 1 local mirror fund, has accrued gains of 121.5% compared to 54.0% of the Ibovespa index back to the funds launch in August 2012. When considering risk as the probability of permanent capital loss, we believe we have reached these returns with lower risk when compared to the Ibovespa. We always look for solid companies with defensive business, with the objective of achieving the best returns based on assumed risk. Please note that the performance numbers included in this letter from this point on refer to the local fund (in BRL).

2018 marked the 7th year anniversary of HIX’s existence; without a doubt, this was one of the most challenging years from a portfolio management point of view. Macro variables dominated Market movements and made company fundamentals temporarily less relevant. This was not the first test we have passed as a company, and we are sure it will not be the last. We remain faithful to our principles and investment philosophy; we seek to improve our processes and continue to strengthen our team, always aiming to achieve best in class results in the long term.

Amongst the various issues that we have debated and analyzed in recent months, we believe there are two interesting issues to be shared with our investing partners. The first is the large movement that occurred in relation to the prices of small and medium-sized companies (more illiquid names). The second is the great paradigm shift that is occurring in some sectors of the economy and its impact on the companies we cover.

Paradigm changes in sectors (and companies)

As markets are very volatile and in the short term there may be significant price distortions, we believe that the best way to invest is to buy companies that, if the Bovespa stopped trading today, we would still like to keep in our portfolio for 20 years. Charlie Munger, investment guru and Warren Buffet’s partner, sums up the reason for this: “if a business earns 6% on capital (…) and you hold it for that 40 years, you’re not going to make much different than a 6% return (…) Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” In short, the most important factor in the long-term return of equities is the return on capital that invested companies can generate. With this point of view, we could draw a simple cake recipe:

This has worked very well in Brazil for the last 10-15 years. There were many examples of companies who focused on the domestic market, with the characteristics described above, that traded at prices that allowed good returns. It seemed easy to follow the precepts of the above recipe; less deviations, the better – better to avoid distractions. How do we think about technology companies? Better stay away from what we do not profoundly understand. How about companies that sell commodities? Cyclicality makes it difficult to find the “right” entry price, best avoid them…

1. Buy companies in growing industries2. Which are dominant in their sectors3. Havereturnoncapitalsignificantlyabovetheircostofcapital

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The accelerated rate of changes in the global economy has led to companies having less time to surf the wave of stability in the competitive environment, stifling efforts to push for really high growth. As managers, we must be more attentive to changes than ever before:

Buying shares of the largest private Brazilian banks was, for a long time, one of the most profitable and obvious investments in the local stock market. The sector is an oligopolywith great pricing power and growing at attractive rates. However, companies such as PagSeguro, Stone, Nubank and XP Investimentos are beginning to threaten their most profitable business units, such as credit cards, investments, services and insurance. This movement, although not yet overthrowing the incumbents, has already managed to leave its first cracks in their armour (such as Credit Card Acquirers).

Another sector that generated great value to its shareholders was fuel distributors. Demand has been resilient and increasing for many years, and the oligopolized characteristics of the industry have guaranteed extraordinary returns. However, recently competition seems to be increasing significantly. Global giants like Total, Glencore and Vitol bough regional distributors (Zema, AleSAT and Rodoil, respectively) showing appetite to change the low competition structure in this sector. As if that wasn’t enough, there is also the threat of electric cars. How will an array of electric vehicles change the profitability and growth potential of a fuel distributor such as Ipiranga?

So, best to invest in shopping malls? But what if, in big cities, services such as Uber reduce demand in parking lots (a relevant source of revenue for these establishments)? And what about the possible impact in the drop of consumer frequency in shopping malls, due to the growth of e-commerce?!

What about the stability of competitive advantages? The scale in shopping and distribution has long been the great fortress of the large retailers over their competitors. That was the big reason that made Walmart the giant it is today. However, today’s technology has brought consumers and businesses closer together, reducing barriers, thereby reducing the value of size and scale. At the same time, the speed in which information circulates makes the quality of service increasingly important.

Today it is impossible to ignore the impact of technological changes on individual habits and, consequently, the profitability of traditional businesses. This effect of change and disruption is nothing new. What seems to have changed is the speed in which a new entrant can decimate the incumbents’ competitive advantages. The speed of change has been steadily increasing, and the impact on incumbents has become more significant. In this sense, the growth of PagSeguro and Stone, which captured Cielo and Rede’s market share, is a very emblematic example. In about three years, these small companies have managed to get out of irrelevance to take a combined 28% stake in the industry pool. This scenario would be unthinkable some years ago for any analyst who looked at these company’s competition against industry giants Itau, Bradesco, Banco do Brasil and Santander.

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Source: Credit Suisse Research

All these changes have shifted paradigms in terms of competitive advantages, meaning these need to be constantly revisited in order to seek good returns in the market. At HIX, we try to be always attentive and flexible to changes, which means that the current situation is not so different from what we always experience in the market. However, the speed of change seems to have increased, and because of this we need to redouble our attention to risks. Just like a diver in troubled waters, the future of business seems to have low visibility today. Some conclusions regarding what we should be attentive to in this environment are:

i. It may make more sense now to pay valuation premiums on businesses with a low risk of disruption (or at least until the industry scenario becomes clearer)

ii. On the other hand, sectors where said risk is clearly noticeable and which aren’t well priced (have a lot of discount) should be avoided

iii. Managers cannot afford to ignore technological changes in the business environment that are occurring in Brazil and in the rest of the world. We are already concentrating our efforts in this direction.

iv. The quality of the business management team is increasingly important. High-performance groups, always focused on evolving, are more likely to be able to anticipate changes and / or react to them and reinvent themselves. Companies and teams will be increasingly tested and will have to put those skills to the test.

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Several very interesting opportunities has come to light in this environment where some companies have lost liquidity, and consequently were excluded from the analysis filters of most investors. Often, human psychology leads the market to make wrong decisions or perform incorrect analysis because it is under the effect of pain related to some relevant loss in a given asset. Daniel Kahneman, winner of the 2002 Nobel Prize in economics, and his research partner Amos Tversky, defined the concept of loss aversion2, and explained that the pain caused by a loss is psychologically twice as strong as the pleasure of winning. Therefore, people tend to take more risks to avoid losses than to seek gains. We believe that this effect, taken to extremes, causes some companies to become undesirable at any price. We have chosen a few cases to better illustrate this concept (and which were not part of HIX’s portfolio), and what happened in the past, in order to show how, in the short term, prices can deviate from fundamentals:

2018 was tough for small and mid-cap companies. The volatility associated with the electoral news flow and the “wait and see” mode of international investors joined the uncertain external environment, causing flows for Brazilian equities to be determined mainly by “macro” factors. In this environment, contrary to market perception, the liquidity of small and mid-caps has in fact decreased while only mid/large have gained liquidity. This has negatively affected the valuation of smaller companies, a phenomenon we believe will gradually be reversed throughout 2019, as the economy should begin to pick up. The table below demonstrates this phenomenon from two perspectives: (i) Comparing the average liquidity of Brazilian equities in the last 3 months in relation to the last 24 months, with the same shares subdivided by market cap (small, mid and large) and (ii) the same analysis deployed according to liquidity ranges (less than R$ 500 thousand per day, between R$ 500 thousand and R$ 2 million, and so on):

Source: Bloomberg

2 Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk.

Kahneman, D. & Tversky, A. (1992). “Advances in prospect theory: Cumulative representation of uncertainty”. Journal of Risk and

Uncertainty. 5 (4): 297–323

Decision making under stress (and opportunities that arise):

The best and simplest way to look at the stock market is always to assume that people are rational and that everything that is known and relevant is already priced in. This is true most of the time and in most assets. However, the complexity of human psychology sometimes creates some distortions of perception in some assets that generate great possibilities of profits (or losses).

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Shortly after its IPO, CCR, which had raised debt in USD, went through a period where investors were concerned about the companies’ solvency . Investors panicked and did not want the stock at any price, leading to a 68.1% drop in a short period of time. Many investors sold their shares at that time to avoid larger losses:

On the other hand, those who invested in the company’s IPO and were cold-blooded enough not to panic, believed in the company’s fundamentals as well as the promise and ability to reorganize their balance sheet, and who did not sell their positions saw their capital multiply by fourteen times in 10 years. Meanwhile, those who sold their shares at the time of greatest stress saw share prices multiply 41-fold in subsequent years.

CCR (CCRO3) in 2002:

Since its IPO in 2011, through 2015, Magazine Luiza investors had experienced the loss of 94% of their initial invested capital. In 2015 alone, stock price was down 71%.

MAGAZINE LUIZA (MGLU3) in 2015:

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Investors who bought in at the IPO and had cold blood to hold on to their position during the crisis and believed in the transformation that Frederico Trajano was implementing in the business saw their shares reach ~R$ 180, or 11x their original invested capital. Those who sold during the end of 2015 saw the shares multiply by 180x in subsequent years, the largest capital multiplication in the Brazilian equities market in recent decades.

Locamérica’s stock underwent similar movement. After a successful IPO in 2012, the stock reached R$ 13,30 before beginning a painful devaluation process, reaching R$ 2.64 / share in April 2014.

LOCAMÉRICA (LCAM3) in 2012:

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Those who could not stand the drop missed out on 15x capital multiplication from April 2014 and more than 5x since the companies IPO.

These three examples are not a superficial attempt to argue that whenever a company’s share price decreases a lot, it becomes a great opportunity. Some companies can actually declare bankruptcy, whilst others become value traps3

due to lousy fundamentals. On the other hand, very significant devaluations are also not necessarily the harbinger of the end of life of certain companies. At certain times the “collective pain” of investor psychology drives them to push certain stock prices to valuations that completely mismatch from their fundamentals. For any investor it is extremely important, at this time, to seek deep knowledge on company fundamentals to make the right and consistent decision.

As we mentioned earlier, many small businesses suffered during 2018, with stock prices falling 30 to 50% across the board. That means that just to get back to their starting point, these companies would have to rise by more than 50% or in some cases even 100%. Tecnisa, Vulcabrás, Qualicorp, Biotoscana, Kraft Heinz, BR Properties, Alliar, Smiles and AES Tiete are all some examples of companies in our coverage universe that went through a similar movement. Unfortunately, we do not believe that all of them will become and extraordinary investment opportunity (and we have in fact divested from these positions), whilst others will become excellent companies to bet on. We will continue to be very careful in our investment process, choosing a few companies to place our bets on, and comparing them with other opportunities available in the market.

3 Companies that, although considered cheap from a valuation point of view, will remain cheap due to worsening results and

fundamentals.

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Portfolio

The main contributors to the Fund’s performance in 2018 were:

During the second half of 2018, as always, we made some changes in the portfolio’s composition. Of the 22 companies that were part of the portfolio on June 2018 (with 93.2% exposure), we divested from 5 companies, representing 11.2% of the portfolio. Four of these sales were motivated, for the most part, by changes in the perception of said companies’ fundamentals and perspectives, and one was influenced by valuation. On the other hand, we added 6 new companies to the portfolio, of which 2 had already been part of the fund in the past. The largest fund position in December 2018 were (in descending order): Eneva, Biotoscana, Klabin, Jereissati Participações and Sanepar. Together, the top 5 accounted for 47% of our portfolio, and cash level was at 4%.

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Results Review (HIX Holding Simulation)

Despite our portfolio companies delivering results in line with our expectations during 2018, stock prices just didn’t keep up. Although most companies still haven’t reported their 4th quarter results, there shouldn’t be any surprises. Thus, it is possible to say that 2018 was a good year for the companies in our portfolio, but that this was not reflected in materially larger multiples, as should nornally be expected. We believe that our portfolio continues to be well positioned, comprised of excellent companies, positioned in interesting markets, managed by competent professionals, and well-priced with significant safety margins for their intrinsic values. Over time, these should have price changes similar to the changes in their profitability.

The second half of the year corrected a few of the strong price distortions seen until the month of June. With the positive portfolio performance in the last 6 months of the year, the average multiple of HIX’s portfolio, if frozen, would have increased from 10.2x to 10.8x. When recalculating this multiple, and adjusting it based on our expectations of 2019, two effects deserve to be highlighted:

Thus, the P/E multiple of the current portfolio, revised for 2019 (P/E fwd), is 10.6x. This multiple is quite attractive compared to the history and quality of the portfolio. The expected profit growth for HIX’s portfolio companies in 2019 is 28%. The expected average IRR for portfolio companies for the next 5 years is 20.2%, a little lower than the number we had in June 2018, but still at an excellent level.

• We have made a few changes to the portfolio, building positions in some companies that are tradinginmultiplesthataresignificantlyhigherthanpreviousaverages(suchasTotvs,HapvidaandBRProperties),aswebelievethatthesecompanieshaveveryhighprofitpotential.Onthe other hand, we decreased and divested exposure to companies that traded at lower multiples, such as Braskem, Qualicorp and Itausa.

• It should be noted that the expectation for strong growth in 2019 compared to 2018 causes the average multiple to decrease again.

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Investment Thesis Update

Vulcabras AzaleiaDecades of experience in sports shoes

In this letter we will address a new investment thesis in the retail segment, in an industry that has invested little in recent years but has returned to our radar and subsequently to our portfolio. A more favorable economic environment, coupled with the fact that we found a high-quality company at a valuation that offers a high margin of safety, led us to set up a medium-sized position in Vulcabras (VULC3) shares.

History

Founded in 1952, Vulcabras is a show manufacturer that started its Operations through the licensing, manufacturing and sales of international brands, such as Adidas, Puma, Reebok and Keds in the Brazilian market4. At the same time, the company built its own set of brands, such as Vulcabras, Opanka and Dijean. In 2007, anticipating the termination of its licensing with Reebok in Brazil (which was eventually acquired by Adidas) the company bought Azaleia, which owns the brands Azaleia and Olympikus. From that moment onwards, the company decided to focus on the development of its own brands. Azaleia’s manufacturing structure was complex (25 factories and 47.000 employees), and along with management problems and the crisis that hit the country, the company’s financial situation became very delicate. In 2012 shareholder decided to hire Galeazzi & Associados (renowned business restructuring consultants) to help run the company’s operational turnaround.

Over the next 4 years, the company reduced the number of factories from 25 to 3, adjusted its staffing, improved its internal processes, reshaped its product line and strategy, and reorganized its business model so that it could react in a more quick and assertive manor towards retail demands (one of the main competitive advantages in relation to international brands that do not have plants in Brazil). They were subsequently able to substantially improve operational results, as shown below:

4 Joint Ventures

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At the end of 2017, the company executed a Follow-on and used the subsequent resources to pay off its debt and prepare to continue its growth strategy. After the offer, the company had its corporate structure changes and the Grendene family remained in control with 69%, whilst 31% of the company remained free float.

Finally, with the turnaround process, the change in commercial strategy and the capital increase carried out in 2017, the company prepared for its new expansion cycle, with and adequate capital structure and ROIC among the best in the sector (see below ROIC of major retail peers):

We believe that one of the company’s main assets is its brands (in addition to the strong manufacturing structure, product development know-how and commercial strength), which follows a summary analysis of the company’s 3 main brands: Olympikus, Under Armor and Azaleia.

5 Kantar

Olympikus

Olympikus is the leading sports footwear brand in Brazil, with a market share of just over 10%5. Surveys by Kantar show that Olympikus has gone from 16% in consumer preference to 22% between 2014 and 2017, ranking second only to Nike.

The Company has relevant sales capillarity in the sports segment; there are 55 commercial representative offices with more than 300 people dedicated to sales and merchandising throughout Brazil:

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Olympikus has a very efficient local manufacturing facility so that it can be flexible in terms of delivery time and delivery grid. In addition to this, the company can be close to the costumer, understand their sales and work better with replacements, a model that international brands have yet to replicate, according to the comparison made in the following chart:

We understand that the Olympikus operation is already well set in terms of sales and should continue to grow in line with the sports footwear market. On the other hand, there is also the opportunity to further modernize the industrial process that the company is already running, which can result in significant improvement in the company’s margins in the coming years.

Under Armour

In the end of 2018, Vulcabras concluded the acquisition of Under Armor Brasil at attractive terms, and now has the right to market the brand for at least 10 years. This new opportunity in the sports segment complements the company’s portfolio with a premium brand that is already the third largest in the world. Additionally Under Armor has a strong clothing line, a market in which Olympikus intends to grow, and expertise in product development, access to sourcing and sales channels, which can help leverage the segment sales within the Olympikus brand.

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The Under Armour brand is still not well known in Brazil, and Vulcabras’ expertise in the development of products for the local sports segment, aligned with its commercial capillarity and factory agility, can be essential to make the brand the same success it is in the USA.

Currently Under Armour has less than 1% market share in Brazil, and we believe that the brand has the potential to at least double its position and have sales of around R$ 500 million by 2023 (in the US, the brand represents 2.5% of all footwear market share and 5.2% of clothing).

Azaleia

Sports footwear industry has a strong growth trend, both in Globally and in Brazil

Azaleia was once an important brand of women’s shoes in the past (Top of Mind brand in 2013vv) and still has relevant recall. This is not reflected in the size of the current brand, which has less than 3% market share of the women’s shoes segment.

The sports footwear market is highly driven by the pursuit of healthier habits and the growth of the fitness and running categories in the day to day population. In the last 23 years, the 6 largest brands in the segment grew 7.7% YoY, compared to global GDP of 4.7%7 in nominal terms. Even in the last 10 and 5 years, the biggest brands have grown more than double the Global GDP (7.3% and 7.2% per annum, respectively).

Recently, the company seems to have found the right path in its Azaleia division, which experienced a contraction and remodeling of its products in 2017 and has begun to show robust growth of ~15% in the last two quarters, with good indications and continuity of this movement at the end of 2018. We believe that this recent product remodeling, in line with strong brand recall, would cause Azaleia to regain market share, which is expected to reach 3.5% by 2023.

6 Revista Amanhã Magazine

7 Bloomberg, World Bank

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Brazil still has a very low per capita footwear consumption8, which indicates that a possible increase in income can accelerate the sector’s growth. Additionally, the consumption of flip flopis still very high, but is already declining (from 45.8% of footwear in 2015 to 45.4% in 2017), giving space for sports, which has been growing more than market averages (from 9.3% to 10% over the same period).

Despite favorable sector dynamics in the long term, 2018 was a difficult year for the segment in Brazil. During the year there were two factors that had a major impact on the sports footwear market: (i) the truck drivers strike and (ii) the international brands that planned 2018 with high expectations and were frustrated with much weaker sales due to the strike and other situations. As a result, they were forced to aggressively liquidate their stock, affecting all competitors. The chart below shows how sales for 2017 were strong, indicating a potentially good 2018, which did not materialize until August, when retail sales growth resumed.

8 Abicalçados

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A difficult 2018 brought us the opportunity to invest in Vulcabras

Positive Market dynamics from 2019 will be beneficial for Vulcabras

The strong expectations for the 2018 Brazilian economy led international brands to import a very aggressive number of shoes. Since imports need to be planned 6-9 months in advance, the pairs that arrived in stores from March to June 2018 were planned during the second half 2017 amid a certain euphoria in retail. The combination of high retail inventories and strong deceleration due to the truckers strike and its side effects (such as the rise in USD, which made shoes more expensive) made 2018 a very challenging year, especially for global brands. Their reaction was to carry out great product deals in order to sell their inventory, in such a way that their prices have strongly affected Olympikus’ products in the market.

We believe that the effects felt by the company in 2018 were cyclical and not structural. This we saw the dip in share prices in the middle of the year as an opportunity to set up a more relevant position in Vulcabras, with an attractive valuation.

In the chart below we show how the fund’s exposure evolved over time, and how price behaved during the same period

From 2014 to 2016 (World Cup and Olympic Games hosted in Brazil) international brands saw the country as the stage for their marketing investments and invested a large sum in the country. Starting in 2017, the companies were more conservative and sought profitability. Still, 2018 was very difficult because of factors we previously discussed. Our validations indicate that volumes of imported products are expected to decrease this year.

Because of this, we believe that the sector environment in 2019 will be more favorable for the following reasons: (i) the International Brand’s decision to import for the 2H19 was made in early October 2018, when the dollar was still at approximately R$4, and there was fear of electoral risk (with this exchange rate, companies should reduce volumes and concentrate sales on premium products); (ii) after suffering last year, international brands are more conservative in import volumes and (iii) the macro environment from 2019 onwards has a chance of being quite positive.

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We hope that thanks to Olympikus growth, the new Under Armour operation and the reorganization of the Azaleia brand, Vulcabras has the scope to grow significantly in the coming years. The following chart presents our estimate of potential growth that each brand can bring:

In conclusion, the 2019 sector dynamics should favor the sports shoe sector with local production, and Vulcabras, whose brands are important and well managed, and which has a number of opportunities for operational improvements, should take advantage of this scenario and grow at very interesting rates. Despite all the company’s positive features, it is still the most discounted opportunity in the apparel retail sector:

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HIX Capital Update

In 2018 HIX had positive net subscriptions of R$ 80 million in its open funds (Local Funds and HIX Equities 1 SP). The main highlight of the year was the Brazilian pension fund segment and new international clients. At the end of 2018, HIX’s AUM was R$ 652 million invested in Brazilian Equities.

Aum Evolution

The current distribution of HIX’s customer base is quite diverse and, in a way, quite sophisticated, a fact that we consider an important pillar for an investment manager’s evolution, and one we work on with great care. In addition to proprietary capital (16% - HIX’s partners are the largest individual clients of our funds), 32% of our investor base comes from direct relationships – clients and long-term partners who are close to HIX and deeply understand our philosophy and investment strategy:

We are very excited with the prospects of HIX’s portfolio and continue to work hard to deliver attractive returns to our partners and investors.

We appreciate your trust,

HIX Capital Team

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LETTER TO INVESTORS2nd Semester, 2018