INVESTSMART GROUP LIMITED — Net Asset Value 2007

Jan 11, 2007

Fat Prophets Australia Fund Limited ACN 111 772 359 Level 33, 2 Park St Sydney, NSW 2000 02 8258 0015 fatfund@fatprophets.com.au

December 2006 NTA Release

12 January 2007

1. Details of Performance and Net Asset Backing at Month end

The net asset backing ("NTA") of Fat Prophets Australia Fund Limited ("Fat Fund") at 29 December 2006 was \$1.3154 per share on a before tax basis, calculated in accordance with ASX Listing Rule 19:12, and represents an increase of 1.65% over the month. By comparison, the Fat Fund's benchmark, the S&P/ASX 300 Accumulation Index, rose by 3.67% in December 2006. The Fat Fund incurred significant tax liabilities on realised gains during the month which accounted for approximately one third of the difference versus benchmark.

After adjusting for the impact of taxation on both realised and unrealised gains, the Fat Fund's after tax NTA at the end of December 2006 was \$1.2388 per share, undiluted for the \$1.00 strike price options which can be exercised until 20 April 2008. If all of the April 2008 options were exercised at \$1.00; the fully diluted NTA/share would be \$1.1186.

Since inception on 15 April 2005, the Fat Fund's pre-tax NTA, calculated in accordance with ASX Listing Rule 19:12, has risen from 97.4c per share to 131.54c per share with dividends of 3.3 cents per share representing a total return of 38.44%; over the same period, the S&P/ASX 300 Accumulation Index has increased by 49.6%.

Month by month details of NTA per share and performance since inception are given in the table in the Appendix at the end of this announcement.

$2.$ Performance Commentary

The major influences on the Fat Fund's performance versus the benchmark during the month of December 2006 were as follows:

Positive Influences			Negative Influences
Company	% move	Position	Company	℅	Position
				move
Metgasco	91.4	Overweight	Ammtec	$-10.8$	Overweight
Tower Aust.	29.8	Overweight	Image Res.	$-4.4$	Overweight
Tassal Group	15.6	Overweight	Espreon	-4.8	Overweight
Konekt	12.3	Overweight	Perseverance	$-5.1$	Overweight
Rinker	$-3.2$	Underweight	SP Telemedia	$-17.9$	Overweight

3. Top 15 Holdings at 29 December

Company	Symbol	% Weighting
BHP Billiton	BHP	10.20
National Aust, Bank	NAB	8.56
Westpac Banking Corp	WBC	6.19
ANZ Banking Group	ANZ	6.15
Commonwealth Bank	CBA	5.51
RIO Tinto Ltd	RIO	3.96
Image Resources	IMA	3.44
Woolworths Ltd	WOW	2.67
Espreon	EON	2.67
Perseverance Corp	PSV	2.59
UXC Limited	UXC	2.49
Lihir Gold	LHG	2.45
Insurance Australia Group	IAG	2.16
Coffey International	COF	2.12
Tower Australia Group	TAL	2.06

4. Portfolio Positioning

"I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: "My name is Warren and I'm an aeroholic." And then they talk me down."

• Warren Buffett - Interview with Daily Telegraph (UK) September 2002

AEP has big plans for its Qantas stake. Mr Yates (AEP CEO) says the deal was done on the predication of a 20-25 per cent internal rate of return for AEP.

• Interview with Sydney Morning Herald, December 2006

Since it's summertime, many of us sit on the beach thinking about the year ahead and catching up on books we meant to read last year. One of the better ones around - albeit a couple of years out from its original incarnation - is "Freakonomics" (published by Penguin) where a journalist (Stephen Dubner) and a quirky Chicago economist (Steven Levitt) explore intriguing questions such as "Why do drug dealers still live with their Moms?" The answer to that is actually very easy - because they don't make enough money to move out.

In a similar vein and to illustrate a key consideration for 2007 in our portfolio thinking, it's tempting to ask investment type relevant but generally unanswered questions: why do people pay \$450 million of goodwill to invest in a uranium exploration company? Why are investors paying five times the price they were three and a half years ago for exploration ground? Why do regulators require two merging insurance companies to send out a 414 page scheme booklet? Why are some of Australia's smartest people doing a leveraged buyout of an airline? Let's examine the last proposition first. In doing so, it provides some serious instruction and an obvious and easy answer - because their risk from successfully doing so is limited versus the upside rewards. It also gives a warning as to market conditions at present.

The proposed Airline Partners Australia ("APA") transaction to acquire Qantas Airways announced in mid December contains a number of examples of smart investment thinking, and making use of markets which are out of kilter. Our first thought, of course, is that it needs to, given the purchase of \$11.1billion of equity in a business which yielded a sub 8% ROE last year, at a historic P/E ratio of 22.6x.

Our maths might not be exact here, and in any case, \$100 million is close to a rounding error on a deal (and business) of this nature. But here goes. APA's investors are putting up about \$3.55 billion of equity into the partnership, which will be levered with just shy of \$8 billion of debt, assuming around \$400 million in transaction fees. Qantas had net on balance sheet debt of \$2.1 billion (at 30 June 2006) to give the post deal vehicle over \$10 billion of debt and an enterprise value of about \$13.6 billion. In addition to this debt, there are three other sets of commitments to make - off balance sheet, non cancelable aircraft leases of \$1.95 billion. commitments to buy \$10 billion of aircraft over the next five years, and about \$2.3 billion of services to provide to passengers which have been paid for but not yet provided at 30 June 2006 (funny how everyone seems to forget about this last bit). After allowing for the lease payments, Qantas has made pre tax, pre interest cash flows of \$2.35 billion in each of the last two years but spent a cumulative \$3.3 billion on new gear.

Some simple arithmetic tells you that if APA/Qantas can earn EBITDA of \$2.2 billion per annum, pay 8% interest on the on balance sheet debt, charge depreciation of \$1.2 billion per annum and not fall foul of AIFRS on goodwill accounting, the structure would make \$200 million of reported profit per annum, or \$140 million after tax, and provide a sub 4% ROE on the equity commitment. If, as postulated in the AEP presentation. EBITDA were to grow to the Macquarie Research Equities forecast of \$2.9 billion by 2009, in that year, the pre tax number would look a much healthier \$900 million or so and provide over \$600 million in after tax profit to APA (>17% ROE). Acknowledged, adding back in the D&A (non cash) component makes the numbers far more attractive - but remember, Qantas needs to spend \$2 billion a year to buy planes on average in the next five years.

Where this deal intersects with investment practicality is in three respects: free options, availability of funds (liquidity) and the pricing of risk.

One of the holy grails of investment is the ability to secure a free option - a stack of upside for no risk. In the case of Qantas/APA, Macquarie Bank may have come pretty close to doing this. Rumours suggest their fees on the transaction may equate to \$300 million plus; they will invest around \$500 - \$530 million for their just less than 15% stake in APA. Not quite a free option, but with other fees (see below) to emerge from Qantas/APA over the next few years, it'll come pretty close. Given that Allco is a strong player in the securitisation and leasing business, there's a chance it will clear a chunk of its \$300million commitment from future fees as well (it also gets fees for managing AEP, the main equity participant in this deal).

Aside from the regulatory issues, this deal can only fly if there's sufficient liquidity. That's where the debt markets come in. Based on our elementary arithmetic, there's enough cash flow to cover the interest payments (at a notional 8%) around 2.75 - 3.5x depending on your view of EBITDA and its appropriateness as a proxy for cash flow. That's before capital expenditure, or asset sales. Over a period, you would expect the investment bankers to package up the consortium debt with that of Qantas, and sell it into global debt markets. If they do so quickly it's a fabulous exhibition of "buy low, sell high".

The key driver of financial markets in the past three to four years has been the availability and leveraged creation of liquidity. Amidst the euphoria of stellar returns, as usual, the pricing of risk has collapsed. In the final quarter of last year, the yield on "junk bonds" (now politically correctly called "high yield bonds") in the US, traversed its lowest spread against US Treasury securities of comparable durations since mid 1997. Investors now only require a spread of about 2.5% for typical US high yield paper (measured by the two main indices for this stuff) against over 10% in August 2002!! The reasons have some logic: the default rate for global speculative grade investments hit a 24-year record low of 0.94% in September 2006, according to Standard and Poors, and finished the year at a forecast near record low of 1.4%. By comparison, according to Visa International, the default rate on Australian credit card loans is about 2% or so.

What would you rather do? Buy this debt paper or issue (sell) it? On the debt component, which dominates the deal, our APA friends are hoping to finance (sell) their debt at high prices exhibited by thin spreads to risk-free paper. Remember, a 1% interest saving here is worth \$100million per annum, let alone any other advantages such as looser covenants or security.

Intuitively, the pricing of credit risk seems to be too low. Aside from liquidity, it's been driven by the creation of other derivative instruments such as collateralized debt obligations (CDO's) - effectively a fund which raises equity from investors to acquire a leveraged selection of fixed interest securities. The debt/liability side of the equation, however, is structured into credit ladder layers with differing credit attributes - in effect, senior, mezzanine, junior - and equity. In calendar 2005, over US\$250billion of CDO's were created; some have credit insurance, the pricing of which is now so low as to create risk free opportunities according to a recent "Financial Times" article!

It's no surprise that two of the very few offers of equity in these type of structure listed on the ASX are managed by.....Macquarie and Allco – the two key domestic partners in APA. (Macquarie Fortress, whose notes are valued at \$140million - a discount to par, but at the bottom of a 5.5:1 leveraged debt portfolio and Allco Max, whose \$136million of units are valued at a 22% discount to their issuance and are being geared up towards 5:1 against a portfolio of property related debt).

It's an interesting sign of certain risk pricing that both of these issues have failed to excite, though the Macquarie Fortress notes have produced a positive return, suggesting at least in this area, that domestic equity investors are cognisant of credit risk (let's hope they're not shoveling the risk onto Australian domiciled debt investors). Hence, if they can get the debt component away, the consortium are buying credit risk extremely cheaply. Until this situation changes, it's one of the key reasons that leveraged buy out deals, supplemented by private equity will continue to proliferate - especially in Australia where the fees are proportionally plentiful to the perceived investment banking skills of a small number of players.

Assuming the APA/Qantas deal goes ahead, having garnered close to free options, and refinanced the debt risk cheaply, it would be beneficial for the main participants to ensure someone else is taking on the major equity risk - in effect, like the junior equity component in a CDO. In this case, the Allco managed AEP has come to the party as the main provider.

The market's assessment of this equity risk is far harsher, since it could be argued that this investment by AEP is akin to that of an undiversified stub of a (managed) airline CDO. AEP trades at a \$162million discount to its net asset backing of \$562million (28%) suggesting that investors want far more than the CEO's mooted 25% pa return.

The pricing of this CDO stub risk provides an interesting counterpoint to other valuations in the Australian equity market, which continue to heighten our belief that cognisance of preservation of capital – whilst always rule number one (and two) - is particularly critical at present.

Here's a table of real, but unnamed (because its not fair to them) Australian exploration stocks: the implied value of acreage has been deduced by backing out cash and marketable securities from diluted equity capitalisation at each date. None have debt (though it wouldn't surprise you in this environment) and all have raised equity in the past six months (not surprisingly):

\$ million	Implied value	Exploration	Implied value	Proven
	of acreage -	spend:	of acreage -	reserves
	June 2003	June 03 to	December
		Sept 06	2006
Stock "A"	\$5.9	\$8.2	\$29.3	No
Stock "B"	\$0.7	\$0.1	\$9.0	No
Stock "C"	\$5.5	\$3.4	\$20.2\$	Small
Stock "D"	\$3.3	\$3.1	\$29.8	No

This is a fairly unhealthy re-rating of exploration land. Unless these companies develop their land, through reserve evaluation and mine building, when the liquidity bubble bursts, they'll be back to fractions of their current share prices. The stocks above are typical of a host of explorers; go through the list of resource securities and look at the effective revaluation of unproven properties - especially in the IPO documentation from the promoters.

The most amazing revaluation - by the market - has been the recent movement in the share price of Deep Yellow Limited (DYL). In June 2006, the company's prospective domestic uranium tenements were valued at some \$67 million; a share transaction to acquire prospective tenements in Namibia placed a value of \$26 million on the acreage. Investors have since seen fit to effectively revalue this to \$90 million through a 270% increase in the share price, and place a \$457 million valuation on the entire company's acreage. To be sure, DYL has some strong links with the success story in resources over the past four years (Paladin), but the implied premium would nearly buy you an interesting integrated communications company - Commander!

Given these types of valuations, the type of volatility seen in the major counters - BHP and Rio Tinto – is easy to explain but difficult to rationalise. We are happy to stay overweight both companies.

In the past month, however, we reduced our exposure to Ammtec which has been a very successful investment on servicing the growth in resource exploration over the past three years; whilst the company's profits have grown strongly, the shares rating had doubled over the cycle. The shares were sold prior to an effective profit downgrade by the company. Along with some other minor sales, the part sale of Ammtec saw a significant increase in the realised tax provision, which now stands at over \$800,000 or approximately 2% of the net value of the portfolio.

On the buy side, we acquired a position in Altium Limited, a world leading manufacturer and developer of solutions for the creation of electronic products, where revenues and profits are starting to improve significantly. The shares have appreciated by over 40% from our original purchase as a result of revenue quidance issued in early January 2007. Overall, however, we continue to have a predilection to asset based investments in out of fashion areas, where there are significant discounts to assessed asset backing; these types of securities comprise around 8% of the portfolio at present and supplement our recent buy back program in the shares of Fat Fund.

Andrew Brown^a Steve O'Hanna^®

On behalf of Fat Prophets Funds Management Australia P/L

Andrew Brown and Steve O'Hanna are employees of Tidewater Investments Limited who currently manage $a$ : the Fat Fund under a sub-contract agreement dated 15 March 2006

Appendix I: Monthly NTA per share and performance since inception

Month by month details of NTA per share and performance since inception are given in the table below;

Undiluted Net Tangible Asset Backing 1 (\$) as of end:
			Monthly change (pre tax)
	Before Tax 2	After Tax \$	Fat Fund	S&P/ASX 300	% cash
April 2005 3	0.976	0.976	0.21%	$-2.48%$	72.0
May 2005	0.981	0.980	0.51%	3.21%	41.0
June 2005	1.032	1.014	5.20%	4.77%	25.0
July 2005	1.067	1.042	3.39%	2.65%	20.0
August 2005	1.077	1.048	0.94%	2.01%	12.0
September 2005	1.133	1.092	5.20%	5.09%	7.0
October 2005	1.081	1.052	$-4.59%$	$-3.84%$	5.7
November 2005	1.113	1.074	2.96%	4.44%	6.6
December 2005	1.140	1.093	2.43%	3.10%	$\overline{2.2}$
January 2006	1.169	1.11	2.54%	3.55%	2.7
February 2006	1.172	1.115	0.26%	0.58%	2.6
March 2006	1.2263(xd)	1.1509(xd)	$5.65\%$ 4	4.77%	4.9
April 2006	1.2736	1.189	3.86%	2.60%	3.9
May 2006	1.2173	1.159	-4.42%	$-4.74%$	9.5
June 2006	1.1999	1.1482	$-1.43%$	2.04%	6.2
July 2006	1.1890	1.1425	$-0.91%$	$-1.68%$	9.4
August 2006	1.2050	1.1584	1.35%	3.34%	8.4
September 2006	1.1823(xd)	1.1380	$-0.14\%$ 4	1.31%	8.7
October 2006	1.2706	1.2030	7.47%	4.71%	6.6
November 2006	1.2941	1.2193	1.85%	2.37%	4.5
December 2006	1.3154	1.2388	1.65%	3.67%	6.0
Since Inception			$38.44\%$ 4	49.60%

This report has been prepared solety for the benefit of the Fat Fund and its shareholders. It summarises information on the financial products held by the Fat Fund and the views of the Fat Fund as at the date of preparation of the report. These views and financial products may and will change after the issue of this report. No assurance can be given by the Fat Fund or Fat Prophets Funds Management Australia Pty Limited (the Manager) or Tidewater Investments Limited (the sub contract manager) as to the accuracy and completeness of the information used to compile this report. Past performance is not necessarily indicative of future performance.

By making this report available, the Fat Fund and the Manager are not providing any general advice or personal advice within the meaning of section 766B of the Corporations Act regarding the Fat Fund, any potential investment in the Fat Fund or any investments or potential investments of the Fat Fund. This report is made without consideration of any specific person's investment objectives, financial situation or needs. The Fat Fund, the Manager and directors and employees of the Fat Fund and the Manager do not accept any liability for the results of any action taken or not taken on the basis of the information contained in this report, any negligent mis-statements, errors or omissions.

The net tangible asset backing stated below is not diluted for the potential issuance of shares arising from the

^32,185,001 options expiring on 20 April 2008 which are exercisable at \$1.00 per share. $\overline{2}$ Defined as before providing for the estimated tax on unrealised income and gains in accordance with ASX Listing Rule 19:12.

Performance from the close on 14 April 2005 to 30 April 2005 starting at NTA of \$0.974 per share

^<sup>4 This number includes the 1.2c dividend that was paid on the 26^th April 2006 and the 2.1 cents per share that was paid on the 24th of October 2006.