Investor's Digest: Investment Outlook |
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Investment Outlook: July 24, 2007. We have been baleful even as the market has sailed up. So you might have missed some of the run-up in stocks over the last 2 years if you had listened to us. As it happens, we were better on what sectors to invest in than we were on the direction of the market. We will be revising our opinion more often in the future, but cautioning you just as much. The market madness—both stock and real estate—has resulted from flawed public policy, particularly at the Federal Reserve. Most of the smart grey old men who have made a ton of money from investing are pretty much agreed that we are in for a wicked tumble sometime soon. We would particularly refer you to John Bogle’s comments in “Bogle Sees Tough Times Ahead for Stock-Market Investors,” Wall Street Journal, March 7, 2007, p. D1. “Here comes Mr. Bogle, warning investors that modest returns may lie ahead”:Mr. Bogle reckons stocks will average 7% a year in the decade ahead. He gets that estimate by dividing the market’s performance into two parts, its investment return and its speculative return. The investment return is easy to calculate. You simply add the market’s 2% dividend yield to its long-term earnings growth, which might be 6% a year. The market’s performance, however, will likely stray from the resulting 8% return, thanks to changes in price/earnings ratios. But there has been one change in Mr. Bogle’s advice: He has become keener on international investing, in part because he foresees a weakening of both the dollar and America’s position in the world. He says investors might allocate up to 20% of their stock-market money to foreign shares, dividing this money equally between developed and emerging markets. But because foreign markets have lately done so well, he suggests moving slowly. “If somebody is at 0% and wants to go to 20%, take two years to do it,” he says. Warren Buffett, in case you have not noticed it, has also been headed for the border, working his money overseas in all sorts of ways. Going international is a tricky business, but it’s got to be done. The international mutual funds have often given investors spotty returns. And some of the hottest markets—notably Asian but others as well—lack proper regulatory supervision, and you can easily lose your hat. Previously we have said that Jimmy Rogers (the investor) seems to be ornery enough to get a lot of things right. He says get out of the U.S. (we are running up a trillion dollars of new foreign debt every 15 months), get into China (it will be the leading economy in the world), and still buy commodities-both oil which is still not in ample supply—and agricultural goods where there are also shortages (too much corn now being used for ethanol). If we are to believe him, you might get out of U.S. stocks and stray into commodities and China.A lot of soft spots in the economy should make us ponder as well. One investment summary concluded: “Recent data indicates that the economy is not performing as strongly as expected. Fourth quarter (2006) GDP growth, initially reported at 3.6%, has been revised downward to 2.5%. This is one of the largest downward adjustments in some time and can be attributed to considerably larger reductions in business inventories than previously forecast. Additional factors were the decline in sales of residential homes, production cutbacks in the auto industry, and a lackluster trend for business investment.” We are troubled as well that businesspeople really lack strategies, improvising on the run. They still don’t sense the very new rules of business imposed by the 21st century. The first quarter 2007 was lackluster, but the second quarter in the United States picked up again, even with all the pain surrounding housing and subprime mortgages. What investment gurus call the Wall of Worry is mounting throughout the world, not just with wise old men like John Bogle. Hedge fund guru Nicholas Nassim Taleb, whom we discussed in “Irishmen Who Married Up,” believes we are going to encounter unprecedented volatility in our financial markets. “Now, Mr. Taleb has a new book, The Black Swan: The Impact of the Highly Improbable, a bestseller that follows his Fooled by Randomness, published in 2001, which enjoys a cult-like status in the hedge-fund industry” (Wall Street Journal, July 13, 2007, p. C1). “In it he argues that most investors don’t properly understand the risks they are taking and overlook ways to survive a steep market decline. Many investors plan for rainy days, he says, but not for tornadoes.” As the Journal summarizes, “Hedgie-Cum-Author Returns to the Game;Waiting for a Crash.” In other words, some investors really believe that hurricanes and huge volatility are on the way. That troubles lie ahead can be seen in the machinations of the private equity funds. With interest rates beginning to firm, the flood of worldwide liquidity on which they depended shows signs of drying up. That being the case, they all seem to be going to the public markets to raise equity, since cheap debt may be evaporating. In effect, they are palming off their bad goods on public investors. When companies go public, we usually think the best returns are coming to an end. In any event, the flood of cash around the world created by irresponsible policies of all the central bank authorities around the globe is disappearing, and the chances of volatility and private equity meltdown are multiplying. So we are hard at work looking for ports in a storm. Often that means finding stocks and bonds and other instruments that the big players regard as too insignificant to merit their attention. August 17, 2005. House Built on a Weak Foundation. We’ve not issued a new investment outlook since the first quarter of 2004, since the thinking put forth there—to search around in deep value sectors of the equity markets and in some unusual asset classes—has not been too risky a course even amidst the bubblegum economy around the world. But things have now gotten more chancy in mid-2005, and it’s time to be goin’ elsewhere. Some of you will remember a long forgotten chant, we think from Harry Belafonte, that ran, “A House Built on A Weak Foundation / Cannot Stand / Oh No, Oh No!” The housing boom is beginning to bust. It and all the rest sits on a weak foundation. It had stemmed from worldwide policies that fostered excessive consumption to include easy money. Prescient Wall Street seer Ray DeVoe can now say “I told you so,” since he has been warning us about puffy housing markets for a couple of years. At last the Fed is firmly and consistently ratcheting up interest rates, having previously flooded us with money. This is Alan Greenspan’s last act as Fed Chairman before his presumptive retirement in January: it looks like he is conscience-stricken and abashed at his spendthrift ways, ready to take on the virtuous mantle before he is carried out of office. Even before his reversal on interest rates, the housing
bubble, the successor to the Internet bubble, was beginning to quiver in the
breeze. Now signs of distress are pouring in, noticed by all but
real-estate promoters, whose venal hope springs eternal. They’re still
building sumptuous, awkward palaces all through exurbia. If you wander down
the street, you may see a new house a-building that looks much like a
dormitory. Squire Firehock of Staunton Virginia advises us that CNN
has provided an ample list of housing markets, led by Boston and closely
followed by several other East and West coast locations, that are ripe for
meltdown entitled “America’s Riskiest Real Estate.” Seattle, Pittsburgh,
and Indianapolis are still safe harbors. But much of the rest is over the
top (http://money.cnn.com/2005/08/03/real_estate/ Swensen’s Doubts. If rising interest rates and declining housing fortunes are not enough to make you nervous about your investments, then take a read of David F. Swensen’s new book Unconventional Success: A Fundamental Approach to Personal Investment. He’s the wizard at Yale who has generated 16.1 percent long term returns, a record other institutional money managers can only dream about. This has been instrumental in giving the university an endowment in excess of $15 billion as well as a $500 million-plus annual contribution to its operating budget. He’s an interesting fellow who beefed up the portion of Yale’s portfolio in equity and alternative investments. We have had calls from more than one chief executive asking how to copy the Swensen approach. He had set out in his book to show the individual investor how to copy his approach. But he has since realized that Joe Doaks simply can’t do it. Poor Joe does not have Yale’s research. He can’t access great hedge managers. All the mutual funds skewer him, overcharging for mediocre or worse performance. So dour Swensen would basically have us invest in a mix of index funds where one can at least avoid excess transaction charges. Don’t take Swensen too seriously. But take him seriously. Like all experts, he has fallen into the trap of believing in experts and expert methodology. Be assured, for instance, that we and our associates, without benefit of inside information, superior research expertise, or Street wizardry, have long exceeded the averages. So you can, maybe, do better than Swensen thinks you can. But his book, coming out now, has great symbolic value
at this very time. It’s a warning to us. We are now in financial quicksand
where it will be easy to lose your shirt, for the world financial markets
are truly a mess: they’re in much worse shape than when we published our
last report in early 2004. Things are so bad that you truly can expect
horrendous returns, if you are looking for short term results (i.e., less
than 7 years). Don’t buy for tomorrow or the day after tomorrow; even the
hedge funds are now having trouble investing for 2-, 3-, or 5-year cycles.
Look out a decade. Read about his book at
www.nytimes.com/2005/ The Bernstein Index. Peter L. Bernstein is a marvelously literate investment advisor and one-time OSS operative, Air Force captain, college teacher, and researcher at the New York Fed (www.peterlbernsteininc.com). For the individual investor, he’s a more important read than Swensen because he has a wider compass. In 1996, he came out with Against the Gods: The Remarkable Story of Risk just as we were entering a world where risk management skills became more critical in running the nation, the economy, and one’s portfolio. Risk assessment surely would have kept more of us out of some of those Internet stocks that crashed and burned, and would contain some of the awesome hubris that still afflicts us in this new century. In 2000 came his Power of Gold, just as it became more and more profitable to plough a bit of your lucre into all sorts of commodities. Now, equally timely, is his Wedding of the Waters: The Erie Canal and the Making of a Great Nation. By implication, it tells us and the nation where to invest now. (See www.foreignaffairs.org/20050301fabook84235/peter-l-bernstein/wedding-of-the-waters-the-erie-canal-and-the-making-of-a-great-nation.html, www.washingtonpost.com/wp-dyn/articles/A54777-2005Jan6.htmlm.) This is the story of the building of the Erie Canal—linking the Midwest and the East to Europe and the world through New York State. Its 300-plus miles made New York the Empire State, and New York City the capital of the world. Interestingly, it was New York politics and finance that put the canal together, just as it will be developments initiated at the state, instead of federal level, which will account for America’s future greatness in the world. New York State is sorely in need of another De Witt Clinton—a man who had enough push and vision to realize New York’s Manifest Destiny at the Canal’s opening in October 1825. See our “Courtly Congressman, Amory Houghton, Jr.,” where we contend that even today New York State can play a unique role in rebuilding the national infrastructure. Now we must each find out own Erie Canal to back. The risks today are too big to manage; commodities and alternate investments, even oil, may turn down quite a bit by 2008, and so one’s investments must drift into areas that will mature some time well over the horizon. Running around in present day markets, busily turning over your portfolio to look for gain or to avoid risk, is probably a zero-sum game that will run down your assets. The wise Bernstein cautions you not to press too hard:
In the present environment where there is no safe house: you had best not scurry about like a trapped rat but, instead, find a way to settle down for a while out of the turmoil. Infrastructure. As we have mentioned in previous letters, there is almost no aspect of our national infrastructure that is not worn out. Moreover, what we have is engineered for yesterday and is in no way suited to the challenges ahead. For instance, our electric power grid was built in a time when our power plants were near the people who would use the electricity. Now we transport power over long distances which means we need a system with national controls, standards, and technology that looks much different from the grid we have today. We will have more blackouts, not just because we have under-invested in our electric power structure, but also because our concepts and policies have not kept pace with the realities of our marketplace. In every way, we need to rebuild the foundation of our country so as to provide underpinnings for our society and to secure our national destiny. What then are some examples of “infrastructure”-type things where investors can take a long-term plunge? Alternate Energy. Most of the captains of industry and policy wizards in Washington claim that alternate sources of energy outside of oil and nuclear fission can only provide a drop in the bucket of our power needs. That said, as we have said in several places in Big Ideas, alternate energy is beginning to make a difference and some of it is even becoming cost competitive with fossil fuel. See our entries on “Shale,” “Oil, Oil, Everywhere?,” “Fusion Time,” “Manure Power,” “Solar Power Revisited,” “Running on Empty,” “Water Batteries,” “Blackout 2003 Equals Blindness 1990,” “Power and Water,” “Wind Power,” and “Ocean Power.” In general, General Electric is a substantial play in alternate energy if you want exposure to wind, solar, and other types of energy development. See “GE and Alternate Energy.” The trouble here, of course, is that you are buying into all sorts of businesses, not just alternate energy, when you invest in General Electric. Windpower alone may be a more interesting investment
where you can find interesting companies solely focused on whirling blades.
Wind energy is slowly becoming rather cost competitive with fossil fuels,
and many countries are making commitments to it, from China to tiny
Denmark. Denmark, in fact, now derives 15% or so of its energy from the
wind. For a good introduction to wind energy and its possibilities, see
www.windustry.com/basics/01-introduction.htm. Perhaps the world’s
leading windpower company is Vestas (www.vestas.com/uk/Home/index.asp),
which supplies turbines to power companies around the globe. It has had
some financial bumps but has an outstanding market position. Its homebase
is, incidentally, Denmark, the very nation that has made such a deep
commitment to windpower. Though the U.S. showed early enthusiasm for
windpower, as it has for many new technologies, its engineering was weak;
the Europeans have since overcome some of our design flaws (www.economist.com/displaystory.cfm?story_id=3850262).
The hopeful outlook for wind energy in the United States is summed up at
www.economist.com/ We still consider sunpower to be a speculative arena. We have, nonetheless, listed a host of providers on the Global Province and find it interesting that Germany and Japan have make more progress in solar development than the United States. Despite the fact that the cost per kilowatt is still tres cher, the demand for solar panels has suddenly bolted upwards, and manufacturers currently have not been able to keep up with demand from contractors. Education and Knowledge Transfer. It’s clear that we are becoming dumber, and that our schools at all levels, both private and public, are failing to equip Americans with enough smarts to play the value-added, knowledge intensive role that lies at the heart of its increasingly service-based economy. Just as women in Arab states such as Saudi Arabia are eroding the chains that hold them down simply by becoming better educated, education and knowledge are America’s hope of not becoming a vassal of Greater Asia. Slowly, very slowly, private business is learning how to make a dent in this sector. Various outfits, from Michael Milken’s Knowledge Universe, to the Edison Project, to Sylvan Systems paved the way with experiments that had limited success, Sylvan probably having the most impact (www.educate-inc.com/aboutus.html). All have tried to supply add-ons to America’s public education colossus, though some commentators perhaps would feel they merely offered band aids for a fatally flawed system. Probably the key to revamping everything and reaching isolated, backward areas of America is online education. This is dependent on the growth of cheaper access via municipal wireless. A host of companies are committed to making a dent in virtual education, none more so that Pearson in Great Britain. There an American, one Marjorie Scardino from Texarkana, has come in, cleaned out the ragtag of businesses that made up the Pearson portfolio, and focused it both on publishing and, more particularly education. Along the line, for instance, she picked up Prentice Hall’s powerful set of entries in educational publishing. (See www.economist.com/displaystory.cfm?story_id=372400, www.pearsoned.co.uk/Aboutus, and www.pearson.com.) She is pushing more deeply into online education and seems to be reaping better financial results from her determined foray into education. An even more interesting conversion of a media company into an educational moneymaker is the Washington Post (www.washpostco.com). Its website does not make clear just how far it has gone in education: for the first time, if we remember rightly, education has become the biggest contributor of revenues. In any event, education revenues increased 35% in 2004 to $1,134.9 million. The annual report, by the way, no longer features articles by and about its journalists and its flagship operation the Washington Post, which is now being overshadowed by its Kaplan education unit. As we have said elsewhere (see the “The New Regional Daily”) there has been a challenge for newspapers everywhere to radically redefine their businesses and become very much broader content providers. It would not be an exaggeration to claim that its education business will be the salvation of this company. There are interesting opportunities aplenty in both training and the knowledge transfer business which are both strongly related to education. As for the latter, we find that companies still do not have a successful dynamic model for archiving, re-using, and sharing knowledge and experiences so as to stoke their own innovation but also to resell intellectual property to others. In general all the companies we have talked about above are burdened with concepts and other baggage from traditional publishing and education which inhibit their potential. Many would be advised to form joint ventures that could provide knowledge management services for several companies. We have long followed a stripling of a company in Boise, Idaho which has stumbled, bit by bit, into a rather different model. We have previously written about PCS in our Agile Companies section. Sprung out of a computer-repair business, it put up bricks and mortar schools where parents could supplement regular education with extra courses in math, science, etc. Now all the buildings are gone. It has migrated totally to the Internet. Using Internet modules combined with Lego Blocks to give the education a tangible feel, it has been selling its services overseas to developing countries such as Egypt and Pakistan. Gradually it is introducing an entirely different global educational model that even the poor in distant lands can afford (http://edventures.com/index.html). Virtual education, however, is as applicable in developed societies such as ours, where we clearly are no longer getting a bang for our educational buck. Obviously, however, it cannot replace social learning that only can transpire face to face. Collaboration. Global markets in a post-Cold War world
also have changed the shape of all economic and governmental activity. No
one nation, even the U.S., controls enough resources, people, knowledge,
etc. to implement a global strategy, and there is almost nothing we can now
do of any meaning that is not both global and complex in nature. In a world
where we lack enough control to get the job done, we must compulsively
cooperate to move the chess pieces around the board. Actors inside and
outside our borders have to play a role in devising a new car, putting
together a defense against terrorism, halting the spread of diseases that
know no boundary, and so on. As Peter Drucker has noted, strategic
alliances and joint ventures are now vastly more important for
forward-looking businesses than old-fashioned, wasteful mergers. See
http://www.conference-board.org/pdf_free/ A host of software schemes, such as Tacit Knowledge and Croquet, have sprung up to foster cross pollination inside companies and around the world. The predecessor to the Internet was devised by DARPA, mostly to promote scientific collaboration. Sundry tools to integrate research on various problems have resulted in undertakings in both open source software and biotech research. (See “Linux for Biotech”.) We are still a long ways off from the kind of
collaboration we require to move on the biggest problems of the world. In
many ways, conquering space and time is not a technical problem, but more of
a psychological or ethical problem. Independent, competitive people have to
learn to meld their activities with others, putting aside their go-it-alone
proclivities. Business schools, companies, and others are now pushing
courses to achieve the necessary re-treading of their managers, but only
have made a start (www.economist.com/business/global As best we know, the best tangible efforts to achieve collaboration are happening in unlikely areas. In the bureaucratic, sclerotic world of healthcare, for instance, there is a movement called “shared decision making” where coaches try to ensure that patients are extra-informed about their illnesses so that they, along with healthcare experts, can participate in their treatment, shaping the plan for dealing with their heart condition or diabetes. Amongst public companies, American Healthways (www.americanhealthways.com) comes to mind, it having made some efforts to engage patients in their course of treatment. Health Dialog, a fast growing private company which we follow closely, is more formally invested in all the disciplines necessary to achieve patient collaboration. It is heavily focused on making patients aware of the full range of clinically reputable treatments for their condition, and it drives each patient to accept responsibility for acting intelligently with the surfeit of information at hand. See our details on Health Dialog at www.globalprovince.com/healthdialog.htm. In fact, Health Dialog is fond of referring to its process as collaborative care (www.collaborativecare.net). As interesting to us is another private company called Virtual Agility, which provides a software dashboard for controlling giant collaborative endeavors that cut across time zones and a host of independent participants (www.virtualagility.com). Its first applications involve very independent-minded government agencies that must attempt massive coordination on various questions of national security. Interestingly it provides a tool that all sorts of people can agree to use. Probably the most advanced forms of collaboration now occur in the supply chain management process. Wal-Mart, for instance, has built its low-cost, low-quality discount model on superior logistics based on digital replenishment and systematic information exchange with its suppliers. Land’s End, now part of Sears, Roebuck, has built a made-to-order jeans system, allowing you to input your measurements and quickly get your pants back from factories in Central America or Malaysia: we waxed enthusiastic about “Land’s End Made-to-Order”, but now, of course, Land’s End is a rounding error in the Sears/K-Mart behemoth, and we wonder if it can have much impact on the Company’s management process. Even in supply chain logistics, most of the interesting companies are private and not accessible to public investors. For instance, Harry Lee’s TAL Apparel in Hong Kong (see “The Shirt King”) is doing everything from design to replenishment on shirts it is producing for a host of branded retailers in the United States, and it is reputed now to be pushing into underwear. Clearly it has a more collaborative relationship with its customers than the Wal-Mart model allows, since the confrontational folks in Arkansas are noted for pushing their suppliers to the wall. TAL Apparel is beginning to achieve the kind of collaborative effort that current business practices do not normally permit. Today the public investor wanting to get a foot in collaborative waters will probably buy a stock like Amazon, which is using its internet marketing machine to peddle a host of products it does not stock. This has stoked its revenues and profit performance, while adding significant volume to some of the third party merchants who sell through its website. In days to come, companies imbued with a much richer collaborative ethic will come to market and offer significant value to investors who can hold out to 2015. Investments in collaborators are hard to come by, but this is where the big money is going to be made. March 24, 2004. Andrew Smithers, an economist and consultant in London, claims that one of the biggest mistakes investors make … is failing to accept that there are often no good investments available. (See the New York Times, March 21, 2004, p. BU 7). We accept his wisdom, but then say, “So now what do I do?” In times of risk, look for security in the most dangerous places. Like the rest of the investor pack, we have turned ever more wary. Stocks—and the investment portfolios of even the smartest managers—have been moving sideways since the beginning of the year. We believe U.S. equity markets are vastly overpriced, fueled as they are by a flood of money from the Fed, coupled with tax policies that encourage rampant speculation. The job picture is still lousy, prices at the gas pump are soaring, and turmoil has invaded the political affairs of every major country. We no longer expect spectacular returns from deep-value, unnoticed, low-capitalization stocks. Just to prove that we, too, have a herd mentality, we, like many others, are suggesting alternate assets, but, in fact, it’s hard to move in and out of the quirky asset classes that offer clear value. Suddenly, we realize, it’s hard to find another place to park your money. It’s even tough to be in cash, since currency is taking a kick as well. So where do you go? In risky times, paradoxically, the safest places to go probably are areas that are taken to be broken and dangerous, away from the herd. For instance, our energy and healthcare systems are a mess. You learned this last summer when your lights went out, or at the hospital when the surgeons inserted a stent that did not do you any good. So we are suggesting oil and energy (the Middle East will continue to be roiled, and the Saudis will have to cut production to maintain their sway in Middle East affairs) and health, pharmaceuticals, and medical devices (our population is getting older and sicker faster in a healthcare system that believes in crisis care instead of prevention). Some narrowly defined, niche companies can capitalize on the unstable conditions in these industry areas. For the adventurous, there is a nickel to be made overseas, investing in a few uptick countries out of the mainstream, such as Malaysia, which has just re-elected the government party over irksome Islamists, that are looking perky lately. Finally, there are still several dollars to be harvested in takeover plays: We should see more of these now that the investment bankers are staffing up again. What you’re looking for are pockets of affluence and stability in disturbed industries and a volatile world. September 10, 2003. Hubris being what it is, we are probably headed for a fall. Below we correctly said you should put 15% of your monies in a short fund, 60% in high-quality small-cap stocks with very low valuations, and 25% in new asset classes. As of 8/29/03, the NASDAQ composite was up a whopping 39.14% for the year. You could have even done better in some of the small-cap stocks we were talking about. These are good companies that are low-priced because major institutions cannot be bothered with them, and because they’re often boring manufacturing companies that don’t excite the young turks of investing. In fact, we would say you could continue to pursue exactly the same strategy for a while longer and do pretty well. But, at a minimum, we must throw up all sorts of warning flags here. The august chairman of the Federal Reserve, having poured on interest rate cuts numbering in the double digits and counting, has not really re-ignited the economy but has reflated a lot of bubbles (e.g., financial services, technology, the stock market, etc) that can pop all too easily. Monetary manipulations will not bring this particular economy back to life. Some professionals think we will see slaughter in the financial services sector equal to that we’ve witnessed in telecommunications. We expect the tech puff ups to implode faster than the electricity network did on August 14 in the Northeast. You need to keep your eye on the unemployment rate, a number we will be watching in the weeks to come. The nation lost 93,000 jobs in August, the worst showing since March and the seventh consecutive month of losses. Pretty bright computer graduates in Boston still cannot get decent jobs. Maybe you have to go to China to see the economy for what it is. “The average person doesn’t want to be smuggled into America anymore,” said Ms. Zhou, who works at a bedding store. “The economy is so terrible there.” (See New York Times, September 7, 2003, p.4). We gather Chinese citizens with big expectations are voting with their feet, no longer viewing America the Beautiful as the land of opportunity. The over-all market has not hit bottom. Stocks carry valuations all out of proportion to their net worth or growth prospects. Even companies that carry a low P/E may be overpriced because managers have stripped out a lot of their muscle over the last 20 years in pursuit of short-term return on equity. For this reason, many stocks are twice-overvalued. Prudent investors now focus on under-priced merchandise where they’re sure they’re getting a deal. March 19, 2003. Our view of the equity markets continues to be bearish. As such, we are suggesting to readers that they carefully hedge (using a short-oriented mutual fund, for instance) their portfolios (15%), invest long in small-cap stocks with decent continuous earnings and a respectable balance sheet that are dramatically underpriced (60%), and commit the rest of their funds to other asset classes (25%) outside of equities and real estate which both remain inflated due to the worldwide credit bubble. Presently we expect equities to under-perform for 5 to 6 more years. World economic markets are being whipsawed simultaneously by both deflationary and inflationary pressures.
The opinion above
represents the personal biases of the staff of William Dunk Partners |
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