Summary of Search Strategic vs. Traditional Approach by v7166R

VIEWS: 2 PAGES: 71

									   Approaches to Investing



 Long Term             Short Term            Efficient Market
                                            • Asset Allocation
                                            • Cost Minimization

Fundamental Fundamental Technical
  (Value)     (Value)
                                   • Momentum
                                   • Price/Volume Patterns
  Levels           Changes
• Mkt. Price vs.   • Current Price + Forecast Change
  Value                      • Micro
                             • Macro




We Are Here

                   Relative Rarely Done Well
                   (Shliefer, Vishny, Lakonishok)
                                                                 1
Essentials of Value Investing
Long-Term Fundamental (Look at Underlying Businesses)



Specific Premises:

• Mr. Market is a Strange Guy
     Prices diverge regularly from fundamental
      values


• You Can Buy Underpriced Stocks
     Fundamental values are often measurable


• Fundamental Value Determines Future
Price
     Buying underpriced stocks plus patience
      implies superior returns




                                                        2
Real S&P 500 and Trend




                         3
4
5
6
7
8
Value Investing in Practice
Long-Term Fundamental (Look at Underlying Businesses)



1) Look Intelligently for Value Opportunities (low P/E,
  M/B)
    • Mr. Market is not Crazy about Everything
    • This is the first step not to be confused with
      Value Investing
2) Know What You Know

    • Not All Value is Measurable
    • Not All Value is Measurable By You (Circle of
      Competence)

3) You Don’t Have to Swing
    • Value Implies Concentration not Diversification
      (look for Margin of Safety)
    • At Worst, Buy the Market




                                                          9
Microsoft Valuation (in 2000)


Assume:
   50% dividend payout (now zero)

   40% annual growth in sales, earnings (by 2010 – 28 times

    current size)
   15% discount rate (15% desired return)




Valuation:                        Terminal Value
                                  (depends on conditions in 2010
                                            & beyond)

 2000                         2010



             Dividends

           15%Value                      85%Value


 Value = current price (i.e. 110)  80x earnings.



                                                               10
Value Investing the Approach




                     Search
      (Look systematically for undervaluation)




                      Value



                    Review



                Manage Risk




                                                 11
 Search Criteria

• Obscure          −Small Capitalization
                   −Spin-Offs
                   −Boring (Low Analyst Coverage)


• Undesirable      −Financial Distress, Bankruptcy
                   −Low Growth, Low P/E, Low M/B
                   −Industry Problems (Bad Loans,
                    Regulatory Threat,
                    Overcapacity)
                   −Company Problem (Lawsuit,
                    Poor Subsidiary Performance,
                    Poor Year)
                   −Disappointing (Long-Term
                    Under performance)




• Supply, Demand −Privatizations
  Imbalance - RTC

                                                    12
Stocks as Underpriced Assets


• Stocks historically outperform bonds, etc.

• Stocks are not that much more risky

But today…
 Stocks: E/P = 4% + 1½ % = 5½ % vs. 11%
                     Inflation      Historical


 Bonds: 5% vs. 3½ % at comparable inflation rates


 Notes: 4 ½ % vs. 2%


 Stock under valuation not so clear


                                                 13
14
15
16
Systematic Biases




1. Institutional
      Herding – Minimize Deviations
      Window Dressing (January Effect)
      Blockbusters


2. Individual
      Loss Aversion
      Hindsight Bias
      Lotteries




                                          17
Loss Aversion - Example




• In addition to whatever you own, you have
  been given $1000.
  Choose Between:
   – $1000 with Prob .5
      $   0 with Prob .5
   – $500 with Certainty


• In addition to whatever you own, you have
  been given $2000.
  Choose between:
   – -$1000 with Prob .5
      $   0 with Prob .5
   – -$500 with Certainty




                                              18
   Summary of Search




• Low M/B, P/E,          Search              • Obscure
  Growth
• Disappointing
                  (Look systematically for   • Undesirable
  Rtns               undervaluation)         • Supply-
• Institutional                                Demand
  Psycho                                       Imbalance
• Logical
  Rationale
                          Value



                        Review



                    Manage Risk




                                                      19
Value Investing the Approach




                      Search
       (Look systematically for undervaluation)




                        Value




                      Review



                  Manage Risk




                                                  20
 Valuation Approaches – Ratio Analysis


Cash Flow Measure              x   Multiple

Earnings                           Depends on:
(Maint. Inv. = Depr + A)
                                   • Economic position
EBIT
                                   • Cyclical situation
(Maint. Inv. = Depr + A; Tax =0)

                                   • Leverage
EBIT - A
(Maint. Inv. = Depr only)          • Mgmt. Quality

EBIT-DA                            • Cost of Capital (Risk)
(Maint. Inv. = 0)
                                   • Growth



                    Range of Error (100%+)


                                                          21
Valuation Approaches
Net Present Value of Cash Flow

                     
                     CF (1 +1 R )
                                             t
                                                             1
       Value =                t                  = CF0 *
                     t=0                                    R-g

Note: NPV Analysis encompasses ratio analysis
      (NPVdiseases are ratio analysis diseases)
Note: NPV is theoretically correct

                              In Practice:
                                  Revenues
Parameters:                                           Forces:
     Market Size                                         Consumer
                                   Margins                 Behavior
     Market Share
                                                          Competitor
     Market Growth                 Required               Behavior
     Price/Cost                  Investments
                                                          Cost Pressures
     Tech
                                  Investment              Technology
     Management
                                                          Tech
      Performance
                                  Cash Flows              Management
                                                           Performance

              Cost of Capital         X
                           NPV </> Market Value
                                                                            22
Shortcomings of NPV Approach in
Practice
 (1) Method of Combining Information
                                               20
                        1                 1
NPV = CFo +CF1               + … +CF20              + ...
                      1+R                1+R


                  Good
                                  Bad Information
               Information
                                    (Imprecise)
                (Precise)
           = Bad/Imprecise Information


 (2) Sensitivity Analysis is Based on Difficult-
     to-Forecast Parameters which co-vary in
     fairly complicated ways

                  Cost of
                  Capital
  Profit                         Required
  Margin                         Investment

               Growth

                                                      23
Valuation Assumptions



Traditional:                  Strategic:

• Profit rate 6%              • Industry is economically
                                viable
• Cost of capital 10%
                              • Entry is “Free” (no
• Investment/sales 60%          incumbent competitive
                                advantage)
• Profit rate +3% (i.e. 9%)
                              • Firm enjoys sustainable
• Growth rate 7% of             competitive advantage
  sales, profits
                              • Competitive advantage is
                                stable, firm grows with
                                industry




                                                           24
Value Investing
Basic Approach to Valuation




“Know what you know”; Circle of competence

1. Organize valuation components by reliability
   Most Reliable                  Least Reliable

2. Organize valuation components by underlying
   strategic assumption
   No Competitive             Growing Competitive
   Advantage                  Advantage




                                                    25
 Basic Elements of Value



Strategic Dimension



Growth in Franchise Only

Franchise Value
Current Competitive Advantage



Free Entry
No Competitive
Advantage


                 Asset Value       Earnings Power     Total Value
Reliability                             Value
Dimension        • Tangible         • Current          • Includes
                 • Balance Sheet      Earnings           Growth
                   Based            • Extrapolation    • Extrapolation
                 • No               • No Forecast      • Forecast
                   Extrapolation




                                                                         26
 Industry Entry - Exit



Industry       Market Value   Net Asset Value       Entry


Chemicals       $2B           $1B               Yes (P  MV )
(Allied)        $1.5B         $1B               Yes
                $1.0B         $1B               Stop


Automobiles     $40B          $25B              Yes (Sales  MV)
(Ford)          $30B          $25B              Yes
                $25B          $25B              Stop


Internet        $10B      $0.010B               ?




              Remember, Exit is Slower than Entry.


                                                                 27
Asset Value

                         Basic Graham-
  Assets                  Dodd Value     Reproduction Value

  Cash                      Book         Book
  Accounts Receivable       Book         Book + Allowance
  Inventories               Book         Book + LIFO
  PPE                        0           Orig Cost  Adj
  Product Portfolio          0           Years R & D
  Customer Relationships     0           Year SGA
  Organization               0
  Licenses, Franchises       0           Private Mkt. Value
  Subsidiaries               0           Private Mkt. Value

  Liabilities
  A/P, AT, AL               Book         Book
  Debt                      Book         Fair Market
  Def Tax, Reserves         Book         DCF

  Bottom Line         Net Net Wk Cap     Net Repro Value




                                                              28
   Asset Value Approaches

    Approach            Graham       Book             Reproduction

Opportunities           None         Limited          More Extended

Value in Practice       Yes          Yes              Yes

Industry Knowledge None              None             Extensive

Stability/Reliability   High         Low              Intermediate

Goodwill                0            Historical       Reproduction

Debt                    Book         Book             Est Market
                        (Low Debt)   (0 Enterprise)   (0 Enterprise)




            Remember, Low M/B is very hard to beat.


                                                                       29
Asset Value Issues


• Management         • Good adds value
                     • Bad subtracts value


• Private Market     • Potentially highly unstable
  Values               (EBITDA multiples of
                       Internet subs)


• Reproduction vs.   • Better where accountants
  Book                 misestimate
                        Tech trends
                        Real estate

                        Intangibles


                     • M/B indicator close to M/Repro
                       value
                     • Improvement requires
                       discipline



• Non Viable         • Value = Zero (except NWC)
  Industries

                                                  30
Asset Value Risk Management

• Private biases         • Personal computer
                           industry
                         • Psychological
                           experiments
                         • Evidence of investment
                           behavior in life

• Catalysts              • Takeover
                         • Reorganization
                         • Management change



• Importance of     • If don’t know, don’t play
  industry knowledge (Circle of Competence)


• Hedging                • Limited


         Ultimately, “Margin of Safety” is risk
                   management tool
                (Otherwise diversify)
                                                    31
Earning Power Value




    Basic Concept – Enterprise value based on this
     years “Earnings”

    Measurement                                  1
      – Earnings Power Value = “Earnings” * Cost of capital

    Second most reliable information earnings today

    Calculation
       – “Earnings” – Accounting Income + Adjustments
       – Cost of Capital = WACC (Enterprise Value)
       – Equity Value = Earnings Power Value – Debt.

    Assumption:
      – Current profitability is sustainable




                                                         32
 Earning Power Value Adjustments

“Earnings” = EBIT (From Financial Statement)

   + One Time Charge Adjustment (if charges before tax
   average 20% of EBIT – 5 years – then reduce EBIT by
   20%)

   +Cyclical Adjustment (calculate peak-to-trough EBIT
   variation – say  20% of average. If a peak subtract 29%
   of EBIT)

   +Tax Adjustment (apply average tax rate to EBIT – debt
   tax shield in WACC)

   + Depreciation Adjustment (Depr + Amort – Zero
   Growth Capex)

   + Subsidiary Earnings Adjustments

   + Other Adjustments (Temporary Problem, Unused
   Pricing Power).




                                                            33
   Earning Power Value Calculation




WACC = Cost of Capital = (Fraction of Debt) (RD) (1-Tax)
                         + (Fraction of Equity) (Cost of
                         Equity)

   Fraction of Debt = 1- Fraction of Equity  Actual or
                      Potential




   Zero Growth Capex =     Actual Capex - Growth Capex


      Growth Capex = (PPE/Sales) *  Sales


                             Balance Sheet




                                                          34
 Earning Power and Entry - Exit



Case A:                            Value Lost to Poor
                                   Management
                                   and/or Industry
                                   Decline
          Asset Value   EP Value



Case B:                            Free Entry
                                   Industry
                                   Balance

          Asset Value   EP Value



Case C:                            Consequence of
                                   Comp. Advantage
                                   and/or Superior
                                   Management
          Asset Value   EP Value

     “Sustainability” depends on Continuing Barriers-
                         to-Entry
                                                        35
  Franchise Value Calculation
(A1) Cost of Capital       = 10%
(A2) Asset Value “AV”    = 1200M
(A3) Earnings Power Value = 2400M = 240M X (1 / 10%)
     “Earnings”

• Competitive “Free Entry Earnings” = 120M
                                    = Cost of Cap. X Asset V
                                    = 10% x 1200

• Franchise Earnings = “Earnings” – “Free Entry Earnings”
                       = 240         -   120
                       = 120

(A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M
  = 240M X (1 / 10%)

• Franchise Margin = 120M ÷2000M = 6% after tax


• Franchise Margin (pre-tax) = 10%
                = (10% - 40% X 10% = 6%)

                               Tax

  EP Value Implies Sustainable 10% Cost and/or Pricing
                        Advantage                           36
Earnings Power Value Issues




    Nature and sustainability of barriers-to-
     entry (competitive advantage)

    Sustainability of management quality

    Quality of reinvestment opportunities

    Value of cash
      –Subtract interest earned from
      –EBIT add
      –Cash to EP value

    Inflation adjustment




                                                 37
 “Real” Earning Power Value
“Real” Earnings = “Earnings” – Inflation driven Investment


“Real” Cost of Capital = WACC – Inflation Rate

Inflation Driven Adjustment = Net Assets (Not including
   ‘goodwill’ items) * Rate of Inflation



Example:
  (A1) EP Value = 2400M = 240M * 10%
  (A2) Net Assets (not including goodwill) =
       Cash + AR + Inv. + PPE – A/P – AL – AT = 800M
  (A3) Inflation rate = 2%


• Inflation Driven Adjustment = 2% * 800M = 16M
• “Real” Earnings = 240M – 16M = 224M
• “Real” Earnings Power =     224   = 224 = 2800M
                            10% - 2% 8%




                                                             38
Summary of Basic Valuation




Compute:     Asset Value (Most reliable)
             EP Value (Second most reliable)

Case A: Asset Value EP Value Value = EP Value
         (500M) (300M)         + Catalyst Value

Case B: Asset Value = EP Value Value = 500M
         (500M) (500M)

Case C: Asset Value EP Value Value = Asset Value
         (500M) (1000M)        + Sustainable
                               Fraction
                               of Franchise Value
                               (1000M-500M)




                                                     39
Summary of Valuation
Strategic vs. Traditional Approach




                                           National Income,
     Traditional    Market Size Estimate
                                           Growth, Consumer
                                           Trends

                                           Competitive
        Revenue         Market Share
                                           Responses;
                                           Entry/Exit


                      Operation Margin
                                           Technology,
   Oper Income
                                           Costs;
        (EBIT)
                                           Prices; Input
                                           Costs

      Cash Flow          Investment        Technology,
                                           Growth


                       Cost of Capital
                                           Financial
           NVP                             Market
                                           Conditions;
                                           Risks
                           Value




 Strategic: Is this the South Bronx of the Investment World?

                                                               40
Basic Strategy Framework
Porter Five Forces – Probability Determinants




                          Substitutes




    Suppliers                                   Customer




                          Industry
                         Competition


                           Entrants


                     Four Forces too many


                                                           41
Strategic Investment Forces



•   Entry-Expansion – Barriers-to-Entry
    “Incumbent Competitive Advantage”
    Does this company enjoy competitive advantage that is
    significant?
       Yes – Being industry creates value

       No – Efficient Operation may create value

       Others enjoy advantage – stay out. (Being in industry

        destroys value)

    What about entrant advantages?
      No good – after entry you become incumbent.




•   Existing Competitor Dynamics  Degree of
    Competition (Phillip Morris)

•   Share the Wealth (Workers, Customers)  Value
    Chain Dynamics




                                                                42
 Consequences of Free Entry
 Commodity Markets (Steel)
$/Q                                        “Economic Profit”
                            AC
                                           ROE (20%) > Cost
                                                  of Capital

                             Price         Entry/Expansion
                                           Supply Up, Price
                                           Down
                                 Q
            Firm Position




                                        (Efficient Producers)
      $/Q
                                             ROE = 12%
                                 AC
                                             No Entry
                                             No Profit

                                     Price


                                       Q
                   Firm Position
                                                              43
 Consequences of Free Entry
 Differentiated Markets (Luxury Cars)
$/Q                                         “Economic Profit”
                        AC
                                            ROE (20%) > Cost
                                                   of Capital
                                            Entry/Expansion
                                   Demand for Firm
                      Demand Curve shifts left (Fewer
                           Q       sales at each
            Firm Position
                                   Price)




                                             ROE = 12%
      $/Q
                                             No Entry
                                             No Profit
                                   AC


                                   Demand
                                   Curve
                                        Q
                   Firm Position
                                                              44
Barriers to Entry
 Incumbent Cost Advantage




 Entrant        Incumbent                 Sources
No “Economic”   “Economic” Profit    Proprietary Tech
Profit                               (Patent, Process)
                ROE = 20%
ROE = 12%                            Learning Curve
No Entry                             Special Resources

                • Not Access to Capital
                • Not Just Smarter


                                                    45
  Barriers to Entry
    Incumbent Demand Advantage




  Entrant              Incumbent              Sources
No “Economic” Profit Higher Profit, Sales   Habit (Coca-Cola)
                                             • High Frequency
ROE = 12%             ROE = 20%                Purchase
No Entry                                    Search Cost (MD’s)
                                              • High Complex
                                                Quality
                                            Switching Cost
                                            (Banks, Computer
                                            Systems)
                                              • Broad Embedded
                                                Applications

                                                                 46
Barriers to Entry
 Economies of Scale




      • Require Significant Fixed Cost
        (Internet)
      • Require “Temporary” Demand
        Advantage
      • Not the Same as Large Size
        (Auto + Health Care Co)


                                         47
Barriers to Entry
 Economies of Scale




 • Advantages are Dynamic and Must be Defended

 • Fixed Costs By:
   • Geographic Region (Cohrs, Nebraska Furniture
     Mart, Wal-Mart)
   • Product Line (Eye Surgery, HMO’s)
   • National (Oreos, Coke, Nike, Autos)
   • Global (Boeing, Intel, Microsoft)



                                                    48
  Barriers to Entry - Sustainability


Static Demand Advantages               Exploitation
   •Tied Customers         •Pricing, focus on “Own” Customers
                           •No advantage with Virgin
                           customers
                           •Shrinkage over time as base
                           changes


Static Cost Advantages     •Cost efficiency in “Own” technology
                           •No advantage with virgin
                           technology
                           •Shrinkage with technology change




Economies-of-Scale + Dynamic Demand Advantage
   • Principal sustainable advantage
   • Constant vigilance




                                                            49
Other Barriers-to-Entry




• Government, Regulatory, Public
(Lead based Gas Additives; Cigarettes)

• Informational (Who Knows What)
(Banks, Financial Services, HMO’s)




                                         50
Performing Strategic Analysis



        (1)    Industry Map      Identify Industry




               Do barriers
       (2)                       Industry History
                 Exist?




                  What            Demand? Cost?
       (3)     Competitive        Economies-of-
               Advantages?        Scale?




              Future Strategy,
       (4)
                Profitability



                                                     51
  Performing Strategic Analysis
  Apple Computer - Industry Map

Industry: Chips        Hardware    Software           Networks
           Intel, AMD, Dell, HP,    Microsoft,        AOL
           Motorola,   Gateway,     Apple,
           Apple       IBM, Compaq, Oracle,
                       Apple        Netscape

           Components
            Power Supply
            Co.’s, etc.

 Step 1:        • Identify Segments

 Step 2:        • Identify firms in each segments

 Step 3:        • If firms are the same, treat
                segments as Single Industry
                •If firms are different, treat segments
                as Separate industry
                •If in doubt, treat segments as
                separate industries
 For Apple Segment Are:
             • Chips
             • Hardware
             • Software                                      52
Performing Strategic Analysis
Do Barriers/Competitive Advantage Exist




                                          53
Performing Strategic Analysis
Nature of Barriers-to-Entry Competitive Advantage




                                                54
Other Strategic Considerations

    Cooperation within Barriers
      –Coke – Pepsi

      –Cigarette Makers


    Division of Spoils in Value Chain
      –Strategic alliances

      –You can not take home, if you don’t bring
       (NuKote)

      –Employee Power (unions, Prof. Services
       firms)




                                                   55
Summary of Strategic Investment

    Without Competitive Advantage –
     no Value in Franchise

    Competitive Advantage must be
     identifiable and sustainable

    In particular, Are existing
     Competitive Advantages
     Sustainable or are they likely to
     erode?

    If in doubt, do not pay for
     franchise

    Ideally look for ‘hidden’ franchise
      –Unused pricing power (Coke, Cereals)
      –Poorly performing divisions
                                              56
Total Value Including Growth




    Least reliable - Forecast change
     not just stability (Earnings Power)

    Highly sensitive to assumptions

    Data indicates that investors
     systematically overpay for growth

    Strict value investors want growth
     for “Free” (Market Value <
     Earnings Power Value)




                                           57
Value of Growth - Basic Forces At Work


    • Growing Stream of Cash Flows is more
      Valuable than a Constant Stream
      (relative to current Cash Flow)




    • Growth Requires Investment which
      reduces current (distributable) Cash
      Flow




                                             58
Value of Growth - Basic Algebra




                                  59
Valuing Growth



Case 1:
   ROC Return on Capital  Cost of Capital R

   Then ROC – G    R–G
                  =         = 1 (for all growth rates)
          R–G       R–G


  e.g. (ROC = R =
                                     ROC – G             10 - 0
        10%)               G = 0%                   =           =1
                                       R-G               10 - 0

ROC = R when there
are no Barriers-to-        G = 2% ROC – G =              10 - 2 = 1
Entry (i.e. no                      R-G                  10 - 2
competitive
advantages – level
                           G = 8% ROC – G =
playing field) then                                      10 - 8
Growth has no Value.                                            =1
                                    R-G                  10 - 8




                                                                 60
Valuing Growth



Case 2:
   Competitive disadvantage with growth


      ROC less than cost of capital
     then ROC – G < R - GROC – G < 1
                               R–G
     and ROC – G gets smaller with higher growth rates.
           R–G


e.g.
(ROC = 8%, R=10%)          G = 0% ROC – G= 8 - 0 = .8
                                    R-G    10 - 0


                           G = 2% ROC – G = 8 - 2 = .75
  Higher Growth at a                R-G     10 - 2
      Competitive
 Disadvantage Destroys
        Value              G = 8% ROC – G = 8 - 8 = 0
                                    R-G     10 - 8


                                                           61
Valuing Growth



 Case 3:
    ROC is greater than R – Firm enjoys a competitive

     advantage (franchise)
          Shares are stable  G = Industry Growth Rate
      then ROC – G is greater than R – G
      and ROC – G is greater than 1 and increasing in G.
            R–G




e.g. (ROC = 15%, R =
        10%)                G = 0% ROC – G = 15 - 0 = 1.5
                                     R-G     10 - 0


                            G = 2% ROC – G = 15 - 2 = 1.625
                                     R-G     10 - 2

  Only within Franchise
  Growth creates Value      G = 8% ROC – G = 15 - 8 = 3.5
                                     R-G     10 - 8

                                                            62
Valuing Growth Basics




    Growth at a competitive
     disadvantage destroys value
     (AT&T in info processing)

    Growth on a level playing field
     neither creates nor destroys
     value
     (Wal-Mart in NE)

    Only franchise growth (at
     industry rate) creates value




                                       63
Valuing Growth - How much Does it
Add?




                                    64
Valuing Growth
High (Unstable) Growth




                         65
Valuing Growth
Breakeven Growth Rate




                        66
Valuing Growth
Keep-In-Mind




     Very hard to do

     Very hard to determine margin of
      safety

     Evidence is that Investors
      systematically overpay

     Best growth is hidden (zero cost
      growth)

          Unused pricing power

          Temporary problem

          Underperforming divisions
                                         67
Summary of Valuation




                      Search
       (Look systematically for undervaluation)




                        Value




                      Review



                  Manage Risk




                                                  68
Managing Risk – Overall Valuation




    Review biases

    Look for asset protection

    Adequate margin of safety (1/3)

    Identify catalysts (create
     catalysts?)

    Appropriate search rationale




                                       69
Summary of Valuation


   Asset       Most             EP       Medium        Growt
              certain                    certain                  Uncert
   Value     but mgt.?
                               Value   Sustainable?
                                                         h         ain
                                                       Value


  MV < AV,                AV < MV <                   AV, EPV <
   EPV                      EPV                          MV


   BUY                   Assess Comp.                  Lots of
                             Adv.                       Luck



                         Sustainable?




                         Yes           No




                         BUY       Lots of
                                    Luck
                                                                           70
  Summary of Valuation




  Strategic Dimension


  Growth in Franchise Only
  Franchise Value
  Current Competitive
  Advantage



  Free Entry
  No Competitive
  Advantage
                      Asset Value       Earnings Power      Total Value
                                             Value
Reliability Dimension • Tangible          • Current          • Includes
                      • Balance Sheet       Earnings           Growth
                        Based             • Extrapolation    • Extrapolation
                      • No                • No Forecast      • Forecast
                        Extrapolation




                                                                               71

								
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