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One of the questions that I have been asked is about individual stocks, and, more specifically, how to monitor developments after the purchase. Now I have mentioned before that I strongly recommend that you do not start off trying to buy individual stocks. ETFs and index mutual funds are a better way to start off investing and will generally garner you higher returns in the long-run. Why? Well, please continue reading, and you will see how I approach the decision to purchase a stock and when I decide to sell. Now my method is strictly my own, but you will see it closely mirrors Warren Buffett’s style of investing. There are many other market participants that use a variation of the Buffett and Graham paradigm. Moreover, there are literally tens of thousands of portfolio managers, hedge fund investors, research analysts, and others that value stocks every second of every day in response to company, economic, and geopolitical news. Once you see how much work it takes, I am hopeful that you do NOT try it to begin with.

Before delving into the process of following a stock after your purchase, I will go through the steps I take prior to a purchase. I strive for a turnover of 15-20%. Turnover measures how long an investor holds a particular stock. A turnover of 100% means that an investor holds a stock for one year. Thus, my turnover equates to a holding period of 5.0 to 7.5 years. So if I am willing to hold a stock for that long, I better make sure I am confident that it is a good investment. How do I start? I have a list of stocks that I am interested in purchasing. If I decide to possibly invest, I go through a lengthy process. Now I am not recommending any security. However, I want to put some meat surrounding the discussion. Therefore, I will talk about my process in terms of my decision to purchase Western Union (WU). Western Union is now my top holding. Should you buy WU? Maybe so. Maybe not. You must do your own homework and not take my word for it. As a show of good faith, I encourage you to look at my Twitter account: @NelsonThought. I have been posting information about WU for several months, so I am not “cherry-picking” to make me look good. Let’s begin.

Regardless of where I get my ideas of stocks to analyze, I start off my analysis by learning everything I can possibly get my hands on. You would be amazed at how much information is out there. Prior to deciding to even value WU, I took a number of steps. First, I read the last three annual reports for WU. What do I focus on? The most important part of any annual report is a section called Management Discussion & Analysis (MD&A). MD&A is indispensable because management has a chance to be open and honest with investors. Now when you purchase a stock, you should view yourself as a fractional owner in the actual company. You do not own a piece of paper that says you have x number of shares. You own a claim to the future cash flows and dividends of that firm. Contained within the MD&A is management’s discussion is a review of the most recent financial developments, their strategy, and what management thinks is the future direction of the company. WU’s management team talks a great deal about emerging markets. WU relies upon the wiring of money between individuals. The most important, growing income stream comes from immigrants sending money back home to their families. For example, did you know that 30% of the Gross Domestic Product of El Salvador comes in the form of these remittances? Wow! That fact always gets to me. Obviously you can see that the emerging markets are a great way for WU to grow earnings. Additionally, WU has a huge market share in the correctional system. If family members or loved ones of prison inmates need money to purchase items behind bars, they can use WU to transfer money into their accounts to buy food, hygiene products, and even other items like TVs and radios. WU’s management speaks at length about these opportunities, and they also focus on growing their network of facilities that provide their services. There is a “network effect” for WU. The more money transfer centers there are, the more people in general will use their services. For instance, if a local WU outlet is right near your house, and you need to wire some money to an individual or business, you are more likely to use it. Well, if you need to wire money to a friend, and the nearest WU outlet is 50 miles from that person, WU is probably not a good option for you. Therefore, it makes sense for WU to provide good incentives to build up their network.

Now I really focus on MD&A going back in time because management is telling you what they intend to do in the future. Think about it in these terms. Have you ever had a friend who tells you that they are going to quit working and start a business? I know that I have. More often than not, when I see that person in several years, they tell me that they are still working but they are starting the business soon or they found a better business to start. It is great to have ideas, but, unless you act upon them and do it, there really is no point. Well, the same scenario happens very often with a business. Management might describe great plans to grow the business back in 2010. If they never speak about it again, or they have new and better ideas when you read the 2012 annual report, that should be a red flag for you. Now changing strategy is sometimes warranted, but management should be transparent with you. If a strategy is no longer relevant, or it did not work out, they should explain why. It is only fair. You own the stock; you own part of the company. Always take the time to compare prior MD&A with current MD&A. This technique can save you a lot of time. Why value a stock if management does not seem to know what they are doing?

After you feel comfortable with management and still have strong beliefs that the business is well-positioned, you can look at the financial statements of the company. Every publicly traded company is required to file financial statements with the Securities and Exchange Commission (SEC). The reports are called 10-Ks on an annual basis and 10-Qs on a quarterly basis. The SEC even has a website that you can go to when you look for them. It is called the EDGAR system can be found here: http://www.sec.gov/edgar.shtml. The financial statements will include the income statement, balance sheet, and statement of cash flows. Which part is most important to me? Well, that is a trick question. I go to the back of the financial statements and look at the notes to the financial statements. Do not feel bad if you got the question wrong. When I pose the question to undergraduate students during presentations that I give, I have never had a finance student give the correct answer.

Why do I say the notes? For one, I have an accounting undergraduate degree, so I am interested in them. You can always get financial statement ratios and earnings expectations online, but they rarely incorporate information from the notes. Now the notes to the financial statements tend to be boilerplate to begin with. The accounting firm that audits the financial statements of a firm will explain that the company used generally accepted accounting principles (GAAP) and disclose the accounting methodology utilized when GAAP allows different choices. After all these disclosures, you will find lesser known items. The second reason why I look at the notes to the financial statements is to see if there is something I do not understand. What do I mean by this? You may remember the downfall of Enron. The downfall of Enron was right in plain sight all along. Enron had a disclosure “buried” in the notes that talked about Special Purpose Vehicles (SPVs). What is a SPV? I still really have a vague understanding, but here are the basics without getting too technical. A SPV is a separate legal entity that is set up to own assets and incur liabilities. It is really like a subsidiary of a company but, since it is a separate entity, the assets and liabilities of the SPV are not required to be reported on the company’s balance sheet. What? This phenomenon is called off-balance sheet reporting. Essentially it is a way to not disclose liabilities. Think about it in terms of the federal government. The federal government does not consider future Social Security and Medicare benefits to be necessary to be reported in the current budget. Thus, the $50+ billion of future payments of benefits is not reported; only think tanks talk about it periodically. Now I do not want this to be a political discussion. That is not my intent. I simply bring it to your attention as a more familiar example of this topic. Thus, Enron had liabilities that it had to repay in the future, but, if you only examined the financial statements, the future payments were not on the balance sheet. The auditors did not look too closely. Why? I liken it to this. No one wanted to raise his/her hand and say what is this SPV thing. In general and in business, people do not want to look uninformed or “dumb”. If you see something in the notes to the financial statements that you do not understand, I would suggest that you pass on the purchase of that stock. When I look at the notes for WU, there is nothing that bothers me in particular.

After I look at the notes, I focus on the statement of cash flows, balance sheet, and then the income statement. I look at them in that exact order. Now I do not prepare a model at this point to value the company. Rather, I do some calculations in my head. Is the company actually generating cash from the operations of the business? Does the company have enough assets to invest in the business? Are earnings coming from sources that will either never occur again or have nothing to do with its core business? These are very vital questions to ponder. Why do you not value the company at this point? Now I really have a number in mind for what the stock is worth, you still need to compare that to the sub-industry and industry that the company operates within.

As one reader commented, he was probably going to use this discussion to cure his insomnia ailment. Hopefully you made it this far. Are we having fun yet? I promise we will get to the discussion of how to follow a stock after making a purchase, but I need to lay the foundation to ensure that my method makes sense. Not that it is right, but the logic of the paradigm is plausible. As it relates to the sub-industry and industry, I perform what is referred to as a SWOT analysis. SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. Now I already know the S and W part from my review of MD&A and the review of the financial statements issued by the company. The O and the T refer to the industry and competitors. The main competitors in this space to WU are MoneyGram International and Euronet Worldwide. How does WU match up against these two? These two companies are smaller than WU, but bigger is not always better. These two firms are constantly innovating and trying to make inroads into the niche of WU. They are referred to as firms within the sub-industry. The industry as a whole is the financial services industry. Now WU is able to grow significantly in the emerging markets because the banking industry is not very developed in these countries. It is easier at this point to simply pick up a wire transfer at a Western Union outlet than to open a checking accounting. I can assure you that banks have noticed taking note. Banks are trying to come up with ways to make it easier to open an account and simply have the money deposited there. That is the most common way to look at the industry. Now sometimes it is easier to ignore other developments, but I try to take everything into account. Did you know that you can make wire transfers at most Wal-Mart stores now? That development might be a game-changer. Think about it this way. Why should you go to WU when you can simply do your normal shopping at Wal-Mart and then send your wire transfer? Remember that there are a plethora of Wal-Mart stores, so they already have a built in “network effect”. They are a definite competitor even though they are technically in the retail industry.

After my entire analysis, I was confident that the purchase of WU would be a good investment. How do I go about valuing any stock? As I mentioned previously, I use a method that Warren Buffett has perfected over the years. Trust me, I am no Warren Buffett. If I were as good as Warren Buffett, I would not be writing this blog. However, his method (coupled with Phil Fisher, David Dodd, Charlie Munger, Bill Ruane, and a few others) makes sense to me. Think about stocks like bonds. Bonds are much easier to value. Why? They are a promise to pay back money loaned to them. The only return from a bond held to maturity comes from the coupon. The coupon is simply the interest rate. As an aside, you will hear coupon over and over again. Where does the term come from? Back in the older days, when you would purchase a bond, the company would give you a certificate that actually had coupons. When a payment was due from the company, you would take the coupon to your local bank and get your money. The bank would collect all the coupons and present them directly to the company. This was prior to the introduction of computer systems to monitor who owned which bond. That is why you will hear the term coupon. Anyway, the interest rate of the bond does not vary over time. A bond is worth a set amount that you will receive upon maturity and the periodic interest payments, but you need to remember that the payment is fixed. What if interest rates fall? If you purchased a bond that had a 6% coupon and the prevailing interest rate for the same type of bond rises to 8%, how are you able to sell the bond? Why would I buy your bond if I can simply buy one with an 8% coupon? You can sell me that bond by lowering the price. A corporate bond is usually issued in $1,000 increments, so, if interest rates rise, you can simply lower the price to make its return equivalent to owning an 8% percent bond. This is what is referred to as an inverse relationship. It works the same way in reverse if interest rates fall. If prevailing interest rates fall to 4%, you can afford to charge what is referred to as a premium because buyers in the marketplace cannot find a better opportunity with your 6% coupon. Therefore, you can charge more than $1,000. How does this relate to stocks? Stocks are nothing more than bonds with variable cash flows. Now if you ignore the fact that owning a bond makes you a creditor and holding a stock makes you an owner of the firm, you really need to value it in the same way. However, it is infinitely more difficult. Why? You do not know how the company will fare in the long-term. Will the strategies work out, will they be executed properly, will another competitor overtake the company, or will a new technology displace the service provided by the company? I have already talked about the competitors of WU, banks knocking at the door, and the “invasion” of Wal-Mart into the space. All of these elements cause the future earnings of WU to be unknown and variable. I am still confident with the prospects of WU, so I move to valuing the company and approach it in the same manner as I would a bond.

To me (and many others), a stock is only worth what a company can earn in the future. If you have a friend that has a business idea but you can see that it is unlikely to work, would you invest in the firm? Probably not. When I look at WU, I see that it is likely to earn money far into the future. What are earnings? You will hear many different terms because there are many different types of market participants and other stakeholders. I focus on a concept called owner earnings. Owner earnings are a combination of Free Cash Flow (FCF) and changes in Plant, Property, and Equipment (PP&E) and working capital. FCF is simply the cash that comes from ongoing operations of the firm. However, you need to remember that the firm needs to make future investments in technology and other items. Thus, when you look at depreciation of PP&E which is only an accounting convention, the company may need to make more or less investments into the business in order to keep competing. Additionally, the company needs cash to simply pay current bills that come due which relates to working capital. If you calculate FCF and adjust for PP&E additions and working capital, you come up with owner earnings. Once you calculate owner earnings, you know that the firm will be able to grow owner earnings over time. If they cannot grow owner earners in the future, you probably would not be at this point in the analysis right now. Well, you also need to remember that these earning will occur in the future. Why is this important? Think about loaning $100 to a friend for a year. If he/she tells you that they will pay you the $100 back sometime next year, you will most likely want more than $100. For one, you automatically know that under normal economic conditions, it will cost more than $100 to buy the same amount of products or services next year. Additionally, you could have bought something else with the $100 and enjoyed it right away. This is the concept of utility. For example, you could have purchased 5 or 6 Blu-Ray discs and enjoyed watching these movies. You are forgoing that consumption because you loaned out the money. In order to make it worth your while, you might tell your friend that you will loan him/her $100, but you want them to pay you $110 next year. This will compensate you for inflation and delaying your consumption. The same economic principle applies to the purchase of stocks. You could spend your money, or you could invest in another stock. Therefore, you will only purchase a stock if the price will increase satisfactorily in the future such that you can make money. You need to discount these future owner earnings.

How do you discount the owner earnings? I come up with my financial model at this point. I determine how much WU will earn over the next five years, the five years after that, and then for the rest of its existence. Once you have calculated the next five years, you need to remember something. If a certain company is earning what is referred to as “excess profits”, other firms will come into the market and try to do the same thing because it is lucrative. Additionally, there might be other technological advances which make the wire transfer business of WU less attractive or obsolete, which is even worse. Thus, I assume that WU will grow at a certain rate for five years, a lower rate for the next five years, and then a growth rate similar to the general economy forever. The last part is somewhat of a plug figure. Most stock analysts will say that WU (or any other company) cannot keep growing at high rates forever, it will eventually grow owner earnings very similar to GDP growth in perpetuity. Now I use an assumed growth rate of 3.5% which is higher than the domestic economy because WU has a significant presence in the emerging markets which are growing at a faster clip. Now that I have a stream of owner earnings, I need to discount them to the present. The discount rate is a subject of much debate. I use a rate of 7% or the equivalent of the yield on the 10-year US Treasury. Other investors will use a higher rate. I won’t get into a debate about the proper discount rate to use. I simply follow the advice of Warren Buffett. Here is a link to see his rationale: http://www.sherlockinvesting.com/help/faq.htm. If I discount that owner income stream back to the present at that discount rate, I come up with what is referred to as an intrinsic value. Intrinsic value is a concept that was coined and explained at length by the father of value investing, Benjamin Graham. The intrinsic value is what I think WU is worth right now given the current business environment and likely future prospect. Now since I am fallible and the future is uncertain, I use the margin of safety concept also introduced by Benjamin Graham. I take the intrinsic value figure and reduce it by a certain amount. For WU, since it is in a somewhat stable industry and finance is my background, I use a margin of safety of 20%. Therefore, I multiply my intrinsic value figure by 80% (100%-20%). If the current stock price of WU is lower than my calculation, I am inclined to buy. The intrinsic value I get for WU is significantly above the current stock price. I purchased WU at $14.24 average cost, and it now trades at $18.36 as of August 9, 2013. I still hold the largest portion of my portfolio in WU because I see the intrinsic value of WU as being higher than that presently.

As you might imagine, this entire process took me roughly 55-60 hours. Surprisingly, there are many stock analysts that may say that I was not thorough enough. An example would be the famed hedge fund investor Bill Ackman. I am willing to bet that I spent more time prior to the purchase of WU than you will spend on financial planning over the course of your lifetime. I do not mean this in a condescending manner. I only point this out to simply show why the purchase of an individual stock is not right for everyone. I tend to refer to myself as a “dork”. I am passionate about investing, and I love to perform this type of analysis and calculations. If you are not willing to put in that type of time to do your homework, I would stop at this point. I will repeat again that ETFs and index mutual funds are much better choices for individual investors. If you would like the chance to beat the index averages, I would rather see you invest in actively managed mutual funds or separate accounts than try your hand at selecting individual securities. With that being said, I will now turn to what I promised to in the beginning. Please forgive me for what might seem to be a circuitous route.

I intend to hold WU for a long time. I have a set intrinsic value, and I am willing to stick to holding the stock through all the “visiccitudes and vagaries” of the stock market. My emotional intelligence is higher than most investors. I view investing as an intellectual exercise. The money is secondary. As soon as you start focusing on the money, you may be tempted to sell your stock if it falls in price significantly for what might seem like no apparent reason. If I need to wait for 5-10 years for WU to reach its intrinsic value, I am willing to do so. Does this sound like fun? Well, it is to me. Unfortunately, this has really nothing to do with what you read in most financial news publications or see on financial media. However, you need to remember that I am an investor in the company and not trading pieces of paper. I can confidently say that the way investing is portrayed in the financial media is much more akin to speculation. My suggestion is to go to the casino if you want to try to double your money. You will have more fun. Investing in stocks to gain significant riches immediately is a fool’s game in my opinion.

What do I focus on after the purchase? The first thing I do is to read all the earnings transcripts of the firm. After each quarter, the company will file a 10-Q with the SEC and announce financial results to the public. Management will then talk to analysts on an earnings call to recap the quarter and then answer questions from a selected group of research analysts. I try to see if the earnings results match up with MD&A and if management uses any “excuses”. An example of a typical excuse is the weather. If a retail outlet has depressed earnings, they tend to use bad weather as an excuse at times. It may be likely, but, more often than not, it is a way to hide poor execution by management. Any particular quarter should not affect your intrinsic value calculation much. In the short-term, there can be developments that affect earnings for a temporary time. I do not worry about quarterly earnings, but I am interested in how the company is doing.

The second thing I do is to keep up with general economic conditions. I visit the Bureau of Labor Statistics (BLS) website on a periodic basis. The link is as follows: http://www.bls.gov/. The BLS is the agency of the government that monitors and releases economic statistics like GDP growth, new housing starts, the trade deficit, and a lengthy amount of others. I focus on leading indicators, but I also am interested in the so-called lagging and coincident indicators released by the BLS. Why do I pay attention to this? I do so for one primary reason. I am very confident in my calculations of future owner earnings for WU. However, I usually extend that to include a three-part probability exercise. For example, the likely path of owner earnings for WU is definitely affected by the current/future state of the economy. I have a percentage for normal, boom, and bust scenarios. The normal part gets the highest weight, and I then attribute different percentages to the other two. Now I will admit that these are very subjective, but they are imperative. How does the calculation work? Well, I assume that WU will earn more money if the economy does better than expected or less money if the economy enters a recession. Therefore, I multiply these scenarios by three different percentages. For example, I currently weight my estimates of future owner earnings by 80% normal, 15% boom, and 5% bust. Therefore, if the state of the economy changes or its future trajectory, I alter the percentages. Since WU relies so much on remittances across borders, if global growth slows significantly, I need to weight the stream that assumes a recession much higher. Using this approach, I do not have to recalculate owner earnings for WU again. I simply use the three different scenarios and weight them differently. Trust me, it saves a lot of time.

The next thing I do is to follow the developments of competitors. I read the earnings transcripts of these firms, do a cursory review of financial statements, and look at how the industry is possibly changing (for better or for worse in terms of WU’s positioning). It is extremely valuable to be constantly testing your investment thesis. You need to be ready to admit that you made a mistake. You can lose a lot of money otherwise. I can attest to that via Best Buy (BBY) and Citigroup (C) stock holdings in the past. With that being said though, you need to do that without referencing the case laid out by speculators. If someone tells me that WU will have a bad third quarter, I really do not care. I am willing to ride out stock price volatility because I know that WU is worth more than the current market price. The advice from speculators relates to traders of stocks (owning pieces of paper) and not investors.

I also follow market developments. Although I do read the Wall Street Journal and Financial Times, I try not to get too hung up on the current news of the day. You can get in trouble that way by feeling itchy and pulling the proverbial trigger and selling in a panic. I commented on this in more detail in a previous blog as it relates to the entire stock market. The link is as follows: https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/. I tend to put more weight in The Economist, Barron’s, Bloomberg Businessweek, and trade journals. I even read a few publications that seem unrelated but can make all the difference. One great source is the Harvard Business Review. This magazine is technical and “heavy duty”, but it can be a great way to identify mistakes that WU management is making or how they are behind the curve when it relates to business strategy. This information helps me to determine whether or not my calculation of future owner earnings is correct and will come to fruition.

My next technique is a little odd to some. I have found that I can learn a great deal about investing from other disciplines. In fact, I will devote an entire post to the name of my firm. I use what Charlie Munger, whom I lovingly refer to as Warren Buffett’s sidekick, calls the latticework of mental models. This approach is to acknowledge that ideas from other disciplines are germane and pertain to investing. A perfect example is psychology. There has been an explosion of ideas in the disciplines of behavioral finance and behavioral economics. These fields do not assume that market participants are rationale. Humans have innate biases and make consistent mistakes. As an investor, you can use this to your advantage. The one adage along these lines comes from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful”. If everyone is telling me that WU is going to the moon, I start to question my investment thesis. Now as a contrarian investor, if everyone is selling WU for reasons that are temporary or are related to general market selling, I perk up and even look to add to my position. You can read more about the latticework of mental models in an excellent book by Robert Hagstrom called Latticework: The New Investing. I use the concept of complex adaptive systems from biology, and the concept of nature searching for equilibrium from physics all the time. In fact, there is an entire website that you can learn a great deal from. It is called the Santa Fe Institute. This think tank is not devoted to investing at all, but they are looking for common themes among different disciplines. Take a look; I promise you will not be disappointed: http://www.santafe.edu/. I now will turn to the little talked about decision to sell a stock.

I think about WU in these terms. If I come across another investment opportunity that is better than WU, I will sell WU. If management or the state of the economy changes, I will sell WU. If you are in a tax-deferred account (401(k), 403(b), Roth IRA, etc), you do not need to worry about taxes. However, my individual stocks are in a taxable account. While taxes should not guide your sell decision, you must take them into account when deciding if another opportunity is truly better. Why? You should only care about terminal values. If you sell WU and buy another stock, that purchase should increase the value of your portfolio in the future. That makes sense intuitively. However, your mind can play tricks on you. What if I am expecting to earn 9% a year from WU and another stock comes along that I can earn 13%? Should I sell WU and earn the 13%? The answer is that it depends. Here is a typical scenario. Let’s say I now own $20,000 of WU and purchased WU with an original investment of $10,000. Thus, I have a $10,000 capital gain that is now subject to a 20% capital gains tax. If I decide to sell WU and receive $20,000, I have to pay $2,000 ($10,000 * 20%) to the federal government come tax time. Let’s look at the scenario in terms of expected yearly results. If I sell WU to earn 13% in another stock, I am really only investing $18,000. If I decide to keep WU, I still earn the 9% and avoid a capital gains tax. What happens at the end of the year? If my scenario holds true, I will have $21,800 ($20,000 + $20,000 * 9%) in my brokerage account at the end of a year if I earn 9% from owning WU. If I decide to sell WU and buy the other stock, I will have $ 20,340 ($18,000 + $18,000 * 9%). Yes, I earned 13% on my new stock, but I have a lower amount in my brokerage account. Why is this a common phenomenon? Well, most people file their taxes and pay any capital gains tax from their checking account. The money does not come out of the brokerage account directly. Your net worth goes down overall, but your brokerage account “misleads” you into thinking you made a great selection because you earned an extra 4% by owning this other stock. In fact, you would need to earn 21.1% in order to have $21,800 in my brokerage account by being able to pay the capital gains tax and then have the same terminal value as I would by simply holding WU and earning 9%. If you ever wondered why Warren Buffett holds onto Coca-Cola (KO) and American Express (AXP), taxes factor in greatly.

Now for all of you readers that are not asleep, I appreciate you bearing with me. As I mentioned before, investing is not meant to be fun or exciting. It is only fun and exciting if you like the intellectual challenge. For all of us “dorks”, we go through this analysis because it is truly fun to us. For most people, they would much rather not spend 60 hours finding a stock to buy and then 20-25 hours per year following your stock after the purchase. Luckily, you can own an ETF or index mutual fund and likely match my investment return in WU or even beat it over the long term. For more information on the style of Warren Buffett, I refer you to the following series of books by Larry Hagstrom (mentioned him before):

1) The Warren Buffett Way

2) The Warren Buffett Portfolio

3) The Essential Buffett

4) Security Analysis by Benjamin Graham the sixth edition

You will note that my investing style is similar to Warren Buffett, but I have incorporated elements from other famous investors and from other disciplines. I will never be another Warren Buffett. However, I can strive to use a similar investing paradigm. Hopefully this discussion was helpful in thinking about one possible way to monitor your stock purchases. Yes, it is a great deal of work and time consuming. You will have much better investment results though, if you know as much as you can about your stock.

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