People don't necessarily feel better or happier when they have more money - they feel happier when they have more money than their friends and neighbours. Psychologists have shown that we are happy when we get a 5% salary increase... that is, until we learn that our peers all got 7% and we turn distinctly unhappy. As William Shakespeare said, "But, O! how bitter a thing it is to look into happiness through another man's eyes!". If our stock portfolio is achieving the long-term goals we have rationally set, let us be thoroughly happy for ourselves as well as anyone fortunate enough to outperform us. Investing is not a zero-sum game, so the happiness and success of our friends is not directly to our detriment.
- Prof. Sage
Saturday, April 26, 2008
Rational decisions and emotions
Fear and greed press internal buttons that suggest action, and such action is almost always contrary to your long-term best interests. The instant gratification of acting in accordance with our emotions is sometimes almost impossible to resist. In the long-term we're all dead anyway, our mind tells us, searching for every possible justification for altering or ignoring our rational goals. But then Homo sapiens are not exactly famous for being rational. People refuse to drink juice from a new urine collection bottle. People won't eat soup that was stirred with a new comb or flyswatter. Few people will eat fudge or chocolate when it is shaped like dog feces. None of these rationalisations make sense. And neither do most of investment decisions when they are driven by emotions.
- Prof. Sage
- Prof. Sage
Conflict of Emotions and Goals
Emotions create a sense of urgency that draw our attention away from long-term rational goals in order to avoid or pursue what is perceived to be a more pressing hazard or reward. My long-term goal may be to be faithful to my wife, but when the attractive young girl across the table takes off her shoe and runs her toes up my leg with the seductive smile and wink - very strong emotions suggest short-term actions that would be contrary to my long-term goal
- Prof. Sage
- Prof. Sage
Thursday, April 24, 2008
Warren Buffet on how he looks at acquisition
We continue, however to need "elephants" in order for us to use Berkshire’s flood of incoming cash. Charlie and I must therefore ignore the pursuit of mice and focus our acquisition efforts on much bigger game.
Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. "She’s a gorgeous blonde," the fellow answered, "with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?" The senior citizen wasted no words: "Forget her, we’ll look for yours."
What we are looking for is described on page 25. If you have an acquisition candidate that fits,call me - day or night. And then watch me shatter a stained glass window.
Sourced from here
Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. "She’s a gorgeous blonde," the fellow answered, "with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?" The senior citizen wasted no words: "Forget her, we’ll look for yours."
What we are looking for is described on page 25. If you have an acquisition candidate that fits,call me - day or night. And then watch me shatter a stained glass window.
Sourced from here
Sunday, April 20, 2008
Understanding Business Statistics
Today we're going to switch a little from hard core analysis into a more basic analysis of stock statistics. This week's article will discuss business metric statistics, next week's article will focus on valuation statistics, and the final week we'll look at financial health measures. While many likely will recognize these, and many already know them, this will give less experienced investors an idea of what these statistics mean, how to calculate them, and what is "good" or "bad".
1) Gross Margin
What does it tell you?
Gross margin is the amount of each sale that is not taken up by direct product or service costs.
How do you calculate it?
(Revenue - Cost of Goods or Services) / Revenue
What's good or bad?
Gross margin is highly dependent on the business, but in general, the higher the better. An excellent value is over 50%. Many companies do not report gross costs separately.
Simple example
A supermarket buys a box of macaroni for 0.70 from Kraft. It then sells it to you for 0.80. It gets to keep 0.10 for itself (gross profit). The gross margin is therefore 13% (0.10 / 0.80).
2) Operating Margin
What does it tell you?
Operating margin is the amount of each sale that is not taken up by costs associated with running the business.
How do you calculate it?
(Revenue - All Operating Costs) / Revenue
What's good or bad?
As with any margin value, it depends on the business. Really great business models can have operating margins north of 30%.
Simple example
After making it's 0.10 gross profit on the macaroni, the supermarket has to subtract 0.02 to go towards paying it's employees, advertising on television, paying for trucks to deliver it's food, etc. The leftover profit is 0.08. Operating margin is therefore 10% (0.08 / 0.80).
3) Net Margin
What does it tell you?
Net margin is the amount of each sale left to the business after all costs, including tax and interest on debt, are accounted for.
How do you calculate it?
(Revenue + Non-Operating Revenue - Total Costs) / Revenue
What's good or bad?
By now you know that all margin figures are relative to competitors! In general, a net margin over 15 or 20% is the sign of an excellent business.
Simple example
The supermarket has some cash in the bank earning interest, but also some debt on which interest must be paid. Broken down to the single box of macaroni, it earns 0.001 of interest, but owes 0.003 of debt (a net interest cost of 0.002). Leftover profit is 0.078. Net margin is therefore 9.8% (0.078 / 0.80).
4) Return on Assets
What does it tell you?
For all property, machinery, trademarks, cash, etc. - all assets owned by the company - how much profit is earned from them?
How do you calculate it?
Net Profit / Total Assets
What's good or bad?
In The Little Book That Beats The Market, Joel Greenblatt lays out a hard percentage to look for - 25%. In reality, this is much higher than many stocks that appear on the screen. A good benchmark to look for is 15%, but the higher, the better.
Simple example
A lemonade stand holds $400 in assets - $200 for the mini-fridge, $100 in cash at the bank, $50 for the stand and signs, and $50 for the lemonade, pitchers, cups, and ice. Over a year, the stand earns $75 in profits. Return on assets is (75 / 400), for a good 19% return on assets.
5) Return on Equity
What does it tell you?
How much profit is earned from the net worth of the company?
How do you calculate it?
Net Profit / Total Equity
What's good or bad?
MagicDiligence feels that return on equity is a poor statistic. It can often be very high for companies in poor financial shape, as equity is very low due to high levels of debt. For companies with low debt, a good figure to look for is 25% or higher.
Simple example
The lemonade stand holds $400 in assets, but the mini-fridge was bought on a credit card, therefore the stand owes $200 of debt. Therefore, net worth is (400 - 200), or $200. Therefore, return on equity is (75 / 200), a 38% return on equity.
6) Return on Invested Capital (ROIC)
What does it tell you?
How much profit is earned from assets that are specifically deployed to earn money?
How do you calculate it?
This one is trickier. You first must calculate the net assets deployed to earn money. In general, this is:
Invested Capital = (Total Assets - Cash - Investments) - Current Liabilities + Short-term Debt
Then you use operating profit (EBIT - this is what we used to calculate Operating Margin in step 2), and subtract out the tax rate:
ROIC = (EBIT * (1 - tax rate)) / Invested Capital
What's good or bad?
Return on invested capital is useful because it's meaningful regardless of the business. A good ROIC is over 25%. An excellent ROIC is 30% or more.
Simple example
Our lemonade stand has $400 in assets, but the $100 in the bank is not being deployed to make money. Therefore our invested capital is $300. For the sake of simplicity, we'll say the stand does not pay taxes. Therefore, ROIC = (75 * (1)) / 300), or 25%.
7) Pre-Tax Return on Tangible Invested Capital (ROTC)
What does it tell you?
Finally, we get to one of the two golden statistics of the Magic Formula. Return on Tangible Capital is the same as ROIC, except we don't include intangible assets (like trademarks, overpayment for acquisition - goodwill, etc.) that are difficult to value. Also, we do not subtract out a tax rate, as they are variable between businesses.
How do you calculate it?
Take Invested Capital from item 6 and subtract out goodwill and intangible items from the balance sheet. Then:
ROTC = EBIT / Tangible Invested Capital
What's good or bad?
ROTC is a great statistic because it provides a meaningful comparison of businesses regardless of sector or tax rate or debt structure. It's also impossible to calculate for many Magic Formula stocks, as the Tangible Invested Capital figure is negative! Negative values and values over 40% are very positive, especially if the company holds a lot of cash.
Simple example
Think of a company like Microsoft. Software requires no warehouses to store inventory or factories to build products. Hard assets are minimal - the company relies on the ideas and skills of it's programmers and trademarks. This is a good business to be in, as there are no factories to upkeep or inventory to sell off to make room. These are the kinds of companies the Magic Formula looks to find, and MagicDiligence looks to review.
Sourced from here
1) Gross Margin
What does it tell you?
Gross margin is the amount of each sale that is not taken up by direct product or service costs.
How do you calculate it?
(Revenue - Cost of Goods or Services) / Revenue
What's good or bad?
Gross margin is highly dependent on the business, but in general, the higher the better. An excellent value is over 50%. Many companies do not report gross costs separately.
Simple example
A supermarket buys a box of macaroni for 0.70 from Kraft. It then sells it to you for 0.80. It gets to keep 0.10 for itself (gross profit). The gross margin is therefore 13% (0.10 / 0.80).
2) Operating Margin
What does it tell you?
Operating margin is the amount of each sale that is not taken up by costs associated with running the business.
How do you calculate it?
(Revenue - All Operating Costs) / Revenue
What's good or bad?
As with any margin value, it depends on the business. Really great business models can have operating margins north of 30%.
Simple example
After making it's 0.10 gross profit on the macaroni, the supermarket has to subtract 0.02 to go towards paying it's employees, advertising on television, paying for trucks to deliver it's food, etc. The leftover profit is 0.08. Operating margin is therefore 10% (0.08 / 0.80).
3) Net Margin
What does it tell you?
Net margin is the amount of each sale left to the business after all costs, including tax and interest on debt, are accounted for.
How do you calculate it?
(Revenue + Non-Operating Revenue - Total Costs) / Revenue
What's good or bad?
By now you know that all margin figures are relative to competitors! In general, a net margin over 15 or 20% is the sign of an excellent business.
Simple example
The supermarket has some cash in the bank earning interest, but also some debt on which interest must be paid. Broken down to the single box of macaroni, it earns 0.001 of interest, but owes 0.003 of debt (a net interest cost of 0.002). Leftover profit is 0.078. Net margin is therefore 9.8% (0.078 / 0.80).
4) Return on Assets
What does it tell you?
For all property, machinery, trademarks, cash, etc. - all assets owned by the company - how much profit is earned from them?
How do you calculate it?
Net Profit / Total Assets
What's good or bad?
In The Little Book That Beats The Market, Joel Greenblatt lays out a hard percentage to look for - 25%. In reality, this is much higher than many stocks that appear on the screen. A good benchmark to look for is 15%, but the higher, the better.
Simple example
A lemonade stand holds $400 in assets - $200 for the mini-fridge, $100 in cash at the bank, $50 for the stand and signs, and $50 for the lemonade, pitchers, cups, and ice. Over a year, the stand earns $75 in profits. Return on assets is (75 / 400), for a good 19% return on assets.
5) Return on Equity
What does it tell you?
How much profit is earned from the net worth of the company?
How do you calculate it?
Net Profit / Total Equity
What's good or bad?
MagicDiligence feels that return on equity is a poor statistic. It can often be very high for companies in poor financial shape, as equity is very low due to high levels of debt. For companies with low debt, a good figure to look for is 25% or higher.
Simple example
The lemonade stand holds $400 in assets, but the mini-fridge was bought on a credit card, therefore the stand owes $200 of debt. Therefore, net worth is (400 - 200), or $200. Therefore, return on equity is (75 / 200), a 38% return on equity.
6) Return on Invested Capital (ROIC)
What does it tell you?
How much profit is earned from assets that are specifically deployed to earn money?
How do you calculate it?
This one is trickier. You first must calculate the net assets deployed to earn money. In general, this is:
Invested Capital = (Total Assets - Cash - Investments) - Current Liabilities + Short-term Debt
Then you use operating profit (EBIT - this is what we used to calculate Operating Margin in step 2), and subtract out the tax rate:
ROIC = (EBIT * (1 - tax rate)) / Invested Capital
What's good or bad?
Return on invested capital is useful because it's meaningful regardless of the business. A good ROIC is over 25%. An excellent ROIC is 30% or more.
Simple example
Our lemonade stand has $400 in assets, but the $100 in the bank is not being deployed to make money. Therefore our invested capital is $300. For the sake of simplicity, we'll say the stand does not pay taxes. Therefore, ROIC = (75 * (1)) / 300), or 25%.
7) Pre-Tax Return on Tangible Invested Capital (ROTC)
What does it tell you?
Finally, we get to one of the two golden statistics of the Magic Formula. Return on Tangible Capital is the same as ROIC, except we don't include intangible assets (like trademarks, overpayment for acquisition - goodwill, etc.) that are difficult to value. Also, we do not subtract out a tax rate, as they are variable between businesses.
How do you calculate it?
Take Invested Capital from item 6 and subtract out goodwill and intangible items from the balance sheet. Then:
ROTC = EBIT / Tangible Invested Capital
What's good or bad?
ROTC is a great statistic because it provides a meaningful comparison of businesses regardless of sector or tax rate or debt structure. It's also impossible to calculate for many Magic Formula stocks, as the Tangible Invested Capital figure is negative! Negative values and values over 40% are very positive, especially if the company holds a lot of cash.
Simple example
Think of a company like Microsoft. Software requires no warehouses to store inventory or factories to build products. Hard assets are minimal - the company relies on the ideas and skills of it's programmers and trademarks. This is a good business to be in, as there are no factories to upkeep or inventory to sell off to make room. These are the kinds of companies the Magic Formula looks to find, and MagicDiligence looks to review.
Sourced from here
Understanding Valuation Measures
First, let's take a moment to define what we're trying to measure. Valuation is a measure of how expensive a stock price is relative to the underlying business. There are several different attributes we can use to determine valuation. Just as you might judge the price of a car based on it's styling, engine power, features, and brand, you judge the price of a business based on it's earnings, net assets, cash flows, and revenues.
1) Price to Earnings Ratio (P/E)
What does it tell you?
How expensive a stock is relative to reported net profits. A higher P/E ratio indicates a more expensive stock relative to earnings.
How do you calculate it?
Stock Price / Earnings Per Share (trailing twelve months)
Forward P/E is used to determine what the P/E ratio should look like a year from now, based on earnings projections. This is useful if trailing earnings included sizable earnings gains or losses that were one-time in nature. It is calculated similarly:
Stock Price / Earnings Per Share (expected 1 year ahead)
What's good or bad?
The market at large has averaged about 15-17 P/E for much of the last 30 years. Some sectors average lower P/E ratios (like energy), and some average higher P/E ratios (like technology). As a rule, a P/E ratio under 10 is very low, and one over 30 is considered rather high.
Simple example
Johnson and Johnson (JNJ) earned a net profit of 3.63 per share of stock in 2007. The stock price today is 62.63. Therefore P/E is (62.63 / 3.63) = 17.24.
2) Price to Book Ratio (P/B)
What does it tell you?
"Book value" refers to the net worth of the company's property, buildings, equipment, cash, and other assets, minus bills outstanding, wages owed to employees, debt, and other liabilities. In essence, book value is what the company would be worth if liquidated. Most companies sell at a premium to book value because the company can generate profits from these assets.
How do you calculate it?
Stock Price / Book Value Per Share (most recent quarter)
What's good or bad?
Price to book is most useful for valuing companies where growth in assets is the goal of the business. Banks, insurance companies, and investment firms are good examples. It is a poor statistic for valuing companies where assets are primarily non-physical, like software and media companies. Benjamin Graham was a well known proponent of buying stocks under book value - although this is difficult to do today. A price-to-book value under 1.0 is really cheap, and under 2 is often considered a favorable valuation for asset based businesses.
Simple example
Johnson and Johnson's reported net equity (same as book value) was about $15 per share for 2007. Using a stock price of 62.63, this gives us a price to book ratio of (62.63 / 15) = 4.18.
3) Price to Sales Ratio (P/S)
What does it tell you?
Simply compares the stock price to the amount of sales per share the company has brought in over the last 12 months.
How do you calculate it?
Stock Price / Sales per Share (trailing twelve months)
What's good or bad?
The P/S ratio is highly correlative with net margin (discussed in last week's article). Higher net margin leads to a higher P/S ratio, because the company converts a higher percentage of sales to profits. The P/S ratio is considered less useful than the other valuation statistics by MagicDiligence. I recommend only using it to compare against other companies in the same business, or against historical averages of the stock being considered.
Simple example
Johnson and Johnson earned about $20.99 in sales per share of stock for 2007. Using the stock price of 62.63, this gives us a price to sales ratio of (62.63 / 20.99) = 2.96.
4) Price to Cash Flow (P/CF)
What does it tell you?
This ratio is very similar to P/E, except it uses the cash flow per share instead of earnings. This cuts out non-cash earnings and charges like depreciation and changes in working capital. This is a better measure of the actual dollars being generated by the business. Cash flow is generally what most people think of when doing their own finances.
How do you calculate it?
Stock Price / Cash Flow per Share (trailing twelve months)
Cash flow can be garnered from the Statement of Cash Flows, under Cash Provided By Operating Activities.
What's good or bad?
Studies have been published that show that companies with higher cash flow numbers than earnings are better performers over the long run. Compare P/CF with P/E and if it is a lower number, consider this a positive sign.
Simple example
Johnson and Johnson delivered 5.28 of cash flow per share in 2007, well over it's 3.63 of reported earnings. This is because the company accounted for depreciation of it's equipment, amortization of it's intangible assets, and other accounting tricks that allow the company to pay lower taxes. But the actual amount of cash the business raked in was significantly higher, giving a P/CF of (62.63 / 5.28) = 11.86, well under the P/E of 17.24. This is a positive sign the company may be undervalued, as Wall Street focuses on P/E to a much larger extent.
5) Price to Free Cash Flow (P/FCF)
What does it tell you?
Same as P/CF, except we subtract out cash needed to replace obsolete equipment and ongoing maintenance expenses. This is considered "free cash flow", that the company can use however it sees fit to reward shareholders. Examples of use of this free cash can be share buybacks, dividend payouts, or investment in growth opportunities.
How do you calculate it?
Free Cash Flow = Operating Cash Flow - Depreciation
This is a simple generalization - most textbooks will say to use Capital Expenditures instead of Depreciation. But MagicDiligence feels this is the best equation for the majority of stocks, as Capital Expenditures often includes growth based investments such as new stores or plants.
Price to Free Cash Flow = Stock Price / Free Cash Flow per Share (ttm)
What's good or bad?
Again, if a company can generate more free cash than it reports in earnings, this is the sign of a very well run business. Companies that generate free cash flow well under earnings generally require a lot of capital investment to sustain the business - an undesirable trait.
Simple example
From Johnson and Johnson's 5.28 of cash flow per share, we deduct 0.96 per share of depreciation expense, which is roughly equivalent to maintenance costs. This leaves us with a free cash flow per share of 4.32. Therefore P/FCF is (62.63 / 4.32) = 14.51. This is still well under the P/E of 17.24, a positive sign.
6) EBIT / Enterprise Value (Earnings Yield)
What does it tell you?
This is the second "golden statistic" of the Magic Formula. In effect, Earnings Yield is the inverse of P/E, but also subtracts out variables such as tax rate and investment income, while adding in the effects of debt. It tells you the percentage of earnings you are getting for each share of stock.
How do you calculate it?
EBIT stands for "earnings before interest and taxes". This is also known as operating earnings (see last week's article for details).
Enterprise value is simply market capitalization plus debt. It represents the price a suitor would have to pay to acquire all of the company.
Earnings yield is simply the quotient of these two statistics:
Earnings Yield = (Operating Earnings / Enterprise Value)
What's good or bad?
Joel Greenblatt decided to use this formula because it is a reliable measure of valuation between companies, regardless of industry. Because of this, a true "good" or "bad" value can be obtained. Look for over 9% earnings yield as the sign of a relatively cheap stock.
Simple example
Earnings yield is calculated more on an overall basis instead of on per share figures. Johnson and Johnson reported operating earnings of 13.7 billion for 2007. Currently, market cap is 181 billion and debt is 9.5 billion, leading to an enterprise value of 190 billion. Earnings yield is (13.7 / 190) = 0.0721, or 7.21%. This is not bad, but below what is required to make the Magic Formula screen.
Sourced from here
Free Cash Yield: The best valution statistic?
Valuation of stocks is a topic on which mountains of material has been written, and it has been discussed on the internet ad-nauseam. It's easy to see why - valuation is probably the single most important part of consistently picking winning investments. Get it right (or close to right), and you give yourself a great chance of significant gain with minimal risk. Get it wrong and... well, you know the rest!
In fundamental stock analysis, there are a number of valuation statistics, many of which have been discussed on this blog before. The most popular, of course, is the price-to-earnings ratio, or P/E. This ratio is easily calculated and can be found almost anywhere you can find a stock price. But is it really the single best valuation statistic to use to determine quickly whether a company may be undervalued?
First, the benefits. As mentioned, P/E is easily accessible. Second, it is a good point of comparison. If a stock's P/E ratio is lower than the overall market's, lower than it's primary competitors, and lower than the specific stock's historical average, the stock is likely to be undervalued and warrants additional inspection.
But there are drawbacks to the P/E ratio as well. First, P/E can be widely skewed by one time charges or benefits. For example, if a company sells off a portion of it's business, the gain on the sale is recorded as earnings, raising the "E" portion of the ratio and bringing the overall P/E down. If we don't dig deeper to ensure that the P/E ratio we're comparing against competitors, the market, and historical average represents an accurate number for the core business, we can be fooled into thinking it's undervalued.
Second, P/E includes charges and benefits not related to the core business. Non-operating income and charges such as interest paid on cash and investments, other investment gains and losses, income taxes, and other items are included in the P/E. Since these can vary considerably between companies, but have no bearing on how good or bad the business itself is, they can skew the ratio, making comparisons with competitors less than perfect.
Joel Greenblatt provides us with a similar, but better, statistic in The Little Book that Beats the Market: Earnings Yield. In essence, earnings yield simply flips the P/E ratio upside down, making the ratio into a percentage. For example, a 15 P/E becomes a 6.7% earnings yield. Turning P/E into a yield percentage is useful, because we can then compare it against bond or treasury yields. The current yield on a 10 year treasury is about 3.5%, so the stock would appear to give us 3.2% extra return for the risk involved.
But Mr. Greenblatt goes farther with his version of the earnings yield. For "E" portion in his version refers to operating earnings. Operating earnings are also known as EBIT - earnings before interest and taxes, which strips out the non-operating costs and revenue from the result, allowing for a more meaningful comparison between companies. The "P" portion refers to Enterprise Value. Enterprise value is simply market capitalization (the price the market has put on the company, or share price times number of shares), plus debt, minus cash on hand. By making these changes, Greenblatt incorporates balance sheet risk (or lack of) into his earnings yield calculation, while making it a better comparison between companies and against treasury and bond yields. Clearly, his version of earnings yield is a better metric than straight P/E.
One problem remains... earnings as reported is not always a tangible figure. A lot of assumptions are used by accountants to come up with earnings figures. First, they must decide what is actually a sale - some customers may never pay, and contracts can always be renegotiated or canceled, even after being reported as revenue in the income statement. Also, income statements include assumptions for such things as depreciation of property and equipment, the eventual value of stock options granted, and so forth.
This is why the cash flow statement exists. A company can use accounting tricks to fake earnings, but cold hard cash is harder to fake - the company either collected it or it didn't. What's more, the true value of a business is simply the discounted sum of all future cash flows, according to accepted finance theory. So, cash earned is clearly a better measure of business performance than earnings. Free cash flow is a step better, as it subtracts out the costs the company must pay to keep the business operating (such as equipment repairs, computer replacements, etc). MagicDiligence uses the depreciation figure to approximate these costs.
Once we have the free cash flow figure, we simply plug that in as the "E" portion of Greenblatt's earnings yield equation, and we have free cash flow yield. This is a powerful figure - it measures a company's cash generation, balance sheet risk, and share price all at once, and allows a meaningful comparison against both other stocks and fixed income assets like bonds and t-bills. No other valuation statistic gives you this much relevant information.
For those who are lost, I'll run through a simple example using my favorite lab rat - Johnson & Johnson (JNJ). To calculate earnings yield, here are the values you need from the 10-K. They've been gathered for this example:
* Net Cash from Operations (Cash Flow Statement)
* Depreciation and Amortization (Cash Flow Statement)
* Cash and Short-term Investments (Balance Sheet)
* Long-term Debt (Balance Sheet)
* Diluted Shares Outstanding (usually in the Income Statement, although sometimes you need to look in the footnotes).
* Current share price (Yahoo! or wherever)
The values from the last 10-K are (in millions):
* 15,249
* 2,777
* 9,315 (7,770 cash + 1,545 short-term investments)
* 7,074
* 2,910.70
* 64.88
First, we calculate free cash flow by subtracting depreciation from net cash earned:
* Free cash flow = (15,249 - 2,777) = 12,472
Next, we calculate enterprise value. First calculate market capitalization by multiplying share price by number of shares. Then add debt and subtract cash and short-term investments to that figure:
* Market Cap = (64.88 * 2910.70) = 189,000
* Enterprise Value = (189,000 + 7,074 - 9,315) = 186,759
Free cash yield is then FCF/EV, or:
* Free cash yield = 12,472 / 186,759 = 6.68%
This seems like a fair premium to the low treasury bill rate, for such a quality company. Stocks get into real bargain territory when free cash yield approaches 10% but remember, fundamental analysis is needed before putting your hard earned money into the stock.
Sourced from here
In fundamental stock analysis, there are a number of valuation statistics, many of which have been discussed on this blog before. The most popular, of course, is the price-to-earnings ratio, or P/E. This ratio is easily calculated and can be found almost anywhere you can find a stock price. But is it really the single best valuation statistic to use to determine quickly whether a company may be undervalued?
First, the benefits. As mentioned, P/E is easily accessible. Second, it is a good point of comparison. If a stock's P/E ratio is lower than the overall market's, lower than it's primary competitors, and lower than the specific stock's historical average, the stock is likely to be undervalued and warrants additional inspection.
But there are drawbacks to the P/E ratio as well. First, P/E can be widely skewed by one time charges or benefits. For example, if a company sells off a portion of it's business, the gain on the sale is recorded as earnings, raising the "E" portion of the ratio and bringing the overall P/E down. If we don't dig deeper to ensure that the P/E ratio we're comparing against competitors, the market, and historical average represents an accurate number for the core business, we can be fooled into thinking it's undervalued.
Second, P/E includes charges and benefits not related to the core business. Non-operating income and charges such as interest paid on cash and investments, other investment gains and losses, income taxes, and other items are included in the P/E. Since these can vary considerably between companies, but have no bearing on how good or bad the business itself is, they can skew the ratio, making comparisons with competitors less than perfect.
Joel Greenblatt provides us with a similar, but better, statistic in The Little Book that Beats the Market: Earnings Yield. In essence, earnings yield simply flips the P/E ratio upside down, making the ratio into a percentage. For example, a 15 P/E becomes a 6.7% earnings yield. Turning P/E into a yield percentage is useful, because we can then compare it against bond or treasury yields. The current yield on a 10 year treasury is about 3.5%, so the stock would appear to give us 3.2% extra return for the risk involved.
But Mr. Greenblatt goes farther with his version of the earnings yield. For "E" portion in his version refers to operating earnings. Operating earnings are also known as EBIT - earnings before interest and taxes, which strips out the non-operating costs and revenue from the result, allowing for a more meaningful comparison between companies. The "P" portion refers to Enterprise Value. Enterprise value is simply market capitalization (the price the market has put on the company, or share price times number of shares), plus debt, minus cash on hand. By making these changes, Greenblatt incorporates balance sheet risk (or lack of) into his earnings yield calculation, while making it a better comparison between companies and against treasury and bond yields. Clearly, his version of earnings yield is a better metric than straight P/E.
One problem remains... earnings as reported is not always a tangible figure. A lot of assumptions are used by accountants to come up with earnings figures. First, they must decide what is actually a sale - some customers may never pay, and contracts can always be renegotiated or canceled, even after being reported as revenue in the income statement. Also, income statements include assumptions for such things as depreciation of property and equipment, the eventual value of stock options granted, and so forth.
This is why the cash flow statement exists. A company can use accounting tricks to fake earnings, but cold hard cash is harder to fake - the company either collected it or it didn't. What's more, the true value of a business is simply the discounted sum of all future cash flows, according to accepted finance theory. So, cash earned is clearly a better measure of business performance than earnings. Free cash flow is a step better, as it subtracts out the costs the company must pay to keep the business operating (such as equipment repairs, computer replacements, etc). MagicDiligence uses the depreciation figure to approximate these costs.
Once we have the free cash flow figure, we simply plug that in as the "E" portion of Greenblatt's earnings yield equation, and we have free cash flow yield. This is a powerful figure - it measures a company's cash generation, balance sheet risk, and share price all at once, and allows a meaningful comparison against both other stocks and fixed income assets like bonds and t-bills. No other valuation statistic gives you this much relevant information.
For those who are lost, I'll run through a simple example using my favorite lab rat - Johnson & Johnson (JNJ). To calculate earnings yield, here are the values you need from the 10-K. They've been gathered for this example:
* Net Cash from Operations (Cash Flow Statement)
* Depreciation and Amortization (Cash Flow Statement)
* Cash and Short-term Investments (Balance Sheet)
* Long-term Debt (Balance Sheet)
* Diluted Shares Outstanding (usually in the Income Statement, although sometimes you need to look in the footnotes).
* Current share price (Yahoo! or wherever)
The values from the last 10-K are (in millions):
* 15,249
* 2,777
* 9,315 (7,770 cash + 1,545 short-term investments)
* 7,074
* 2,910.70
* 64.88
First, we calculate free cash flow by subtracting depreciation from net cash earned:
* Free cash flow = (15,249 - 2,777) = 12,472
Next, we calculate enterprise value. First calculate market capitalization by multiplying share price by number of shares. Then add debt and subtract cash and short-term investments to that figure:
* Market Cap = (64.88 * 2910.70) = 189,000
* Enterprise Value = (189,000 + 7,074 - 9,315) = 186,759
Free cash yield is then FCF/EV, or:
* Free cash yield = 12,472 / 186,759 = 6.68%
This seems like a fair premium to the low treasury bill rate, for such a quality company. Stocks get into real bargain territory when free cash yield approaches 10% but remember, fundamental analysis is needed before putting your hard earned money into the stock.
Sourced from here
Tips for choosing Small Cap value stocks
1) Find the Big Fish in Small Ponds
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and at MD we're not speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
Take for example an MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.
For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (20-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. But as I showed in the first article of this series, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up. The MD mission is to keep you away from the former and get you into the latter.
Sourced from here
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and at MD we're not speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
Take for example an MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.
For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (20-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. But as I showed in the first article of this series, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up. The MD mission is to keep you away from the former and get you into the latter.
Sourced from here
5 Reasons to own Small Cap stock
This is the first in a series of articles examining how and why to own small cap, value based stocks. This is an important component of the Magic Formula, and most companies on the overall screen fall into this category.
1) They Outperform Every Other Class of Stock. Period.
Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin.
If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.
2) The Market's Valuation of Small Cap Stocks Is Inefficient
Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small.
One of the best books ever written on investing, Peter Lynch's One Up On Wall Street, explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.
Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.
If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.
3) Small Caps Can Become Big Caps
This one is obvious - you're not going to find the next Microsoft or Wal-Mart by investing in Microsoft and Wal-Mart. When Microsoft started trading on the NASDAQ in 1986, it's market capitalization was about 700 million. Today, it's worth 260 billion - giving you back your initial investment 370 times over (and that's not including dividends!).
Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.
Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.
If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.
4) Small Caps Are Attractive Buyout Bait
Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.
Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent small-cap buyouts:
* Getty Images - bought for a 48% premium to the trading price.
* PETCO - bought for a 45% premium to the trading price.
* Russell Athletic - bought for a 35% premium to the trading price.
These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.
5) Warren Buffett Says So
No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?
"...look for small securities in your area of competence where you can understand the business"
If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!
Sourced from here
1) They Outperform Every Other Class of Stock. Period.
Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin.
If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.
2) The Market's Valuation of Small Cap Stocks Is Inefficient
Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small.
One of the best books ever written on investing, Peter Lynch's One Up On Wall Street, explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.
Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.
If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.
3) Small Caps Can Become Big Caps
This one is obvious - you're not going to find the next Microsoft or Wal-Mart by investing in Microsoft and Wal-Mart. When Microsoft started trading on the NASDAQ in 1986, it's market capitalization was about 700 million. Today, it's worth 260 billion - giving you back your initial investment 370 times over (and that's not including dividends!).
Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.
Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.
If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.
4) Small Caps Are Attractive Buyout Bait
Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.
Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent small-cap buyouts:
* Getty Images - bought for a 48% premium to the trading price.
* PETCO - bought for a 45% premium to the trading price.
* Russell Athletic - bought for a 35% premium to the trading price.
These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.
5) Warren Buffett Says So
No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?
"...look for small securities in your area of competence where you can understand the business"
If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!
Sourced from here
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