June 2018 | Annual Report

Introduction

Welcome to the ‘new-look’ Alluvium Global Fund report.

With this updated format we have endeavoured to provide commentary on our investment activities in a more engaging and informative manner for you, our clients. We recognise that each individual investor has preferences for how they like to receive news, and with that in mind we created a snapshot with key highlights. Further reading follows if you would like more detail and the reasoning behind our decisions.

And we are proud to say that in the course of the last year we have had some great successes. A number of the investments we have made provided substantial returns for the Fund, leaving us in a very positive position. That said, we also made some other investments that have proven to be significant learning opportunities for us. All are explained within the report.

We are grateful for your interest, and we especially thank those investors and other supporters of our business. We look forward to working closely with you all in the future.

Snapshot

  • Overall, we look at the Fund’s return of 10.1%1   for the year with some satisfaction, given the risks we refused to take.
  • Our investment style – not paying too much – has remained out of favour. Reflecting our policy of only deploying capital
    when we can find quality businesses available at reasonable prices, our cash position hovered between 20% and 30%.
  • Successful investments include our forays in unloved US retailers and unappreciated Canadian timber, pulp and paper suppliers. By recognising value and timely purchasing, these positions together contributed 7.8% to the Fund’s return.
  • Our ‘learning opportunities’ were investments in British newspaper distribution and Swedish property development businesses. These experiences have been invaluable and we reflect on these decisions with some measure of humility.
  • We take the good with the bad. As investors in US companies, we will see benefits from the tax cuts of December, but conversely many of our investee businesses face tougher trading conditions as the tariff impacts take effect.
  • At the broader level, the fall in the AUD provided a nice tailwind, particularly during the June quarter.
  • Our administrator/unit registrar and custodian changes are now complete and we have updated our internal policies for
    the more stringent regulatory requirements we face as we excitedly look to provide a European offering.

There has only been a few short periods since the Fund’s inception when our investment style has been vindicated – like during those jitters in early February when most major markets (and many ‘growth’ stocks) were down around 8%. But with our more conservatively priced investments, our unhedged currency positions and our cash level of around 25%, the Fund was up marginally over that period. This type of resilience is what we expect of the Fund’s investment strategy.

“Even the intelligent investor is likely to need considerable willpower to keep from following the crowd” – Benjamin Graham

With meaningful amounts of our own capital invested in the Fund, we are simply not prepared to risk it by succumbing to the momentum market – for we will surely mistime the peak and more likely than not lose much of our capital. And when will this reverse? Who knows. The top five stocks in the MSCI World Index posted an average return of 40% over the year – and we do question whether those increases are justifiable by improving merits of the underlying businesses. Rather, perhaps they are simply the result of their large index weights and inflows into ‘index like’ products? In contrast to those stocks, we believe the portfolio of quality businesses held by the Fund are priced prudently (refer Table 6).

Performance

Figure 1: Value of AUD 100,000 (Net Dividends Reinvested)

Source: Administrator, Alluvium, Factset, Interactive Brokers. Past performance is not a reliable indicator of future performance2  .

Figure 2: Net Fund Returns Compared to Gross Index Returns (AUD)

Source: Administrator, Alluvium, Factset, Interactive Brokers. Returns more than 1 year are annualised. Past performance is not a reliable indicator of future performance. Date of inception: 1 January 2015.

Contribution

Figure 3: Top Contributors/Detractors (Quarter)

Source: Alluvium, Factset, Private Reporting

Figure 4: Top Contributors/Detractors (Year)

Source: Alluvium, Factset, Private Reporting

Holdings

Table 1: Contribution Details

June 2018 June 2018 Quarter Summary June 2018 Year Summary
Stock End Weight Start Weight Return Contrib. Start Weight Return Contrib.
Canfor Pulp 6.5% 4.3% 54.6% 2.2% 0.0% 107.6% 3.1%
American Eagle 0.0% 0.0% 0.0% 0.0% 3.9% 66.2% 1.9%
Williams-Sonoma 2.8% 4.0% 21.6% 0.7% 3.7% 35.2% 1.5%
Lear Corporation 4.4% 4.6% 4.2% 0.2% 3.9% 37.8% 1.5%
Western Forest 0.0% 4.4% 22.5% 0.6% 4.8% 1.3% 1.3%
Transcontinental 6.2% 5.5% 13.1% 1.2% 5.0% 28.6% 1.3%
Bpost 0.0% 0.0% 0.0% 0.0% 4.1% 3.6% 1.1%
Codan 0.0% 3.3% 13.7% 0.4% 0.0% 35.6% 0.9%
Nichirin 3.8% 3.7% -17.9% -0.6% 0.0% -10.4% -0.4%
Tenneco 3.1% 3.3% -16.3% -0.5% 0.0% -16.6% -0.5%
J.M. 0.0% 4.3% -9.3% -0.4% 0.0% -32.2% -1.1%
Connect Group 0.0% 2.3% -46.5% -1.1% 0.0% -58.5% -1.6%
Other 57.3% 37.7% 5.0% -1.3% 44.8% -7.0% 0.8%
Cash 15.9% 22.6% 1.2% 0.3% 29.8% 1.8% 0.3%
Total 100.0% 100.0% 1.7% 1.7% 100.0% 10.1% 10.1%

Source: Alluvium, Factset, Private Reporting. Returns include dividends and are time-weighted in AUD. Returns quoted in commentary sections are in local currencies.

Table 2: Quarterly Purchases

Gap New Position
Sanderson Farms New Position
H&R Block New Position
Samsung Electronics New Position

Table 3: Quarterly Sales

Western Forest Complete Sale
J.M. Complete Sale
Codan Complete Sale
Connect Complete Sale

The Good, the Bad not so Good and the Ugly Learning Opportunities

Let’s start with the ‘Good’- it’s so much more encouraging this way.

One could say we saw both the forest and the trees in Canada. We did not buy a share of Canfor Pulp3   during the quarter, but as a result of the market ascribing a price of this business 52%4   higher than it did in March, the position grew from 4.3% to 6.5%. And it’s not like it was due for any rebound – its share price had already increased more than 30% from when we started buying in August last year. The result from this extraordinary gain (from an ordinary business with better than ordinary financial metrics) was a 3.1% contribution to the Fund’s annual return, mostly coming through during the June quarter. And with Western Forest, the lumber supplier we accumulated in early 2017, we saw (no pun intended) a strong contribution to the Fund’s annual returns. Whilst we welcome such pleasing gains, we are cognisant of the investment risks, with both businesses being susceptible to the prices of their underlying commodities.

Sticking with Canada, Transcontinental (the packaging and media business, and one of the Fund’s original investments) was also a material contributor. All three of these Canadian companies report quarterly. For Canfor Pulp and Transcontinental our updated analysis continued to justify their positions in the Fund, but the share price increases resulted in their weights representing too great a risk to the portfolio, so their positions were trimmed (Canfor Pulp a few days after quarter’s end). For Western Forest, we ramped up the selling that we had commenced in small volumes in September last year, ultimately reducing the Fund’s position to zero. There were no alarm bells – the business just became too expensive.

Moving to the US listed retailers – it was pleasing that Williams Sonoma (the homewares business) posted a return of 17.4%5   for the quarter, making it 30.7% for the year and resulting in it being a significant contributor to the Fund’s returns over both timeframes. We first bought Williams Sonoma in April last year, as well as American Eagle, another US retailer that contributed meaningfully to the Fund’s annual return (refer September report). With some trepidation, we ‘averaged down’ in both, at times around 20% below our initial purchase price to build our larger stakes. During the December and March quarters we completely sold American Eagle, and we have now substantially lowered the Fund’s weighting to Williams Sonoma. In the case of American Eagle, we left some on the table for the next guy (we are such nice guys – we do this often), to make way for fellow apparel retailer Gap – which we assessed to be a better quality business available at a cheaper price.

Other contributors worth mentioning include: BPost (the Belgian freight company, no longer held, which we wrote about in our last report); Lear Corporation (the US listed supplier of seats and electrical systems to automobile manufacturers which remains a large position in the Fund as we think its business fundamentals justify its current price); and Codan (the Australian listed communications equipment business which we had sold by the end of June).

Let’s now turn to the ‘not so Good’. Two of the Fund’s poor performers (Nichirin and Tenneco) produce automotive parts. Both were purchased in February this year. Hindsight suggests the timing of those purchases was poor – President Trump announced his tariff plans in early March. There’s little doubt that increasing tariffs leads to poorer business conditions for companies which produce international tradable goods. However, in our view the extent of the ramifications, beyond that broad generalisation, are unknowable.

Our investment process is somewhat predicated on buying with enough ‘margin of safety’ to absorb the likely negative consequences of most ‘unknowables’ (and, incidentally, to graciously accept the positive effects of ‘unknowables’). So although we are far from thrilled with these trade war developments, we do not account for them in our portfolio construction or investment process. To do so would be inconsistent with our investment philosophy and therefore foolish. But the Fund is certainly not immune to the reactions of other market participants with their different philosophies and processes and the consequential effects on share prices. In the cases of Nichirin and Tenneco, these were decidedly negative and as a result they meaningfully detracted from the Fund’s return over the June quarter (and noticeably over the year). Thankfully, for reasons we do not know, fellow auto parts supplier, Lear Corporation was spared.

Introducing New Positions, Welcoming Back Old Ones

The major positions we sold during the quarter have been discussed, but aside from Gap, we are yet to mention a few of the Fund’s new positions. In June, shortly after the Financial Times reported “H&R Block whacked after margin guidance”, we built our position. Yes, management indicated that H&R Block’s margins would suffer as a consequence of their decision to invest in their online capability – but when we apply lower margins to its reasonably stable revenue stream we judge this business to be trading at attractive multiples to underlying earnings and cash flows (and providing some margin of safety to account for risks of such analysis). We considered the different ways the business may look in the future and we debated the likely extent of the decline of ‘assisted’ tax returns and the competitive advantages of H&R Block’s street presence. The synopsis: no doubt there are risks, but given H&R Block’s pricing we are prepared to accept them.

Our expanded investment universe now includes South Korea, and here we found a large, well known company meeting our criteria. From late May we have built a position in Samsung Electronics.

As we wrote in our last report, the Fund held a large position in Sanderson Farms (the US chicken farmer) last year. Despite missing its share price peak, we were quite satisfied when we sold it in September with our gain of around 60% in just six months. More recently, by late April its share price had fallen around 35%, and we became enticed to buy it again. As the share price continued to decline, we purchased more at progressively lower levels.

Astute readers may note that we are displaying prima facie evidence of the value investor’s curse – both buying and selling too early. But we are never too fussed with short-term market gyrations. And in the case of Samsung Electronics and our recent purchases of Sanderson Farms, so far we have again provided evidence to prove we are not great market timers.

And we saved the worst for last, the ‘Learning Opportunities’.

Writing about mistakes is a little painful, but by openly acknowledging them we are creating a Commitment Effect which we know will help ingrain our learnings into our thick skulls. Mistakes are inevitable and excusable. Not learning from them isn’t.

We start with J.M. – the Swedish residential developer which we began accumulating in September last year and continued buying at progressively lower prices through to February. We sold in mid June. After factoring in a dividend paid in April, this resulted in us losing around 18.1% of the capital we invested. For those canny observers of this being less severe than the time-weighted return quoted in Table 1, it simply reflects us losing less capital on each subsequent purchase tranche. Irrespective, as it represented over 4% of the Fund, that really hurts.

J.M.’s largest market is Stockholm – it accounts for over half of its operating capital. And, according to widespread media reports early this year, Swedish house prices were rapidly retreating and apartment prices in the capital were worst hit – reported to be down 8% over 2017. It is apparent the widespread reporting of the poor market conditions led to J.M.’s share price decline. The extent to which this will affect the long term viability of J.M.’s business is unknown, but we do suggest that the share price fall of over 50% (from its peak in April 2017) is likely to be an over-reaction. J.M.’s first quarter results that were released in April did indeed reveal deteriorating fundamentals and our updated analysis and investment rules encouraged (but did not require) us to divest the position. To a large extent, our strategy relishes cyclicality, and we were cognisant that by selling perhaps we would not have given this position enough time to ‘pan out’. Your investment team debated this. We considered the important question addressing the Endowment Effect: “at this price, if I didn’t own it, would I buy it?” We mulled over the tax consequences. Our resulting decision was to sell.

When it comes to Connect Group (the UK newspaper and magazine distribution business), it doesn’t matter how you assess it – whether it be by simply looking at the investment results or on any most forgiving qualitative measure – it was our worst ever investment decision. It alone cost the Fund 1.6% of its capital over the year. We let ourselves and our investors down.

The overwhelming majority of Connect Group’s earnings come from a core business in structural decline. Nonetheless, it is highly cash generative and it certainly has some steadily declining value until its ultimate extinction. And, rightly or wrongly, we will invest in any business provided it ‘stacks up’ on our quantitative measures and it passess our subjective overlay. And in the case of Connect Group – to cut to the chase – we erred in allowing this business to pass our subjective overlay.

Management’s strategy to address its core business issues was to add a B2B parcel delivery business. Surely through route duplication you couldn’t avoid realising some ‘synergies’. Then add to this the ability to ‘leverage’ the network in a new ‘Click and Collect’ offering to online retailers – where significant volume growth is of course inevitable, well – what could go wrong? Competitive pressures, lack of pricing power, margin squeeze, merger implementation issues – to name just a few issues. And what made matters worse is that we took our eye off the ball. Firstly, tempted by its declining price, we ‘averaged down’. But unlike our averaging down of the US retailers we did so without any further insight as to the business conditions. And then, when provided with such insight in early May, we declined to take advantage of that ‘escape clause’. Maintaining our position, we finally overcame our Loss Aversion and relented when it was announced in June that the CEO and CFO were leaving. By that time the share price had fallen another 45%. The end result, we lost almost 60% of the capital we invested.

What are the key lessons learned? Never take our eye off the ball. When business updates disappoint relative to our expectations, act accordingly and immediately – we never actually know what’s ‘in the price’. And stick to our core competence by investing in existing business prospects, not in the strategy of the management team.

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” – Warren Buffett

Introducing New Positions, Welcoming Back Old Ones

The major positions we sold during the quarter have been discussed, but aside from Gap, we are yet to mention a few of the Fund’s new positions. In June, shortly after the Financial Times reported “H&R Block whacked after margin guidance”, we built our position. Yes, management indicated that H&R Block’s margins would suffer as a consequence of their decision to invest in their online capability – but when we apply lower margins to its reasonably stable revenue stream we judge this business to be trading at attractive multiples to underlying earnings and cash flows (and providing some margin of safety to account for risks of such analysis). We considered the different ways the business may look in the future and we debated the likely extent of the decline of ‘assisted’ tax returns and the competitive advantages of H&R Block’s street presence. The synopsis: no doubt there are risks, but given H&R Block’s pricing we are prepared to accept them.

Our expanded investment universe now includes South Korea, and here we found a large, well known company meeting our criteria. From late May we have built a position in Samsung Electronics.

As we wrote in our last report, the Fund held a large position in Sanderson Farms (the US chicken farmer) last year. Despite missing its share price peak, we were quite satisfied when we sold it in September with our gain of around 60% in just six months. More recently, by late April its share price had fallen around 35%, and we became enticed to buy it again. As the share price continued to decline, we purchased more at progressively lower levels.

Astute readers may note that we are displaying prima facie evidence of the value investor’s curse – both buying and selling too early. But we are never too fussed with short-term market gyrations. And in the case of Samsung Electronics and our recent purchases of Sanderson Farms, so far we have again provided evidence to prove we are not great market timers.

Reflection

Who are you to call yourself a ‘value investor’ if you haven’t indulged in the orgy of Omaha activities with 40,000 like-minded Buffett disciples in May. Half of your investment team experienced it in 2014. It was now the other half’s turn. Of course it’s not just the day at the Berkshire AGM, it’s the conferences, the Markel Corp AGM, the side meetings with interesting fellow investors, the keynote speaker at a dinner function, the chats in the Starbucks line with Berkshire staff, the steak dinner at Gorat’s and the walk around Nebraska Furniture Mart.

These experiences, together with our ‘learning opportunities’ prompts reflection on our investment strategy.

Helped by this solid dose of Confirmation Bias in Omaha, the level of comfort we have with our broad investment philosophy has been reinforced. This is a little ironic when one of its underlying tenets is an innate appreciation of how little we know – a belief which has led to our analysis being overwhelmingly based on objective, measurable data. There has been little allowance for subjective input and we have been very hesitant to introduce more. By doing so, we sense that with our generally risk averse nature, we would no doubt miss some good opportunities. But our recent experiences have encouraged us to pay greater heed to the converse, that is, to think about the poor investments we may potentially avoid if we were to introduce more ‘judgement’ to our process. In essence, we now question the degree to which the mistrust we have in our own judgment is a net benefit to our investment process.

We do not see value in preparing any explicit forecasts. And we remain overwhelmingly focused on the numbers. But we have introduced more qualitative input – we now better allow for ‘thinking’ and ‘judgement’ in our analysis. It has simply become necessary as we increase our focus on business quality.

Introducing New Positions, Welcoming Back Old Ones

The major positions we sold during the quarter have been discussed, but aside from Gap, we are yet to mention a few of the Fund’s new positions. In June, shortly after the Financial Times reported “H&R Block whacked after margin guidance”, we built our position. Yes, management indicated that H&R Block’s margins would suffer as a consequence of their decision to invest in their online capability – but when we apply lower margins to its reasonably stable revenue stream we judge this business to be trading at attractive multiples to underlying earnings and cash flows (and providing some margin of safety to account for risks of such analysis). We considered the different ways the business may look in the future and we debated the likely extent of the decline of ‘assisted’ tax returns and the competitive advantages of H&R Block’s street presence. The synopsis: no doubt there are risks, but given H&R Block’s pricing we are prepared to accept them.

Our expanded investment universe now includes South Korea, and here we found a large, well known company meeting our criteria. From late May we have built a position in Samsung Electronics.

As we wrote in our last report, the Fund held a large position in Sanderson Farms (the US chicken farmer) last year. Despite missing its share price peak, we were quite satisfied when we sold it in September with our gain of around 60% in just six months. More recently, by late April its share price had fallen around 35%, and we became enticed to buy it again. As the share price continued to decline, we purchased more at progressively lower levels.

Astute readers may note that we are displaying prima facie evidence of the value investor’s curse – both buying and selling too early. But we are never too fussed with short-term market gyrations. And in the case of Samsung Electronics and our recent purchases of Sanderson Farms, so far we have again provided evidence to prove we are not great market timers.

Risk, Asset Allocation and Benchmarks

Risk is complex. It is personal. And because investment risk and asset allocation are inextricably linked, it follows that the ‘comfortable’ or ‘right’ mix of investment assets is also personal. In our view it depends on one’s understanding of investing, their beliefs, the confidence they have in their understanding of investing and the conviction they have in their beliefs.

“You have to invest in a way that’s comfortable for you.” – Walter Schloss

We mention this because the Fund’s investment style caters best to those investors who share our thoughts. Consistent with what we wrote in our June 2016 report, the Strategy was developed to address what we wish to achieve from investing in listed equities – which is not to outperform an index, nor to beat competitors, but rather to access a diversified portfolio of businesses with attributes we see as attractive, with the intent of compounding capital while minimizing the chance of permanently losing it. This means that to a large degree our strategy incorporates a dynamic ‘asset allocation’ component (between equities and cash). It also means avoiding risks associated with chasing short term returns. History suggests this leads to resilience in down markets and results in market beating returns over the long run.

It is not our place to suggest how investors judge our performance. But for what it’s worth, our internal benchmark is incredibly simple – absolute return since inception.

Closing Remarks

The strategy has now been running for three and a half years, and the Fund for a little over two. Over the time of its operation, it has returned 11.6% annualised. We are satisfied with this performance. We hope for better, but truth be told if in 30 years time we were able to look back having achieved this on average since inception, we would be two very happy gentlemen.

As a result of these returns the Fund incurred performance fees for each of its two years of operation. We have long expressed our thoughts that it is inappropriate to pay performance fees that relate to long term investments on a short term basis. Such arrangements are simply not investor friendly – it doesn’t take much volatility to end up with the situation of heads you win, tails I lose (refer More Secrets insight). And – don’t get us started with re-setting benchmarks…

As Alluvium is not subject to the demands of corporate ownership, we have the freedom of delaying, or even not accepting any performance fees. Applying this discretion, the Fund did not pay its performance fee for the 2017 financial year until recently. And, with respect to the performance fee it has expensed for the year just ended, our intention is not to pay it until June 2019 and to refuse it should we feel undeserving of it. And if it is paid, we will invest it back into the Fund. This only serves to strengthen our alignment of interests with external investors.

We remain passionate and very committed to our investment strategy. As we continue to prove the merits of our offering we hope to welcome new investors. As always, we are happy to meet with you to further explain our strategy.

Thank you again for your interest.

Stuart Pearce
Principal

31 July 2018

Alexis Delloye
Principal

Profile

Figure 5: Diversification by Sector

Source: Alluvium, Factset

Figure 6: Diversification by Region

Source: Alluvium, Factset

Table 4: Fund Overview

Cash 15.9%
Top 15 holdings 67.0%
Number of holdings 22
Weighted Average Market Cap. (USD m) 24,550

Source: Alluvium, Factset

Table 5: Quality Metrics (weighted average)

Debt (% of EV) 11.0%
Piotroski score 6.9
Return on Invested Capital (5y average) 27.0%
Latest Return on Invested Capital 27.3%

Source: Alluvium, Factset

Table 6: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV) 13.9%
Earnings yield (NPAT/Mkt Cap) 10.4%
Fee cashflow yield (FCF/Mkt Cap) 9.6%

Source: Alluvium, Factset

Table 7: Top 15 Holdings

Canfor Pulp 6.5%
Transcontinental 6.2%
Gap 5.3%
LyondellBasell 4.6%
Haseko 4.5%
Lear Corporation 4.4%
Franklin 4.4%
Sanderson Farms 4.3%
Gilead 4.2%
Delta Air Lines 4.1%
Odelic 3.8%
Michelin 3.8%
Nichirin 3.8%
H&R Block 3.7%
Samsung Electronics 3.4%

Source: Alluvium, Factset

Definitions

General

Administrator: Apex and/or Mainstream
Alluvium: Alluvium Asset Management Pty Ltd, ABN 69 143 914 390, AFSL 476067
Apex: Apex Fund Services Limited
Factset: Factset Research Systems, Inc.
Fund: Alluvium Global Fund
GST: Goods and services tax
Interactive Brokers: Interactive Brokers, LLC
JP Morgan: JPMorgan Chase & Co.
Mainstream: Mainstream Fund Services Pty Ltd
MSCI World Index: MSCI World Net Total Return Index (AUD, unhedged)
Nexia: Nexia Sydney Audit Pty Ltd

Portfolio Metrics

Enterprise Value (EV): The market value of equity plus the book value of debt
EBIT: Earnings before interest and tax
Earnings Yield: The most conservative result from four different calculations at the equity level
Free Cash Flow (FCF): Cash flow from operations less capital expenditure
Return on Invested Capital: EBIT as a percentage of the average capital invested in the business operations
Piotroski Score: A discrete score (from 0 to 9) to assess the strength of a firm’s financial position

Footnotes

1 Source: Administrator

2 Comprises: (i) a separately managed account for the period 1 January 2015 to 6 June 2016 sourced from Interactive Brokers and reduced by an assumed administration fee of 0.45% and a base management fee of 0.90% (both inclusive of the net effect of GST), as calculated by Alluvium; and (ii) the Fund from 7 June 2016 sourced from the Administrator.

3 Company names have been abbreviated throughout this document in the interest of readability.

4 Source: Factset

5 Returns include dividends and are expressed in local currency. Source: Alluvium, Factset, Interactive Brokers.

Alluvium is the issuer of units in the Fund and is solely responsible for the preparation of this document. The Fund is an unregistered managed investment trust available to Wholesale Clients as defined under Section 761G of the Corporations Act 2001 (Cth). An Information Memorandum for the Fund is available and can be obtained from our website. A person should obtain a copy of the Information Memorandum and should consider the Information Memorandum carefully before deciding whether to acquire, or to continue to hold, or making any other decision in respect of, the units in the Fund. This document was prepared by Alluvium and does not contain any investment recommendation or investment advice. This document has been prepared without taking account of any person’s objectives, financial situation or needs. Therefore, before acting on any information contained within this document a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs. Neither Alluvium, nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in, the Fund.

By | 2018-08-03T14:33:39+00:00 July 2018|Reports|0 Comments

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