|Title:||STOCKS AND MUTUAL FUNDS||
Status: IN STOCK
|Printable Copy (PDF)|
|Stocks and Mutual Funds|
The ups and downs of the stock market make the national news nightly, and most people know someone who has made--or lost--money in the stock market. This is not surprising because individual investors have traditionally been the major owners of common stock.
In the New York Stock Exchange, however, most trading activity is done by institutional investors who have large portfolios to invest, such as managers of pension funds, investment companies, life insurance companies, and bank trust departments. Individual investors may account for more activity in other markets, such as the American Stock Exchange and the over-the-counter market.
Most experts agree that over the long run, stocks have performed better than most other financial assets. Tables from The Price Waterhouse Book of Personal Financial Planning indicate that small company stocks gave an average return to investors of 12.6 percent over the 60-year period from 1926 to 1985, and common stocks averaged 9.8 percent over the same period. Compare these figures to the 4.8 percent average for long-term corporate bonds and 3.4 percent for U.S. Treasury bills (T-bills). Keep in mind that these figures show returns for the long run only--during a shorter term the return would have fluctuated greatly. Before you consider investing in the stock market, you should understand the basics of stocks and of the market.
The two basic types of stock are preferred and common stock. Preferred stock is so named because shareholders receive preferential treatment in certain respects: they are paid dividends before common stockholders are paid anything, and if the corporation liquidates they are also paid off (after bondholders). Preferred stock usually has a fixed dividend rate, which means that preferred stockholders are protected in times of low company profit. On the other hand, in peak performance times preferred stockholders may receive less than common stockholders. Also, preferred stockholders do not usually have voting rights in the company.
Common stock, however, is what most stockholders buy. With common stock, the potential return is not limited by a fixed rate. Also, common stockholders have voting rights in the company; the weight of that vote is based on number of shares owned. However, a higher potential return on common stock also means a higher risk of little or no return. (See Extension publication HE-625 in this series, "Savings and Investments," for an explanation of the trade-off between risk and return.)
Both kinds of stockholders have limited liability for the debts of the corporation up to the amount of their investment.
The book value of a corporation is the value of the stockholders' equity, or ownership interest, as shown on the "books"--that is, the balance sheet. (Balance sheets are discussed below.) The book value per share is a measure of the company's net assets divided by the number of shares of common stock that are outstanding.
Dividends are cash payments made by the corporation to its stockholders. They are determined by the board of directors and can range from zero to any amount the company can afford to pay. As a stockholder, you have no guarantee that you will receive dividends.
A stock dividend is a payment by the corporation in shares of stock instead of cash. A stock split is the issuance of a larger number of shares in proportion to the number of shares outstanding. For example, a corporation might issue a "2 for 1" split, which means two shares of stock will be issued for each one share outstanding. Other things being equal, a stock dividend or stock split usually does not represent additional value to the investor with respect to his or her proportional ownership of the corporation. It simply means that each share of stock now costs less and is more attractive to buyers.
Stockholders with voting rights may attend the annual meeting of a corporation and vote on major issues such as electing directors. Most stockholders vote by proxy, which means that the stockholder gives someone else, usually the management of the corporation, authority to vote the stockholder's shares.
Types of Stocks
Stocks are often classified by financial analysts into four separate categories. The first is income stocks, which are stocks that produce steady income in the form of dividends. These stocks appeal to the investor who needs current income. Income stocks are usually the least risky, so they fit into the portfolio of the more conservative investor.
Second are growth-and-income stocks. These are stocks that produce perhaps more modest dividends, but that also have a reasonable expectation of growth, or appreciation. These are relatively safe investments and appeal to the investor with a low tolerance for risk. An example of this type is "blue chip" stocks, which are stocks of companies that are well known and have strong records of growth, profit, and dividend payments.
Next are growth stocks, which are stocks of faster-growing companies. These stocks are more volatile in price than the stocks in the first two categories and they are more risky. These companies usually do not pay dividends because they reinvest their earnings.
The fourth category is aggressive growth stocks. These also are stocks of fast-growing companies that pay few or no dividends. The stock prices are more volatile than the growth stocks described above, and they are considered high-risk stocks. Although the chances for loss of principal are high, so are the chances of success.
The Stock Market
The market for buying and selling stocks is primarily a secondary market. This means that most stocks are traded at resale among other investors. Often stocks are bought and sold through brokers, who work with buyers and sellers as intermediaries or go-betweens. Brokers receive commissions for their work.
Stocks are traded on the New York Stock Exchange, the American Stock Exchange, regional exchanges, and the over-the-counter market.
The New York Stock Exchange (NYSE) is the oldest (founded in 1792) and most prominent secondary market in the United States. Approximately 2,100 stocks, mostly of large firms, are listed on the NYSE. The New York Stock Exchange is a not-for-profit corporation whose members are primarily partners or directors of stockbrokerage firms. Most members of the NYSE act as brokers for customers or for their own accounts. Others are specialists who buy and sell shares of an assigned stock in such a way as to make sure the market in the securities of their assigned companies remains orderly.
The American Stock Exchange (AMEX) is the only other national organized exchange. Until 1921, the AMEX was known as the Curb Exchange and is sometimes still referred to as the Curb. The organization of the AMEX is similar to that of the NYSE except that it is smaller and fewer companies are listed there. Usually, the stocks and bonds that are traded on this exchange belong to companies smaller than those found on the New York Stock Exchange.
There are several regional exchanges located throughout the country, such as the Midwest Stock Exchange, the Boston Stock Exchange, and the Cincinnati Stock Exchange. The listing requirements for these exchanges are much more lenient than the New York Stock Exchange. Usually, regional exchanges list small companies that have limited geographic interest, but most of the securities traded on these exchanges are also traded on the NYSE or the AMEX.
Another market for stocks is the over-the-counter market (OTC). Unlike the markets described above, the over-the-counter market is not a central place to trade stocks. Rather, it is a way of doing business. Dealers in stock make transactions through computerized communications systems. The OTC market handles stocks that are not traded or listed on an organized exchange such as the NYSE or the AMEX. While over-the-counter stocks have traditionally been those of smaller companies, some larger companies have recently decided to remain with over-the-counter trading. These companies sometimes find trading in this market more advantageous. The OTC market is becoming increasingly important in the arena of market trading alternatives.
The individuals and organizations engaged in buying and selling securities are self-regulating organizations operating with the oversight of the Securities and Exchange Commission. The group that oversees OTC practices is the National Association of Securities Dealers (NASD), which is a self-regulating body of brokers and dealers. The NASD introduced a computerized communications network called NASDAQ, which stands for National Association of Securities Dealers Automated Quotations System. This system offers current price quotations for stocks traded over the counter as well as quotations for many stocks listed in the NYSE and AMEX. NASDAQ quotes are published in the financial pages of most newspapers.
Finally, there are other markets that are used primarily by large institutional investors and wealthy individuals. These markets offer certain services that are not offered by the larger exchanges.
Risks and Returns on Common Stocks
It is relatively easy to mathematically determine your return for any particular period on stock that you own. The return on your stock can be separated into two parts, dividends and capital gains or losses. The capital gain or loss is the difference between the amount at which you purchased the stock and the price at which you could sell it. Although many investors are attracted to stocks by the potential capital gain, many stocks derive a major portion of their total return from the dividends they yield.
Determining the holding period yield (HPY) will help you measure the return that you have received over a certain period of time. The formula for holding period yield is as follows:
Holding Period Yield = Dividends + Price Change divided by Purchase Price
Suppose, for example, you bought fifty shares of stock at $100 per share 1 year ago. You have received a total of $0.95 per share over this quarter from dividends, and the price of the stock has risen to $110 per share. Your holding period yield would be:
|Dividends||=||0.95 x 4 = $3.80 per share per year|
|=||(3.80 divided by 100) + (10 divided by 100)|
|=||0.038 + 0.10|
|HPY||=||13.8 percent per share|
This means that you had a 13.8 percent yield on your stock. If you want to compare this yield with the yield on other investments, be sure to use the same time interval for all investments. This time period was 1 year. That is why we multiplied the $0.95 dividend received each quarter by 4--to get the total amount of dividends for the year.
As with any investment, common stock also has its own sources of risk. One of these risks is that the price of stock can drop dramatically at any given time. The chance that an investor will suffer losses due to changes in the stock market price is called market risk. Another risk is interest rate risk. When interest rates go up, the price of stock usually goes down. Another risk with common stock is inflation risk. Because inflation decreases the dollar value of the returns received from any investment, inflation affects the values of all assets. Whether your stock does well in an inflationary period depends on the industry in which the company operates and the strength of the company itself.
Finally, other risks connected with investing in stocks include business risk and financial risk. Business risk describes the probability that a company will make less profit than expected or even suffer losses because of adverse circumstances affecting the business. For example, business risk could occur because of trade restrictions in a country in which the company does business or because of inefficient operations by the company in an increasingly competitive environment. A type of risk that may also be included in business risk is the possibility that all firms in a given industry will be unfavorably affected by some factor that does not affect firms outside of that industry. This type of risk is also called industry risk. Financial risk concerns the use of debt in financing the assets of a company. The company's return varies with the use of debt because of the risk of default as well as other factors.
How to Analyze and Select Stock
Many experts believe that the key to investing in the stock market is diversification--that is, offsetting losses in some stocks against gains in others by spreading investments over a number of stocks. Some say it is difficult for anyone with less than $50,000 to diversify enough by buying individual stocks. For smaller investors such as these, experts often recommend buying shares of a mutual fund. Mutual funds are discussed later in this publication. Investors with more money to invest can diversify on their own.
How do investors decide which stocks to buy? There are several methods, but two of the most well known are fundamental analysis and technical analysis. While both of these methods are helpful in analyzing a company's stock, you should remember that selecting stock is an art, not a science. The discussion below touches upon just a few basic evaluating tools for the purpose of exposing you to concepts used by the professionals. For more information, consult a broker or other financial professional, or consider investing in mutual funds that are managed by professionals.
When you use the fundamental analysis approach to investing in stocks, you are actually analyzing a stock's underlying value--its "fundamentals." Basically, after you determine the fundamental value of a stock, you compare that value to the market price and determine whether the stock is a good buy.
The Securities Market. The first step in fundamental analysis is to look at the overall economy and the securities market. The stock market as a whole is strongly influenced by the state of the economy, and an individual investor's return is affected by the movement of the stock market. Some investors are encouraged to invest if stocks are moving upward and to pull out of the market if stocks are moving downward. Many investors use market indicators to tell how all stocks in general are doing at any time. There are many such indexes, none of which is precise.
The best-known and oldest indicator of the stock market is the Dow Jones Industrial Average (DJIA). The DJIA is computed from thirty leading industrial stocks of large, well-established companies. The level of the DJIA is one indication of what the average price of these stocks would be if no splits or dividends had occurred. The DJIA is price-weighted--that is, high-priced stocks carry more weight than low-priced stocks.
Another market index is the Standard & Poor's Corporation Composite Index. This index is much broader than the Dow and should be more representative of the general market. However, the stocks selected are primarily NYSE stocks, so small companies are not well represented on this index.
The New York Stock Exchange Composite Index covers all stocks listed on the NYSE and is probably a more accurate reflection of the activity on the New York Stock Exchange. Again, however, smaller stocks may not be well represented. Other indexes include the American Stock Exchange, the National Association of Securities Dealers, and the Wilshire 5000, which represents the dollar market value of all NYSE and AMEX stocks plus all actively traded over-the-counter stocks.
Although none of these indicators is perfect, they all do attempt to measure the market's performance. This is important because, for a well-diversified portfolio (a "portfolio" is the group of securities that an investor owns), the market is the major factor that affects the portfolio's return. When you use the fundamental analysis approach, you first look at the performance of the market overall. This will serve as a baseline against which to measure the performance of the stock that you are thinking of buying.
The Industry. The second step in the fundamental analysis of common stocks is to determine the characteristics of the industry to which your prospective stock belongs. Consider the following questions:
Is the company in an industry that is emerging or mature? If the industry is emerging, the possibility of stock price appreciation is greater.
Is the industry stable or volatile? A volatile industry means a greater chance of sharp increases or decreases in stock prices.
How is the industry affected by the economy? Some industries such as durable goods perform poorly during a recession, while others such as food or public utilities are able to endure economic hard times reasonably well.
How does the industry respond to changes in the interest rate? Some industries are more dramatically affected by changes in the interest rate than others. Examples of these are the banking industry and the real estate industry.
How is the industry affected by political events? Some industries respond dramatically to changes such as a new administration or an increase in defense spending.
These and other questions must be asked to identify those industries that will perform best in the future.
How can you obtain information about the industry of your prospective company's stock? There are several sources that provide basic data about industries. Standard and Poor's puts out several publications such as The Annual Analysis Handbook and the Industry Survey that analyze and provide statistics on major industries. The Federal Trade Commission and the Securities and Exchange Commission provide information on individual industries in a publication called The Quarterly Financial Report for Manufacturing, Mining, and Trade Corporations.
Forbes magazine has an annual rating of industry performance in the early January issue each year. Other publications such as industry magazines provide more specific industry information. Investment advisory services such as The Value Line Investment Survey, Zweig Forecast, and Dow Theory Forecasts are also resources.
The Company. Once you have determined through your market analysis that the time is right to invest in stocks and have analyzed industries to determine those with the most promising future, you then must choose the most promising companies within those industries. This is the last step to the fundamental analysis approach.
In order to learn important information about a company you should get a copy of the financial statements of the corporation. These provide the major financial data used in investment decisions. One of these statements is the balance sheet. This table shows the assets, liabilities, and owner's equity or ownership interest in the company at one point in time. In other words, a balance sheet is like a snapshot of the company on a certain date.
The income statement, another type of financial statement, is used more frequently by investors to size up current management performance. It is also a basis for estimating how profitable a company may be in the future. The income statement shows the after-tax net income of the company which, when divided by the number of common shares outstanding, becomes earnings per share (EPS). This EPS number is often used to judge how well a company is doing.
EPS is made up of many factors, one of them being the return on equity of the company. Return on equity lets you know how efficiently a company is using its resources. In very basic terms, it is the company's net worth divided into its net income after it has paid its preferred stock dividends but before it pays common stock dividends. You can check the company's financial statements for its past return on equity.
Another important figure to check is the Price/Earnings (P/E) ratio. This ratio is calculated by dividing the current price of the stock by the latest 12 months of earnings per share. For example, if the current price of a share of stock is $40 and the stock earned $4 per share during the last 12 months, the P/E ratio would be 10:
Current price divided by last 12 months' earnings = $4 divided by $40 = 10
What does this tell you about the stock? It lets you know how much you are paying for a company's earning power. When a stock has a high P/E ratio, investors are willing to pay more for a stock's earnings, usually because they expect earnings to grow quickly.
High P/E ratios are often found in rapidly growing, newer companies. These stocks are riskier to trade than those with a low P/E ratio because the potential that the earnings will not reach those high expectations is greater. Stocks with a low P/E ratio are usually in slow-growing, mature industries, in blue-chip companies, or in stock groups that are not currently in favor with investors.
Stocks with a low P/E ratio usually offer higher dividends than stocks with high P/E ratios. In fact, high P/E ratio stocks often pay no dividends at all. Dividends, of course, are another factor to consider in analyzing the stock of a company.
Finally, take a look at the debt-to-equity ratio of the stock. This can be measured in two ways. Dividing total liabilities by total shareholders' equity can show how well the owners' equity can cushion creditors' claims in case the company liquidates. Alternatively, dividing total long-term debt by total shareholders' equity can give you a measure of leverage, or the company's use of borrowed money to boost the return on owners' equity.
Total liabilities, total shareholders' equity, and total long-term debt are figures that can be found on the company's financial statements. Comparing the debt-to-equity ratio of your prospective company with that of other companies in the industry can give you a picture of the company's health in terms of its debt.
In summary, the fundamental analysis approach to selecting stocks deals with fundamental economic factors that determine value. It is designed to assess long-term values compared to current market prices.
The second method of determining which securities to buy is called technical analysis. It focuses on timing--that is, when to buy and sell securities. Fundamental analysis focuses on how to find the value of stocks so that you can invest in quality stocks. Good timing in buying these stocks will help you produce greater profits (and smaller losses) sooner. Technical analysis is based on the idea that common stock prices tend to move together. In addition, these prices are determined by the investors' demand for stocks and the supply of stocks available.
To determine the short-term price movements in either individual stocks or the market as a whole, day-to-day changes in prices, trading volume, investor sentiment, and other technical indicators are analyzed. Technical analysts are primarily interested in changes in stock prices. The assumption is that prices move in trends and that the trends last long enough to profit from them. This means that technical analysis is more useful for trading stocks than for long-term investing.
Market trends are either "bullish" (meaning stock prices are trending up overall) or "bearish" (meaning prices are falling overall). Bull markets reflect investor optimism and economic growth, while bear markets reflect investor pessimism and declines in economic growth.
Technical analysts use market indexes to measure the general movements of stock prices. Five general market indexes frequently used by technical analysts are the Dow Jones Industrial Average, Standard & Poor's 500 Composite Index, the New York Stock Exchange Composite Index, the American Stock Exchange Index, and the Over-the-Counter Composite Index published by the National Association of Securities Dealers. All of these are reported daily in financial publications such as the Wall Street Journal and weekly in Barron's Financial Weekly.
Technical analysts also look at other factors, such as the relationship of changes in stock prices and the volume of trading. Volume, or the number of stocks traded, indicates whether investors are interested enough to trade. Other important factors to the technical analyst are the ratio of stocks advancing or increasing to stocks declining or decreasing in price, and the cycles that stock prices tend to take. Technical analysts use charts and computer models to track a stock's history and detect changes in trading trends.
While most of us do not have the knowledge that is needed to perform sophisticated analysis on stocks before we invest, it is helpful to know what the experts study in giving investment advice. A basic knowledge of analysis techniques helps us better understand what to look for when we seek out more detailed information about investing. In conclusion, although the stock market has rewarded individual investors, making money in the stock market is not simple. Learn as much as you can about the market before you invest.
Mutual funds are one way to simplify your investment decisions. With a mutual fund you "hire" a professional to study and monitor the economic outlook for investing as well as to deterrnine when to buy and sell individual securities. In addition, mutual funds provide the diversification in your portfolio that is difficult for a small investor to obtain.
A mutual fund is an investment company that pools money from individual investors and invests it in a diversified portfolio of securities. Most mutual funds invest in stocks and bonds, but some invest in other securities. Mutual funds continually issue new shares and buy them back again when you redeem your shares. That is why they are referred to as open-end investment companies. You purchase a share of ownership in a mutual fund, and it gains or loses value just at it would in individual stocks.
Mutual funds are often recommended for the small investor, one with less than $10,000 to $20,000 to invest. Most mutual funds allow investments for as little as $100 per transaction, an advantage that is often not available when investing in a significant number of stocks.
Moreover, small investors often like the idea that their investment is being managed professionally by a mutual fund manager. If the management firm offers a "family of funds," you have the advantage of moving all or part of your money back and forth between the different types of funds, usually with a simple toll-free phone call. Finally, mutual funds send quarterly reports to inform you of income, expenses, portfolio holdings, and performance. Still, since mutual funds rarely outperform the market, you may feel that you can do better, more cheaply and with less risk, on your own.
Mutual funds must compensate their managers and others who provide services such as financial advice. A load fund charges you a front-end commission or fee to invest. With a no-load fund, no commission is charged. Shares are bought by mail from the fund. Experts say that there is no evidence that load funds perform any better than no-load funds, but some investors choose load funds because they need investment advice. Both types of funds require a management fee. In addition, even a so-called no-load fund may have hidden costs.
Examples of such hidden costs are as follows:
- Redemption, surrender, or back-end charges may be levied when you sell shares.
- Contingent deferred sales charges are fees that may be charged whenever you sell shares before a set time period.
- Annual fees may be charged to help pay operating expenses and usually add up to 0.5 to 1.5 percent of the value of your fund shares.
- 12b-1 Plans help pay for advertising and sales literature. This fee gets its name from the rule set out by the Securities and Exchange Commission that allows its use.
- Other fees such as one-time account start-up fees, account maintenance fees, and transfer agency fees are also sales charges.
Since these fees are taken out of your earnings, it makes sense to find out about a fund's fee structure before you invest. Read the fund's prospectus and the supplementary documents called the "Statement of Additional Information." Also, look at the latest annual and interim reports to shareholders. Some of these fees can be avoided with good research on your part.
Look for funds that have low expense ratios: for example, less than 0.75 percent of net asset value. The net asset value (NAV) is quoted daily for mutual funds in the business section of major newspapers. Also, consider that a high turnover ratio, such as 100 percent, usually means extra brokerage fees because it means that the entire portfolio was traded once.
Selecting Your Mutual Fund
There are many different types of funds. How do you select the one that is right for you? The same questions that you ask in making any investment apply in selecting a mutual fund. Look at mutual funds from the standpoint of your investment objectives. For example, you should consider whether you will have a long-term commitment in the future for college costs or retirement. Perhaps you are more interested in receiving current income to finance shorter-term goals. Again, realize that mutual funds invest in many types of securities, including common stocks, preferred stocks, and bonds.
If you are looking for a common stock fund, ask yourself these questions:
- Do you want maximum gains with no emphasis on current income? Then you would be interested in the riskiest type of fund, one shooting for aggressive growth. These funds often invest in small companies that pay no dividends and can provide dramatic gains--or dramatic losses. These funds may cost you more because aggressive growth fund managers may buy and sell stocks more often than managers of more conservative funds. Since turnover is high, brokerage costs are high, and this reduces your assets in the fund.
- Are you more interested in a relatively stable return in current income and in financing some long-term goals? Growth-and-income funds might make sense for you if your tolerance for risk is low. These funds buy stocks that pay a dividend and have a reasonable potential for growth.
- Are you a conservative investor interested primarily in getting current income? Income funds are probably for you since these are the least risky. Managers of these funds put your money into the shares of companies in mature industries that pay healthy dividends.
As mentioned above, there are other types of funds besides common stock funds. A mutual fund that combines investments in common stocks, bonds, and preferred stocks to provide income plus some growth is called a balanced fund. These are also referred to as income funds, equity-income funds, or total return funds. These funds should be evaluated on the basis of total return from dividends and capital appreciation.
A bond fund is a mutual fund that invests in corporate and government bonds for safety and current income. These used to be considered conservative investments, but interest rate fluctuations have added more risk to this type of fund.
A money market fund, sometimes called cash reserves or liquid assets, invests in short-term, high-quality securities such as T-bills and bank CDs to provide high current yield and safety of principal.
Money market funds are somewhat similar to a bank account, except they are more sensitive to changing market conditions. Unlike most bank accounts, they are not federally insured against losses. These types of funds have become the most popular type of mutual fund investment.
Once you know your investment goals, you will be better able to select your mutual fund. A fund's objectives and investment options should be clearly stated in its prospectus. In addition, there are a few other factors to consider. Be sure, for example, that your fund is registered with the Securities and Exchange Commission. Also, consider how a mutual fund has performed over the long run in the past. Look for consistency in performance and continuity of the people managing the fund. Look for a fund that has done relatively well in both bull and bear markets.
To check out a fund's performance in bull and bear markets, look at publications such as Forbes magazine's annual survey of mutual funds. This survey rates mutual funds during both up and down markets. Other fund ratings can be found in Barron's "Quarterly Survey," Money magazine's "Fund Watch," Standard & Poor's "Stock Guide," and United Mutual Fund "Selector." Most of these can be found in your local library. You may also want to consult a stock broker. Remember, however, past performance is no guarantee of future performance.
Another factor to consider in selecting your mutual fund is convenience and flexibility. What kind of services does it offer? Does it have check-writing privileges? What is the minimum amount of the check that you can write? How easy is it to buy or redeem shares? Can you switch your funds into a stock or bond fund by phone? Are there any fees or limits attached to switching funds? Many mutual funds make it extremely easy for you to move around among the different types of funds in one family. This makes it simpler for you to monitor your investment.
In summary, mutual funds provide many choices in investments and offer the added benefits of a diversified portfolio and professional management. For these reasons, most investors use mutual funds for at least a portion of their investment strategy.
This publication has given an overview of some basic points about stocks and mutual funds, but it is not a "how-to" manual. Your investments are too important to take chances with. Seek professional assistance in determining which investment options will best meet your needs.
Breitbard, Stanley H. and Donna S. Carpenter. The Price Waterhouse Book of Personal Financial Planning. New York: Henry Holt and Company, 1988.
Jones, Charles P. Investments: Analysis and Management. New York: John Wiley & Sons, 1988.
Senchack, Andrew J. Smart Investing. Dallas: Taylor Publishing Company, 1987.
Stokes, Barrie Balzli, J.D. Personal consultation.
For more information, contact your county Extension office. Look in your telephone directory under your county's name to find the number.
Published by the Alabama Cooperative Extension System (Alabama A&M University and Auburn University), an equal opportunity educator and employer.
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