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Sunday, November 23, 2008

Tales of fortunes made and lost in recessions

Sunday, 23 November 2008
Success can be one of life's worst enemies. It engenders overconfidence and, as a result, one tends to let one's guard down - in some instances, to the extent of recklessness


MARKET crashes are the greatest redistributor of wealth. This has been true of previous crashes. But in the current turmoil, there are few beneficiaries, a friend noted. It is more a great destruction of wealth on a global scale so far.

A recession is a good time to start a business as costs are low. Disney, Microsoft, Hewlett-Packard, Oracle and Cisco are some of the companies that were founded in downturns.
Well, okay, some short-sellers may have profited from some of their trades. But many get wiped out in their next trade. Perhaps it is those who are not invested at all and who have the cash to pick through the carnage in the next few years who will really come out ahead. Who knows? Nobody is certain of anything anymore.

A lot of people have been hit hard this time around. There are a few reasons for this. One, prior to this, we've had four years of a bull market where prices had gone in only one direction. Success, notes a friend, is one of life's worst enemies. It engenders overconfidence and, as a result, one tends to let down one's guard - in some instances, to the extent of recklessness. Economist Hyman Minsky sees the cycle of risk-taking in the economy as following a pattern: stability and absence of crises encourage risk-taking, complacency, and lowered awareness of the possibility of problems.

But even for those who are conservative and have their heads centred and feet firmly planted on the ground, the economics just a few months back suggested that being invested was the right course of action. Then, inflation was running at 5 or 6 per cent and banks' interest rates were at less than one per cent.

For someone who didn't want to have his or her purchasing power eroded, keeping the money in the bank wasn't the most logical of options. Which was why a lot of people are invested - and, worse, a lot took loans to invest. If the borrowing cost was so low, and one was expecting to make a return higher than that cost of borrowing, it made sense to borrow.

If one were to assume risk, let it be with capital that one will not need for at least 3-5 years. In the meantime, be grateful for what you have - be it your health or time with your family.
Of course, we know now that a lot of people had underestimated or even ignored the risk of trying to earn those extra percentage points of returns.

A friend shared with me some of the horrendous stories of how an enormous amount of wealth was destroyed in the last few months.

Up till last year, one man had $100 million of his worth in only one stock. Towards the end of last year, that stock started to decline. By early this year, the stock was down more than 50 per cent from its peak just a few months before. The man picked up quite a few additional shares - on margin - thinking that the stock had bottomed and would eventually rebound. Since then, the stock has plunged by another 80 per cent. The $100 million is more than wiped out! The stock is Cosco Corp, which went from 10 cents in March 2003 to $8.20 in October last year - an 82 times jump. It is now trading at less than 70 cents.

Another guy had relatively much more modest means. His net worth was estimated at $2-3 million. He heard from 'reliable' sources that a particular company would be taken over by another at a significantly higher price than the stock's then market price. He bet all he had and, if I remember correctly, also took margin financing to buy that stock. The stock was FerroChina, which has since been suspended because it had run out of money to pay its suppliers and debtors.

One value investor thought Thailand was cheap a few years back. One particular company, a very big one, was trading at 1.2 baht - significantly below its book value. The investor concentrated his bet on that company. And, indeed, the market began to recognise the value of the company and the stock tripled to over 3 baht. The value investor's portfolio grew to $26 million. In the last year or so, the stock has plunged to below 0.7 baht. The investor is now down some 50 per cent on his original capital.

Another man was shrewd enough to think that the market was overvalued towards the end of 2007. So he got out of the market, and even shorted it. He was happy that the market went the way he predicted. He was the smartest guy in town.

By June or July, thinking that the market had fallen enough, he loaded up on shares. Like the guys above, he too used margin financing to pick up the shares. As we know, the market took an even more severe turn in September and October. He too was dealt a severe blow.

A friend was also bearish about the market towards the end of last year. He had put in some shorts. Then last October, the market went on to hit record highs. He lost his resolve, and reversed his trades and got hit as well.

Another made quite a bit of money in the Singapore market. His confidence grew. He wanted a bigger stage. He bought US shares on margin. US stocks took a precipitous plunge a few months back. He has had a few rounds of margin calls.

A young banker in his late 20s made $2-3 million from the property market in the last few years. He ploughed all the profits into a $10 million property, and took loans of some $7 million. He's now saddled with a mortgage payment of some $30,000 a month.

Many of the real-life examples above show just how lethal leverage can be. In a rising market, leverage is your friend; in a down market, the blow dealt by leverage can knock one out for good.

Perhaps another lesson is to always take some profit off the table. Today, the valuations of stocks are at levels unseen in years, if not decades. 'It is at times like these, when there is a lot of fear, that one can make three or four times return on your capital,' a friend said.

Yes, we all know that. But so far this year, every time one thinks that fear is at its maximum, it moves up another level. And another problem is that a lot of investors have run out of money to buy. A lot of the 'liquidity in the system' before the crisis was from loans; now, that has dried up.

In any case, whether a stock is cheap or not is still debatable. According to State Street Global Markets, its global Investor Confidence Index® for November fell another 1.4 points to a historic low of 57 points. Commenting on the index, Andrew Capon of State Street said: 'Investors face a difficult dilemma. On the one hand, equities are cheap. Using earnings adjusted for leverage and cyclicality, the equity strategy team at State Street Global Markets estimates that the US price-earnings multiple is 26 per cent below its 147-year average.

'These are levels seen only in periods of extreme dislocation such as the Great Depression, World War II and the 1870s. On the other hand, nobody can be confident that this current economic slowdown will not turn out to be just such a period rather than a more typical recession. 'So far, during this crisis, it is the bleakest forecasters who have been proved right.'

Indeed, we are in unprecedented times now. The euro area and Japan are now officially in recession. Even without the US officially joining this unhappy club, countries representing close to 50 per cent of global GDP are now seeing growth contract, noted Mr Capon. Consensus economic forecasts for GDP growth in the developed world have been falling for 16 months and are at 20-year lows.

Growth in the last seven years or so was propped up by debt-financed consumption from the US. And Asia has built up tremendous capacities to cater to that growth. Now, that consumption has contracted because the enormous financial leverage has to be unwound. That deleveraging process and contraction of consumption will drag on for some time because income has also diminished - if not totally disappeared, given the waves of job losses.

In Asia, companies have to deal with all the excess capacities and the vanishing demand. Many companies will go bust. Jobs will be lost, pay cut. In China, the hardship could trigger social unrest. It could be apocalyptic. We just don't know what will happen in the future.

But the fact is that we are now in the throes of a crisis and that itself may colour our judgment. 'Last year, it felt like the sky was the limit; now, it's like we are sinking into a bottomless pit,' said a friend.

Back to what economist Hyman Minsky says about the cycle of risk-taking: stability encourages risk-taking and complacency. But when a crisis strikes, people become shell-shocked and scared of investing their resources. People also often overestimate the probability of the worst-case scenario after a crisis has occurred.

So, for the optimists out there (if there are still any left), here's an inspiring story.

In 1939, with Hitler's Germany ravaging Europe, John Templeton - who believed in buying into companies at points of what he called 'maximum pessimism' - bought US$100 of every stock trading below US$1 on the New York and American stock exchanges.

Templeton's trade got him a junk pile of some 104 companies, 34 of which were bankrupt, for a total investment of roughly US$10,400. Four years later, he sold these stocks for more than US$40,000! Only four out of the 104 became worthless.

Yet another positive spin. A recession is also a good time to start a business. Costs are low. But it is not a good time to do financial deals - that's for a bull market, an investment banker told me recently.
Indeed, in a downturn, established firms tend to cut back on their growth investments to focus on defending their established core activities. That will create niches to be served by smaller companies. And once the start-ups develop to a certain size and the general economy picks up, there will be no lack of big company buyers that are willing to absorb these start-ups into their fold. That fits into the theory of starting a business in a recession and selling it in a bull market.

Well, here are some of the companies that were founded in downturns: Disney, Microsoft, Hewlett-Packard, Oracle and Cisco. There is no lack of examples in the local context as well. The first Sakae Sushi outlet was set up in September 1997. Financial PR, one of the largest investor relations firms in Singapore, was founded in August 2001.

Over the next year, there will certainly be more people forced to work for themselves because they will lose their jobs and not be able to find other suitable employment. And it will be no surprise if some of the talented people now unable to find work in an investment bank or other big company direct their energies towards creating a new generation of successful start- ups, said The Economist in a recent article.

I'm sure we all know of friends who created businesses which are now worth millions of dollars because they decided to venture out on their own after being retrenched. Retrenchment can be a blessing in disguise for some.

The key, I guess, is not to lose hope - despite how bleak the outlook may seem now. And if one were to assume risk, let it be with capital that one will not need for at least 3-5 years. In the meantime, be grateful for what you have - be it your health or time with your family.

The writer is a CFA charterholder

Wednesday, November 19, 2008

What Happy People Don’t Do

Published: November 19, 2008

Happy people spend a lot of time socializing, going to church and reading newspapers — but they don’t spend a lot of time watching television, a new study finds.

That’s what unhappy people do.

Although people who describe themselves as happy enjoy watching television, it turns out to be the single activity they engage in less often than unhappy people, said John Robinson, a professor of sociology at the University of Maryland and the author of the study, which appeared in the journal Social Indicators Research.

While most large studies on happiness have focused on the demographic characteristics of happy people — factors like age and marital status — Dr. Robinson and his colleagues tried to identify what activities happy people engage in. The study relied primarily on the responses of 45,000 Americans collected over 35 years by the University of Chicago’s General Social Survey, and on published “time diary” studies recording the daily activities of participants.

“We looked at 8 to 10 activities that happy people engage in, and for each one, the people who did the activities more — visiting others, going to church, all those things — were more happy,” Dr. Robinson said. “TV was the one activity that showed a negative relationship. Unhappy people did it more, and happy people did it less.”

But the researchers could not tell whether unhappy people watch more television or whether being glued to the set is what makes people unhappy. “I don’t know that turning off the TV will make you more happy,” Dr. Robinson said.

Still, he said, the data show that people who spend the most time watching television are least happy in the long run.

Since the major predictor of how much time is spent watching television is whether someone works or not, Dr. Robinson added, it’s possible that rising unemployment will lead to more TV time.

Picking stocks is the wrong way to go

Published November 19, 2008


ASIAN investors should wean themselves away from the illusion that they can pick stocks and time markets. Says Saxo Bank Group chief investment officer Steen Jakobsen: 'I think 80 per cent of readers should not invest in markets themselves. You need to treat investing as the most difficult thing in the world. Why are there more heart surgeons than successful traders?'

Markets are undergoing a 'paradigm shift' which should result in investment options that are low cost, more transparent and based on asset allocation principles. Against such a backdrop, structured products - notoriously non-transparent in risks and fees - have no place. 'Individuals need to realise that the allocation between equities, bonds, alternative assets and real estate is the biggest choice that they make. Whether you buy Singapore or China stocks, in the long term it makes no difference. The ability to pick stocks is (rather) useless. The discrepancy between the best 25 per cent of fund managers and the worst 25 per cent is less than 200 basis points . . . You should just be indexed. Spend time to get the allocation right. Finding the right stock is like a lottery ticket.'

Asia, he says, has fallen victim to structured products offering high yields. 'I'm a sophisticated investor. I would never buy a structured product. It has no transparency and a lot of fees. Every time you buy one, you're 5-6 per cent down at the start. As an investor, I only buy if there is transparency.' He himself writes a blog where he discusses the moves of the global macro fund he runs.

Mr Jakobsen, who has been trading since he was 17, says he follows three key principles. One is to recognise capital preservation is important - something investors often pay only lip service to. Second, have a true understanding of compounding in rising and falling markets. 'I know if I have $100 and I lost $10, I'm down 10 per cent. But if I want to go from $90 to $100, I have to make 11.1 per cent. That means I'm not willing to lose a lot of $10 bets.' The third is to understand you can't predict the future nor time markets. 'If I'm very convinced of something, I'm 60 per cent for and 40 per cent against. If I get to 100 per cent conviction, I'll be wrong. There are 100,000 people smarter than me trying to do the same thing.'

As an investor, he also scrutinises opportunity costs. 'I have 75 per cent in fixed income and cash. Every week I measure how much it costs me to be so defensive relative to the market. I'm gaining because I have positive yield carry. Investors can commit to a strategy but they need to measure the opportunity cost of doing something else.'

Also: 'Control your ego. When you make money, you think you're God; when you lose, it's everyone else's fault. It's not so. Whether you make or lose money, it's partly you but also partly random. There is a gravity in the market. Mathematically, if you speculate, you go bankrupt.'

Monday, November 17, 2008

Copper Drop Deepens as China Growth, Housing Falter

By Millie Munshi, Glenys Sim and Lee Spears

Nov. 17 (Bloomberg) -- Not even $586 billion of emergency spending by China can slow the plunge in copper, the worst- performing metal since the commodities market crashed in July.

Global inventories more than doubled in the past four months as the economic slowdown spread. U.S. auto sales slumped 32 percent in October to the lowest level since January 1991. A report this week may show U.S. builders broke ground on the fewest houses in at least a half century, curbing demand for cables, wires and pipes. China, the world's biggest copper user, is heading for its slowest growth in almost two decades.

``The raw materials sector had come grinding to such a screeching halt that this plan doesn't turn the outlook around immediately,'' Chip Hanlon, who oversees $1.5 billion at Delta Global Advisors in Huntington Beach, California, said of China's stimulus program. ``I'm leery about global growth right now. At the moment, I would still not want to be in base metals.''

Copper is an indicator for the world economy and sets the pace for other industrial metals because an average 400 pounds (181 kilograms) are used in homes and 50 pounds in cars, according to the Copper Development Association. Prices collapsed after rising as high as $8,940 a metric ton on the London Metal Exchange July 2. The International Monetary Fund in Washington said the U.S., Europe and Japan will fall into a recession simultaneously for the first time since World War II.

China is the key to commodity prices because the country is the largest user of iron ore, aluminum, zinc and copper. The nation's economy may grow 7.5 percent or less next year, Morgan Stanley and Credit Suisse Group AG say. That would be the slowest pace since 1990, data compiled by Bloomberg data show.

Chinese Demand

Demand from China helped copper prices more than double in the past six years. Now, the price may fall 37 percent from the Nov. 14 close to $2,400 a metric ton next year, said Andrew Keen, an analyst at Sanford C. Bernstein & Co. in London, the second most-accurate forecaster in the weekly Bloomberg copper survey.

Catherine Virga, an analyst with CPM Group in New York, expects the metal to fall to $2,550 and Adam Rowley, an analyst at Macquarie Group Ltd., forecasts about $3,300. Three-month futures on the London Metal Exchange slumped as much as 3.3 percent today to $3,695, and traded at $3,710 at 11:37 a.m. in Singapore.

Zinc may drop as much as 18 percent to $985 a ton, lead may lose 12 percent to $1,185 and aluminum may slide 7 percent to $1,800, Virga says.

Commodity prices, measured by the Standard & Poor's GSCI Index of 24 raw materials, plunged by more than half from their record on July 3 as the global credit crisis threatened to push the world into a recession, reducing demand. Crude oil has slumped 57 percent in four months.

`A Bubble'

``It was a bubble,'' Stephen Roach, chairman of Morgan Stanley Asia Ltd., said in an interview Nov. 13. The last one was in the early 1970s when ``you had the same type of global growth boom that we've had in the last 4 1/2 years,'' he said. ``The boom has gone to bust. The global economy is growing at 2 to 2.5 percent, less than half the pace we've been running at.''

BHP Billiton Ltd., the world's biggest mining company, has dropped about half in Australian trading from its intraday peak of A$50 ($32) in May as commodity demand slowed and traded today at A$25.06. Rio Tinto Group has tumbled by 55 percent to A$70.36.

Leaders from the biggest developed and emerging nations agreed to further steps at the weekend to prop up the global economy. The Group of 20 cited the potential for more interest- rate cuts and fiscal stimulus. Federal Reserve Chairman Ben S. Bernanke said Nov. 14 central bankers are prepared to take additional action as needed to unfreeze credit markets.

Slowing Output

China faces a ``formidable challenge,'' Mu Hong, a top planning official, said Nov. 14. Export growth and inflation slowed in October. Industrial output grew at the slowest pace in seven years and money supply expanded by the least since 2005.

Steel output in China, producer of a third of world supply, dropped 9.1 in September, the Brussels-based World Steel Association said Oct. 22. Power production fell in October from a year earlier, the first decline since February 2005, the China Securities Journal said Nov. 7.

``We are in a period of very severe production cuts as mid- stream industries such as steel reduce both raw material and product stocks, with massive reverberations through raw material markets,'' Macquarie Bank Ltd. said Nov. 10.

China has pledged ``fast and heavy-handed investment'' in housing and infrastructure through 2010 and a ``relatively loose'' monetary policy in a plan unveiled Nov. 9. The package offered funding for housing, infrastructure, railways, power grids, social welfare and rebuilding. The country plans thousands of kilometers of highways and railroads as it speeds development of the resource-rich western regions.

Seeking the Bottom

``The Chinese are very pragmatic,'' said Richard Elman, chief executive officer of Hong Kong-based Noble Group Ltd., a supplier of iron ore, coffee and grains. ``They will revitalize the economy. We've seen a leveling of steel prices internationally. We're encouraged that the bottom may be here,'' he said in an interview Nov. 11.

More money is being pumped into second-tier cities, Robert Theleen, chairman and co-founder of investment capital firm ChinaVest Ltd., said in a Bloomberg Television interview Oct. 29. As the economy slows, more factories will shut, unemployment will climb and people will return to the countryside.

``Those are the issues that are going to cause indigestion in Beijing,'' he said.

Home Slump

The U.S. housing recession at the heart of the economic decline shows no signs of letting up, signaling copper demand may stay depressed. New-home starts in October dropped to a 780,000 annual pace, the lowest since records began in 1959, economists said. The Commerce Department reports on Nov. 19.

Industrywide U.S. auto sales fell for the 12th straight month in October, extending the longest slide in 17 years and hurting demand for metals. October total sales dropped to 838,156 from 1.23 million, according to Autodata Corp.

General Motors Corp. said this month it may run short of funds before the end of the year and Chrysler LLC said survival would be difficult without aid.

Friday, November 14, 2008

China: At Its Most Attractive Level In The Past Decade

November 14, 2008

Author : Eddy Wong

The China equity market, represented by the Hang Seng Mainland Composite Index (HSMLCI), continues to drop sharply in 2008. The HSMLCI saw a 19% (in SGD terms) drop in October. In fact, the index dropped to a 3-year low and closed at 1794.24 points on 27 October 2008. This means that the index had dropped 36.7% (in SGD terms) during the first 27 days in October!

After the crazy sell-down in September and October, we believe that China equities are at their most attractive level in a decade, and we have therefore decided to upgrade China to 5 Stars, the best possible rating!

Chart 1: The HSMLCI dropped more than 50% this year!

Markets have collapsed since October 2007. After a painful market slump for more than a year, we believe that China is one of the best markets to buy at this point due to its attractive valuation. A sharp slowdown in the global economy seems likely in the coming 12 months. Also, we have seen a huge correction in commodities over concerns from the impact of a global recession. This suggests that the future demand for commodities could decline.

As wealth growth slows and demand softens, investors may be concerned about the possibility of a “hard landing” in China. We agree that China’s economic growth will slow further. Having said that, we are not expecting China to experience a “hard landing” in 2009! We think that investors could be overly pessimistic when they worry that China will head for a “hard landing”. Equities are facing a huge sell-off even when valuations are extremely low. We all know that “Buy Low and Sell High” is the ultimate goal for every investor, and now that the market is so low in terms of valuation, there is no doubt that it is a good time to invest in China!
No “Hard Landing”!

“Hard Landing” refers to the economic growth of a country shifting from a period of expansion to contraction within a very short period of time. For the case in China, since its economy has been expanding at a relatively high speed, we consider that the economy may undergo a “hard landing” if it expands at a rate of less than 6% year-on-year. The 3Q GDP growth is only 9% year-on-year, the slowest pace in more than 5 years. In fact, China’s economy expanded 9.9% year-on-year in the first three quarters of 2008. Economic expansion dropped to below 10%, so what does that mean?

It simply means that the Chinese economy is affected by the credit crunch across the world and hence its economic growth has dropped from a skyrocketing pace. But its growth rate is still faster than its Asian peers.

According to the International Monetary Fund (IMF), the world is estimated to expand by 3.7% in 2008 and 2.2% in 2009. In Emerging markets, the estimated growth is 6.6% for 2008 and 5.1% for 2009. However, China is estimated to grow by 9.7% in 2008 and 8.5% in 2009. Since the Chinese economy is still growing at a rate faster than its peers even during a global economic slowdown, it would be a more attractive investment destination than the other emerging markets such as Russia or India.

Table 1: The World Is Slowing

Source: IMF, World Economic Outlook, November 2008

If we look at the breakdown of the contribution to China’s GDP growth from net exports, consumption and investment, we find that the possibility of having a “hard landing” is nearly impossible. In 2007, the contribution to GDP growth by net exports, consumption and investment were 22%, 39% and 39% respectively. In the first 3 quarters of 2008, the contribution by the net exports dropped from 22% last year to only 12.5%. In fact, the Chinese economy expanded 9.9% in the first 3 quarters in 2008 vis-à-vis the first 3 quarters in 2007. It means that the net exports contributed 1.2% to the growth in China’s GDP in the first 3 quarters of 2008. As the demand for Chinese goods is expected to drop in late 2008 and 2009, we believe that the contribution by the net exports will continue to decrease. Even if contribution of net exports to GDP is reduced drastically, we expect the economy to grow more than 7%.

Another supportive factor for economic growth would be that Chinese households tend to save excessively in banks. As a result, it is not surprising that Chinese consumption has remained relatvely resilient, despite the sharp decline in the stock and property market. Retail sales increased 22% year-on-year in the first 3 quarter in 2008. A pick-up in domestic demand is going to play a more important role in supporting the economic growth.

On Fixed Assets Investments (FAI) - it increased 27.0% year-on-year in the first 3 quarters in 2008. Real estate development continued to slow and increased by less than 30% year-on-year in August and September 2008. At the same time, due to the increasing railway transportation spending by the government, FAI continues to grow strongly. Investors may worry if “hot money” stops flowing to China, or could even leave the country.

According to Alliance Bernstein, there was an estimated modest speculative inflow of around US$5.5 billion in the 3Q 2008, compared with more than US$60 billion and US$20 billion in the 1Q and 2Q 2008. Although credit has tightened sharply in the 3Q, monies are still trickling through to China and we do not expect any significant outflow of monies in the coming future.

After a full body checkup of China, we believe that a “hard landing” is not likely to occur in 2009. However, we do agree that economic growth will slow, affected by the external factors such as decreasing in demand for Chinese goods. Hence, corporate earnings may be hurt as well. If we are not expecting a “hard landing” in China, we should be able to examine the attractiveness of the Chinese equity market by looking at valuations.

Stimulus Package
On 9 November, the Chinese government announced a stimulus package with 10 measures to boost domestic demand growth. A total of 4 trillion yuan (US$586 billion) will be spent by the end of 2010. Plans include support for low-end and public housing, infrastructure in rural areas and building more railways, highways, airport etc. This package and the aggressive rate cut by the People’s Bank of China since September can help to support domestic demand. As we mentioned above, consumption is one of the most important contributors to China’s economic growth. We believe that the bottom line for the Chinese government is to maintain its growth at higher than 8% in 2009.

It is all about valuation!

Chinese equities used to trade at higher than 15X PE since November 2003. However, the PE level has dropped significantly from about 34X in October 2007 to about 10X in October 2008. According to our estimates, the PEs for the HSMLCI index are 10.3X and 9.1X for 2008 and 2009 (as at 7 November). It is the lowest since the index was launched.

In fact, we believe that the index already bottomed at 1794.24 on 27 October 2008!
Despite all this pessimism and the recent downward earnings revision, we have upgraded the China equity market to 5 stars – Very Attractive. We believe that current valuations have overpriced the negatives, resulting in an undervalued Chinese equity market. Another important component for examining the attractiveness of a market is the estimated earnings growth. The estimated earnings growth for 2008, 2009 and 2010 are 11.7%, 13.9% and 17.6% respectively. It is one of the strongest amongst Asian countries.

Chart 2: PE hit all time low!

There is no denying that China is not insulated from the global credit crunch. However, we believe that China has strong fundamentals to withstand this financial tsunami. When we look back at the basics of investing, valuations of Chinese equities look extremely attractive. In addition, we believe that the market has hit bottom in October, and hence, we have upgraded China to 5 stars – Very Attractive.

We saw panic selling in September and October. The best investment strategy is to buy when others are panicking and sell when others are too excited. Are you panicking and waiting for the market to shoot up? Or are you investing now to obtain the huge potential upside with a limited potential downside risk? I belong to the latter group of investors. How about you?