The Pace of Stock Market Gains Slows Down

With stock valuations near a historic high, in concert with concerns about the Federal Reserve raising short-term interest rates later this year, the pace of gains in the stock market dramatically slowed during the first quarter — when compared to the sizable gains over the past six calendar years. As the table to the left illustrates, the  S&P 500 Index posted a small total return of +1.0 percent during the first quarter.

Our portfolios trailed the indices during the first quarter. We have slowly been selling off companies in the better performing sectors, such as consumer staples and healthcare, as they reach our intrinsic value targets. Recent sales in these sectors in- clude Procter & Gamble (in the fourth quarter), and Wal-Mart and Becton Dickinson in the first quarter. Many companies in these sectors are richly valued but they continue to drive the stock indices higher. We are finding better value in economically sensitive and financial companies. We review some of these recent transactions later in the newsletter. Right now the stock market is behaving in accordance with Ben Graham’s timeless quote, “In the short-term the stock market is a voting machine; in the long-term it is a weighing machine.” We feel at some point the stock market will correct its errors and properly value our economically sensitive and financial holdings.

In lieu of trying to ride the trend of the strong performance of defensive companies, such as healthcare and consumer staples, we continue to follow the value investing school of thought that Benjamin Graham set forth over 80 years ago. Since Graham first laid out these principles, dozens of famous value investors, which include Warren Buffett, Walter Schloss, John Temple- ton, Michael Price and Seth Klarman have posted multi-decade periods of returns that have beaten the stock market indices. There have been periods of time when these investors have underperformed. In each instance, the managers remained disci- plined and adhered to Graham’s valued based principles. At some point their patience and discipline was rewarded. We have great confidence in the value investing approach. We think a synopsis of Benjamin Graham’s value based investment princi- ples would be helpful for clients in understanding how it has impacted Granite Value Capital’s investment philosophy of man- aging money and the importance of patience and discipline in our process.


The above post has been excerpted from a recent newsletter of Granite Value Capital.

This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.

Granite Value Capital, LLC is an SEC registered investment adviser with its principal place of business in Hanover, NH. Granite Value Capital and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which Granite Value Capital maintains clients. Granite Value Capital may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This newsletter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Granite Value Capital with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Granite Value Capital, please contact Granite Value Capital or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

For additional information about Granite Value, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.

A Berkshire Opportunity Cost: Listed Family Firms

unnamedThe following is adapted from “Berkshire’s Blemishes,” a working paper delineating the costs, rather than the vaunted benefits, of Warren Buffett’sBerkshire Hathaway as a management model.

Warren Buffett loves family businesses whose owner-managers care more about their constituents than about profits, recognizing instead that customer care tends to translate into economic gain. Those entrepreneurs, in turn, love Berkshire Hathaway, Buffett’s company, because it offers intangible benefits such as managerial autonomy and a permanent home. When family businesses sell to Berkshire, they know they can still run them as they see fit and will not be sold if prospects falter: Berkshire has not sold a subsidiary in forty years and promises not to.

Buffett hates using Berkshire stock to pay for acquisitions, however, since few companies can match the time-tested premium currency Berkshire has come to represent. In fact, Berkshire’s worst acquisition was paid for in stock and Buffett still translates the cost into current values: $443 million paid in 1993, equivalent to more than $5 billion in Berkshire stock now. Preferring to pay cash, Berkshire is often able to acquire family businesses at a discount because selling shareholders value Berkshire culture. Buffett also hates auctions, plagued by frightful dangers like the winner’s curse, which can push bids well above value, rationally calculated.

Sensible as these tenets are, there is always an opportunity cost, in this case forsaking listed family firms–publicly traded companies controlled by a family. Unlike those owned solely by close-knit groups who all wish to sell to Berkshire, directors of listed family businesses owe duties to non-family shareholders when selling control. In most states, led by Delaware, they are duty-bound to get the best value for shareholders.  (The doctrine is known by famous cases illustrating it, including Revlon and Paramount v. QVC.)

In a stock deal where all holders share gains in future business value, directors could consider Berkshire’s special culture in valuing the transaction. But with cash, all such future value goes to Berkshire’s shareholders, not selling public stockholders, who would also gain nothing from the autonomy or permanence that family members prize in a sale to Berkshire. So directors resist an all cash sale at a discount and seek rival suitors at higher prices, even stimulating an auction to drive price up—repelling Berkshire’s interest.

An example can be drawn from Berkshire’s 2003 acquisition of Clayton Homes, a publicly traded family business bought for a modest (seven percent) premium to market. Many Clayton shareholders objected; one, Cerberus Capital Management, told Clayton it wanted the chance to make a competing bid; another sued. The result was a six-month delay in getting to a shareholder vote, which narrowly approved the Berkshire deal. Many Clayton shareholders were disappointed, but Cerberus opted not to outbid Berkshire, and the court dismissed the lawsuit.

The scenario remains unattractive to Berkshire, however, given the risk of litigation, delay and rival bids. After all, courts might require directors to e affirmative steps, presenting the risk of an auction, which in itself suffices to deter Berkshire from bidding in the first place. The upshot: the publicly traded family business is outside Berkshire’s acquisition model, amounting to an opportunity cost for what would otherwise be a sweet spot. On balance, it is probably a price worth paying, but it’s useful to know the price.

Lawrence A. Cunningham, a professor at George Washington University,  has written numerous books on a wide range of subjects relating to business and law. 

Subprime Auto Lending: Myth & Reality

The availability heuristic is a mental shortcut that frames recent events from previous experiences. The mind interprets events that can be easily recalled as important. The easier we can recall the consequences, the more likely and greater those consequences are perceived to be. Consequently, we tend to place greater emphasis on recent information, forming new opinions biased toward recent news.

Given the severity of the Great Recession and the magnitude of losses suffered during the subprime mortgage crisis, it is natural for investors to be concerned about the next asset bubble and its potential consequences. Against this backdrop, subprime auto loans have become an easy target for the media and regulators today. While the comparison between subprime auto lending and the subprime mortgage market makes for attention-grabbing headlines, there is little empirical evidence to support the thesis.

According to Carmine Gallo, author of Talk Like TED, the best way to connect with people is to tell them an emotional story. Emotionally charged stories release dopamine in the brain and cement the narrative in our memory. Consider these examples and accompanying images from a series of articles from the NY Times.1,2,3,4,5,6

Image_2 Image_3 Image_4 Image_5

These are terrible stories, but they serve a deliberate purpose. They paint an emotionally charged narrative helping the audience jump to the conclusion that all subprime auto lending is evil just as all subprime mortgage lending resulted in the loss of thousands of homes for hardworking Americans. While it is true that auto loan balances have been rising for years, it also true that the demand for cars has increased significantly over this period.

Cheaper financing is unquestionably increasing the demand for credit, but it is not the only factor driving auto sales. A weak labor market and tight credit standards have restricted new vehicle purchases throughout the economy’s weak recovery. As a result, the average age of cars on our roads increased from 9.8 years in 2005 to 11.4 years by 2014. Since then, employment has recovered, and credit markets have thawed, unleashing pent-up demand that is now showing up in the loan data.

All businesses have their share of bad actors. The auto market is not different in this regard, but it is dangerous to derive broad conclusions from isolated examples. A more rational approach would be to examine the empirical data rather than relying on heart-warming anecdotes. A closer look at the loans being extended shows that more credit is available to all consumers today, not just those with low credit ratings.

Auto Balances ($Billions)

Source New York Fed

Source: New York Fed

While day traders and condo speculators each had their time in the spotlight, we have not seen any evidence of record profits from flipping Honda Accords. Extremes in particular segments of the luxury market aside7, depreciating, mass-produced assets are simply not obvious candidates for speculative bubbles.

Since the term “bubble” is often associated with loose lending, it may be instructive to compare the pre- crisis growth in home lending to the more recent growth in auto lending. Home lending grew 66% from 2002 through 2005. While auto loans have increased in recent years, growth of 31% since 2011 has been less than half that pace coming off a much lower base. In comparison, C&I loans have grown 40%, multifamily loans have grown 42%, and U.S. Treasuries have grown 49% over the same period. In other words, growth in auto loans appears to be consistent with the overall growth in credit more broadly.

US Banks: Auto & US Family Cumulative Growth (%)

Source Bank Call Reports

Source: Bank Call Reports

Many pundits cite increasing subprime lending as a leading indicator of a bubble in auto credit. However, while subprime auto loans have grown, they are growing at a slower rate than the overall auto loan market. As a result, the share of subprime auto loans is declining and currently sits at 15-year lows. In contrast, the share of subprime mortgages increased considerably from 2006 to 2010 as subprime mortgages grew 104% relative to overall mortgage growth of 22% over the same period. The charts below, from the Federal Reserve Bank of Atlanta, compare the percentage of subprime auto loans with the percentage homes loans that are considered subprime.

Subprime Share of Loan Balances

Source New York Fed 2

Source: New York Fed

Auto lending is closely correlated with other consumer loans that tend to have high levels of subprime borrowers. The fact that one in four auto loans is subprime might raise red flags, but it becomes less of a concern when you consider that more than one in two households in the U.S. is rated subprime today. The quality of these loans is a much more important indicator than the overall quantity of lending in the marketplace, and as such, we are monitoring loan terms closely. Historically, auto loans have median loss rates that exceed mortgages; however, auto performed significantly better than mortgages during the crisis. As they say, you can sleep in your car, but you can’t drive your house to work.

Consumer Credit Default Indices

Source Bloomberg

Source: Bloomberg

Headlines have highlighted increased delinquencies in individual markets as a sign of problems, but to date, delinquency trends for auto are generally flat. The slight increase in recent write-offs is anticipated in light of increased volume as lending standards are no longer as restrictive as they were during the crisis. The chart below displays cumulative write-offs for subprime borrowers across vintages with the solid lines at the top and bottom representing the maximum and minimum loss rates for 2006-2013 vintages. Note that the red line which represents the average of the first six vintages from 2014 falls squarely in the middle of this range.

Image 6

Finally, there are vast differences in the quality of loans being originated in this highly fragmented market. A bottom-up analysis of vintage originations by issuer demonstrates the higher quality of loans made by Ally over time and relative to peers. As should be expected, credit standards have loosened since the financial crisis, but we see no evidence that loan terms have deteriorated substantially, outside of more aggressive peers lending to deep subprime borrowers at 15% – 20% annually (chart below). More importantly, we see no cause for concern at Ally, particularly at the current price, which already discounts a worst case scenario in our opinion. Any positive surprises relative to depressed expectations should result in healthy gains for investors today.

Broyhill_Asset_Management_Estimates,_Company_Filings

Source: Broyhill Asset Management Estimates, Company Filings

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1Silver-Greenberg, J., & Corkery, M. (2014, July 19). In a Subprime Bubble for Used Cars. New York Times.
2Silver-Greenberg, J., & Corkery, M. (2014, September 24). Miss a Payment? Good Luck Moving That Car. New York Times.
3Silver-Greenberg, J., & Corkery, M. (2014, October 1). Loan Fraud Inquiry Said to Focus on Used-Car Dealers. New York Times.
4Silver-Greenberg, J., & Corkery, M. (2014, December 25). Rise in Loans Linked to Cars is Hurting Poor. New York Times.
5Silver-Greenberg, J., & Corkery, M. (2014, December 2014). Rise in Loans Linked to Cars Is Hurting Poor. New York Times.
6Silver-Greenberg, J., & Corkery, M. (2015, January 26). Investment Riches Built on Subprime Auto Loans to Poor. New York Times.
7A 1963 Ferrari 250 GTO became the world’s most expensive car, selling for $52 million in October 2013.


The above post has been excerpted from the 2015 Q1 Letter of Broyhill Asset Management. For related commentary, visit The View from the Blue Ridge.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Broyhill Asset Management. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates, or other factors. Performance numbers are calculated using a time-weighted rate of return. Additional information will be provided upon request.


The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

Discount Auto Shopping

Warren Buffett has said, “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.” Brilliant reputations are difficult to come by in the auto industry. Bad economics are much more common. That being said, some of the greatest opportunities for investment arise when cyclically depressed assets are trading at cheap multiples of trough earnings. This has been the case as the auto sector has slowly recovered from the depths of the recession only recently reaching pre-crisis unit sales after years of production below trend.

We made our initial investment in the industry early last year as recurring front page headlines eventually caught the attention of Congress who jumped at the chance to fault General Motors (GM) for ignition switch failures. Trading at nearly half the multiple of its peers, with largely restructured operations and an overcapitalized balance sheet, the company had a variety of operational and financial levers at its disposal. Shares of GM gained 8% during the quarter. Since quarter end, some of those levers have been pulled for them.

Our next investment in the sector was CDK Global (CDK), a business we have discussed in previous letters. We purchased CDK, which provides mission critical technology to auto dealers, shortly after it was spun out of ADP in September 2014. The company’s Digital Marketing business claims GM as its most significant client, creating additional synergies in our internal research efforts. CDK advanced 15% in the first quarter after a powerful rally post-spin.

Other corporate actions in the auto industry proved to be equally compelling. We had been following Fiat Chrysler (FCAU) for some time as the company progressed towards its merger as one holding company and moved toward a US listing. We leveraged ongoing conversation with auto dealers while exploring CDK’s competitive moat to better understand the value embedded in Fiat brands like Maserati and Ferrari. We ultimately made our investment at a price we felt represented little downside risk given the value of the company’s luxury brands and parts business. Assuming CEO Marchionne comes anywhere close to his long-term goals for Jeep and the company’s other core brands (an assumption the street is unwilling to make) the upside is very compelling. Shares of FCAU rallied over 40% during the quarter.

As our investment in Fiat appreciated, and Chrysler continued to set new records for sales gains, we began to question the level of incentives at play in driving top line growth. Around this time, questions around subprime auto lending began to arise. Given our general skepticism for lending practices in the financial system, we decided to take a closer look. We doubled back on our conversations with auto dealers and dug into the data ourselves. Which brings us to Ally Financial (ALLY).

By way of background, Ally is the artist formerly known as General Motors Acceptance Corp, a name that should probably make you wince when you say it. The old GMAC collapsed under the weight of massive mortgage losses and auto loans largely dependent upon a failing General Motors.

The transition from GMAC to Ally Financial was a long, treacherous process and as a result, investors have been slow to recognize the value in the new company today. After receiving billions in equity from the US Treasury, Ally shed its mortgage business, became a bank holding company with a rapidly growing online bank, and refocused on its core competency of auto lending while diversifying away from GM.

In January, GM “assisted” the company’s diversification efforts by announcing its plans to use the new GM Financial as its exclusive provider of the manufacturer’s leases. We believe the market overreacted to the GM loss which provided an attractive entry point for our investment in Ally. We expect management to execute on their multi-year plan to increase normalized earnings power through balance sheet optimization given the easing of regulatory constraints after exiting TARP last year. Ally has already begun reducing its high-cost funding which should allow for greater flexibility from its rapidly growing online bank. We expect a continued reduction in funding costs this year.

Today, Ally is trading at 70% of tangible book value. Even assuming no asset growth over the next few years and cumulative losses on par with the financial crisis, book value should remain well in excess of the current price, providing ample downside protection. Given the higher quality of Ally’s current book, low- hanging fruit in the form of high-cost debt and rapid growth in non-GM originations, we view this scenario as quite extreme. We believe Ally is poised to grow its capital base and the returns it earns on that capital, and if successful, the stock should trade at book value or higher.

The upside case is quite clear and far more likely in our view. Assuming management is successful in its plan, which we believe is very achievable, and the company continues to grow per share book value at the current pace, Ally’s book value should approach $40 over the next few years. If the stock were to trade back to book value, this would represent a 2x return on our investment.


The above post has been excerpted from the 2015 Q1 Letter of Broyhill Asset Management. For related commentary, visit The View from the Blue Ridge.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Broyhill Asset Management. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates, or other factors. Performance numbers are calculated using a time-weighted rate of return. Additional information will be provided upon request.


The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

Profit Growth, Job Growth and Stock Prices: A Case Study in Temporary Employment

The four largest internationally active employment agencies, of which we own three, are an interesting case study in how everyone benefits when a company pursues the profit motive. Kelly Sevices, one of these, has not done so very well. But that doesn’t make it a bad investment today.

There are four large, publicly traded temporary employment agencies active worldwide: Adecco, Randstad, Manpower and Kelly Services, and our funds own shares in all of them except Manpower. Kelly, founded 1947 in Detroit, Michigan, is the oldest. A comparison of its performance to that of the other three is an interesting case study in how companies that do not put enough emphasis on profit maximization do a disservice to themselves, their employees and stockholders and with that to the society as a whole.

The following graph compares the EBITA (earnings before interest, tax and amortization of intangibles through acquisitions of companies) margins of Kelly with those of its major listed peers from 1993 (the earliest year for which we can get data electronically) to 2014. The numbers are adjusted for one-time costs such as restructuring expenses and asset write downs. Please bear in mind that this is an industry, in which margins of 4-6% are very good. Never a leader in terms of profitability, Kelly is clearly the laggard since 2000. At an EBITA margin 2013 of 1%, Kelly was at roughly 1/3 the level of its competitors. The comparison is even worse in 2014, but that was an unusual year for Kelly.

Blog-eng-26.05.2015-520x348

Kelly is clearly less profitable than its three major competitors for two reasons. First, it has placed a high priority on offering steady employment and being a pillar of the community. In other words, the company carries an enormous overhead burden, because it has been very reluctant to cut costs, which in the staffing industry essentially means corporate employees – those that work for their company full time and place the temporary workers or provide the infrastructure necessary for the functioning of the corporation. Indeed, Kelly’s corporate central expenses alone are the size of Manpower’s and larger than Randstad’s, although these companies are about four times the size of Kelly measured by revenues. This alone accounts for about 1%-point of the margin differential to peers. Secondly, Kelly’s strategy has been to concentrate on serving large American corporations wherever they are active worldwide. In return for the enormous volume of business this provides, Kelly has accepted lower prices in the hope of offsetting them with efficiencies. The company has done this well enough in the American field operations, but the foreign subsidiaries, which account for about 25% of sales, are barely profitable even in good years, nota bene without allocating the corporate costs to the operating units.

By contrast, Kelly’s European competitors have been much more ruthless in cutting jobs when the need arose, especially after mergers but also during market downturns. Their systems are designed to reward even low level managers for achieving profits, whether that is in times of growth, when investments are required, or during recessions, when costs need to be cut. Moreover, they have found efficient ways to serve high volume customers. An example is Randstad’s in-house concept, in which a dedicated team serves the customer right from its own premises instead of a typical branch office, simplifying communication, reducing overhead costs and tying the customer closer to Randstad. Adecco and Randstad thus have much higher profit margins. Manpower is something in between. It had been managed poorly, leading to poor pricing decisions in some markets and a lack of cost discipline, but these mistakes have been corrected in the last years, and it, too, has been reducing headcount.

High profits allow an enterprise to grow (if, of course, they are real and result in corresponding cash flows) by enabling investments. These can go either into organic growth opportunities, which in this industry means renting new locations, hiring people to recruit and place temporary staff and buying software to make the process more efficient, or they can go into acquisitions, opening access to new markets or strengthening positions in existing ones.

The benefits of high profit margins are apparent in the statistics in the table below. In 1993 Manpower, then the largest, was roughly twice as big as Randstad, the smallest of the group and essentially focused on the Netherlands. Adecco and Kelly Services were in between and roughly equal in size. But 21 years later, thanks to acquisitions and comparatively high rates of organic growth, Adecco and Randstad had increased their revenues 13- and 14-fold, nearly twice as much as Manpower, and relegated it to third place. In this time Kelly, always starved for cash, did not even triple its revenues. Adecco is now 4.8 times larger.

As one might expect, the stock prices of these four companies reflect their revenue and margin performance. The shares of Randstad have done best, after it successfully expanded internationally, followed by Adecco and Manpower. Kelly’s stock has essentially stagnated, leaving it miles behind even the relative laggard Manpower.

It is worth pointing out that this share price performance has not come at the expense of the workers. The number of corporate employees has risen roughly half as fast as revenues at the two European firms. Essentially this reflects the productivity gains the industry has achieved, largely thanks to better software. The two Americans benefitted from the same effect, but as inferior operators to a lesser extent. Thanks to their outstanding growth, Adecco has nearly six times as many corporate employees and Randstad nearly eight times as 21 years ago, while Kelly has not even doubled this number.

Untitled

You may at this point be wondering why 3.0% of the Classic Global Equity Fund is invested in Kelly, and why we would own it in the Classic Value Equity Fund if its market capitalization were large enough (at least CHF 2 billion). The answer, quite simply, is that the stock price more than discounts Kelly’s problems. The company has boxed itself into a corner strategically. It depends on large clients, and these require an international presence, but Kelly is too weak to grow its non-US operations to a scale that would allow them to be consistently profitable. Nevertheless, the company does have strengths – an excellent brand name, a strong position in US mass temping, and some innovative ideas. Even though Kelly recently reduced the size of its large headquarters and is slowly whittling down its international presence, the cost cutting potential remains huge for an acquirer who is willing to eliminate the headquarters and who can handle the international business in its own network. We hope that the controlling shareholders soon realize that their only realistic option is to put the company up for sale. That should ensure the growth of the healthy assets, create jobs in the long term and provide us with a good stock return.


The above post was originally published on the blog of Braun, von Wyss & Müller.