QBAMCO - Value is the Thing
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Transcript of QBAMCO - Value is the Thing
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7/28/2019 QBAMCO - Value is the Thing
1/11
QB ASSET MANAGEMENT www.qbamco.com
1See Important Disclosures at the end of this report.
July 2013
Value is the Thing
Take a big risk to grow and add jobs
Manufacture disks to rid corn of their cobsKernels for bisques and gluttonous hogs
The idea cant miss, wealth by the gobs
But oer in a land far, far away
A small little brand and a sweaty array
Of cheap, hungry hands foregoing all play
Producing cob corers for two bucks a day
Sales soon drop as waist belts get big
Canned bisque is a flop, up is the jig
Now only needed as slop for the pigs
Production to stop? (Unlikely, you dig?)
The factory is fair cause workers stay sated
With bennies and shares and grandeur now dated
Bosses need only keep shareholders elated
By showing great flair at new highs unabated
Cobber Inc. shares rise year after year
Through buybacks contrived to make them more dear
Debt long-lived to some distant year
Funds the whole lie that production is here
And so it goes
The economy grows, see NGDP
Though everyone knows the growth isnt free
Real growth may be slow but dont disagree
Continue the pose (even when negative, see?)
Growths only good when capitals built
Debts dead wood when its done to the hilt
Look under the hood and under the kilt
Real value has stood when growth starts to tilt
Only three ways to mend leverage amok
Formally suspend all debt owed in bucks
Or let debt end on its own (that sucks)
Or simply rend new money in trucks
Simple and significant in drink and clear thought
Forget what they think and what you were taught
Price metrics stink when theyre commonly sought
Real values the thing, half sold is well-bought
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3See Important Disclosures at the end of this report.
Our sense of sustainable value in todays global markets is tied directly to the general perception of
future inflation. The overwhelming majority of investment capital is positioned for low inflation today
and tomorrow. This implies and explains the current dominance of levered revenue models sponsored by
levered investors borrowing from levered creditors. Were expectations of rising inflation to come to the
fore, we believe un-levered assets and businesses that do not rely on ever-more public leveraging would
perform far, far better than currently levered assets owned by levered investors selling goods and
services to businesses and consumers that fund their purchases through credit.
Since very few investors expect rising inflation anytime soon, the return skew is overwhelmingly positive
in its favor. Both deep value and gamma are buried in the changing popular perception of future
inflation, and the best part about this is that rising price inflation expectations are precisely what all
central banks around the world will soon be forced to promote. Dont fight the Fed front-run it.
Macroplasty
Macro trends impact global, regional, sector and entity-specific revenues, costs, earnings by impacting
the magnitude of supply and demand for specific goods and services. They also drive the relative valueof currencies in which assets are denominated. As we have seen so often, rotating central bank currency
devaluations signal predictable corporate strength in certain domiciles and industries over others.
Macro considerations need not be abstract. Would Wal-Mart have a viable business model without low-
cost foreign production? What would GEs enterprise value be without GE Credit and an accommodative
Fed? Would the business flowing through Goldman Sachs be nearly as robust were it not for the Feds
reliably accommodative monetary policies? Would weakening JPM earnings make steepening yield
curves more predictable? Would health care costs (and revenues) in the US have risen at the same torrid
clip were Americans not getting older, or if insurance premiums were not ultimately subsidized through
ever-increasing government deficit spending that funds Medicare and Medicaid? Will Apple
shareholders benefit more over time than the providers of credit for consumers buying its products?
Macro may be the new black, and for exceedingly good reasons, but it seems very few are profiting
directly from it today. Is that because most are dull or ill-informed, lazy or not in touch with good
information? We dont think so. More likely it is because our currencies are moving targets, and
therefore the secular value of everything cannot be accurately judged. Macroeconomics cannot be
reasonably explained or anticipated today, and, as a result, macro-market cross-rates and relative values
cannot be quantified. If we may, macroeconomics has been reduced by world-improving monetary
authorities to the study of gibberish. The folly (Im tapering, just kidding, Im tapering, just kidding)
would be funny if it were not so real and contemporary and meaningful.
The entire spectacle is manifest in the public capital markets where almost no new capital is being
formed, or (and heres the weird part), where little sustainable wealth is being created and transferred.
Our time is defined by economic releases suggesting little and unreserved electronic credits hop-
scotching back and forth in search of financial return. Bernanke or Draghi, Ackman or Icahn, place your
bets. (Hey, I love this guy cause I make money betting against him!) Wheres the value proposition?
As humbled investors longing to be falsely modest, we need not be bitter by the markets de-emphasis
on real value or on the value of experience (or even on the evanescence of the Dollar Empire). We shall
apply ourselves further and stay the course, just in case everyone acknowledges once again that the sun
rises in the east and markets are for capital formation and pricing. To find real value today we take a
fresh look at economic fundamentals and the implied commercial fundamentals beholden to them.
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QB ASSET MANAGEMENT www.qbamco.com
4See Important Disclosures at the end of this report.
Everything has a Price
Two hundred years before Smith and Hume, longer still before Ricardo, and almost half a millennium
before Keynes and Friedman, Nicolaus Copernicus (while he was not redefining the solar system by
putting the sun at its center) first put forth the Quantity Theory of Money. Good
stuff, that. It is an immutable truth that the change in the supply of money directly
impacts prices. More money chasing constant value must increase nominal prices.
It begins to get squirrelly when observers mistake credit for money and desire for
aggregate demand. In fact, desire not demand for goods, services and
everything wonderful may be infinite but prices cannot rise without the means to
satisfy that desire. Desire plus money (and credit) equals demand that economists
may then quantify. Thus, the quantity of money drives the general price level regardless of needs and
wants, regardless of human incentives, or regardless of economic theories and policies that suspend or
misdirect its popular understanding.
The common rejoinder what about monetary velocity?! is pig in a poke, in our view, where and whenit counts. Yes, nominal price levels may rise or fall when more or less money (or credit) is exchanged in
the economy. But nominalprice levels ultimately mean little. Why? Because in non-barter societies the
only thing that truly matters to users of money is value, not price. The inherent value of a good, service
or asset does not change with its price, which may fluctuate wildly with the money stock and/or velocity.
The most critical determinant of a well-functioning and sustainable economy, no matter how large or
provincial, is the spread separating nominal wage and price levels from their ongoing value to society.
Strong economies are those where clearing prices reflect well the sustainable social value of labor,
goods, services and assets. Weak economies are those where the general price level is more abstract.
Economic viability is ultimately defined by how many of us produce something of value. Production not demand is where economies start because without production members of society do not have
the means to fulfill their desires, unless they borrow it from those that have produced. (The temporary
bridge is credit, which we discuss below.) Without production there can be no lasting supply of goods
and services, no stable pricing, no sustainable money, and no economy. Thus, the means of production
ultimately define and price real value and determine the scale and nature of economic activity.
The nominal price of everything from labor to crude oil to shipping lanes, from iPhones to AAPL shares,
is derivative of their values to society. Fiscal policy makers trying to tweak where money flows, and
monetary agents trying to tweak nominal price levels by fiddling with the quantity of money and credit,
are also beholden to the means of production. Monetary policies seeking to change or stabilize prices in
order to manage temporal human incentives mean little when societies are not producing.
Copernicus insight almost 500 years ago would no doubt lead him to believe today that while the
money stock and general price level are indeed linked, the center of a viable economy the economic
sun, if you will is not price but the value generated from sustainable production.
Top Down for the Bottom Up
Most economists and investors believe unpredictable animal spirits influence overall demand for goods
and services, and from these mysterious sociological oscillations economic and business cycles emerge.
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5See Important Disclosures at the end of this report.
Bah. For centuries, with varying degrees of intensity, governments and banking systems have had
incentive to leverage our economies governments through deficit spending so politicians could exert
their will without coincident consequence, and banks through fractionally reserved lending so they
could produce near-term profits. Ultimately, governments, banking systems and, as a result, the means
of production, become less able to service the consequent systemic debt created by all the credit, and
so our economies are naturally, reflexively, compelled to de-lever (and so too are banking systems).
Most believe the process of de-levering must take the form of nominal debt destruction (i.e., Detroit?).
It can, but does not have to, especially when central banks are involved. The need to de-lever arises
from the increasing burden of servicing liabilities and the attendant growing disincentives to grow
liabilities further. During these times real output tends to slow and can turn
negative. When this occurs, those in charge of money and credit tend to
manufacture more of it, leveraging the system further and increasing the
burden of repayment. (A loan created today also creates an offsetting deposit
in a quantity able only to retire the principal of amount of the loan, not the
interest burden it bears. Hence, new loans/deposits must be created today to
service the interest burden of the loan created yesterday.)
Balance sheets continue to be stressed until it becomes necessary to sell assets
and use the proceeds to pay down debt. But guess what? This cannot happen if there is not enough
money in the economy with which to buy the assets. The system is not fully funded with base money
(bank reserves and physical currency in float). It is funded with credit not reserved with base money. So,
a very high ratio of unreserved credit-to-base money, perpetuated by fractional reserve lending and
central bank monetary (i.e., credit) policies, becomes the focal point of systemic de-levering. Hence,
base money inflation can be a form of de-levering. (QE is not de-levering the aggregate economy. It is
de-levering bank balance sheets by creating reserves, but it is levering Treasurys and the Feds balance
sheets further.)
Ultimately, necessary de-levering usually comes in the form of currency devaluation against a morestable one, or against a scarcer monetary metal. There need not be economic contraction or savings loss
in nominal terms, or even nominal price declines of goods, services and assets. In real (inflation-
adjusted) terms, however, there does have to be economic contraction, as well as savings and
investment losses. (There is also a transfer of relative wealth between savers and debtors. Nominal
inflation or deflation determines the direction that wealth transfer flows.)
Todays apparently a-cyclical economies make it crystal clear that the leverage cycle is the ultimate
determinant of demand for goods, services and labor not animal spirits. To be more specific, the
fluctuating ratios of 1) credit-to-base money in the banking system, and its evil twin, 2) public debt-to-
assets in the broader economy, literally determine secular economic and business cycles. (Debt to GDP
ratios are fine but they compare the stock of debt to the flow of output. One cannot service or repay a
dollar-denominated debt with an iPhone. Money is needed.) We argue that consistently easy credit
conditions have led to ever-increasing consumption of goods, services and assets, which in turn have
levitated output and prices to levels unsupportable by production.
Credit comes in two forms: 1) collateralized credit/secured debt into which any two counterparties may
enter, and 2) unreserved credit that may only be created in a fractionally reserved banking system. The
great majority of economists across the political spectrum seem to conflate the two and under-
appreciate the lasting impact on economies of the latter, unreserved credit.
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6See Important Disclosures at the end of this report.
If unreserved bank credit is not extinguished, only continually rolled over, it eventually pressures banks
and their central banks to inflate nominal asset prices on which that credit was extended (and they can,
through almost infinite credit extension and infinite money creation). Alternatively, bondholders (or,
say, your uncle) do not have infinite balance sheets or printing presses with which to prop up asset
prices collateralizing their credit. So, the only credit in a modern economy likely to be extinguished is
non-bank credit, and at great pain to everyone else.
This process is harmful to the real economy. Excessive bank system leverage that further instigates
excessive economy-wide leverage ultimately leads to debt destruction or re-arrangement not in the
banking system but in the real economy. Exhibit 1: today, where asset prices continue to increase while
output languishes. Debtors are dutifully using their wages and revenues to service their obligations, in
turn keeping bank assets marked at par, while central banks are creating new bank reserves to de-lever
bank balance sheets. Nowhere in this scheme do natural economic or commercial incentives matter.
Indeed, all this finance is crowding out saving and investment in plant, equipment and labor.
Stable Pricing => Unstable Economy
As central banks freely proclaim, their primary objective is stable prices. (Sadly, they do not seeaffordability across the greatest portion of society as a first priority, which would occur were they to
observe the economy through a production model rather than a demand model. The Fed may try to
claim that banking systems only fundcommerce, and so production is not their jurisdiction. The Feds
record, however, seems to show a total disregard for promoting a sustainably productive economy.)
In advanced economies today, the economic elephant in the room is the almost complete takeover of
commerce by the financial and political dimensions, which has been promulgated by central bank
policies. Consistently easy credit conditions for a generation increased demand and the general price
level higher than they would otherwise be. Meanwhile, wages in these domiciles have not been able to
keep pace because the value of labor is more objectively priced by the commercial marketplace.
As a result, the scale and growth path of our economies remain reliant upon the continuation of easy
credit policies even when financing rates can go no lower, even while monetary authorities are directly
subsidizing deficit funding, even when everyone in the marketplace and markets knows the frightening
counter-cyclical impact were policy makers to stop, even when the efficacy of new debt on real
economic output is diminishing. The graph below shows how pointless new debt issuance has become.1
Increase in Real GDP per Dollar of Incremental Debt
Source: Ned Davis Research, Gary Shilling, Federal Reserve, Incrementum
1In Gold we Trust 2013; Incrementum Lichtenstein; Ronald-Peter Stoeferle and Mark J. Valek; June 27, 2013.
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7See Important Disclosures at the end of this report.
Policy makers in advanced economies seem to think they must do everything in their power to ensure
prices do not fall, even if prices do not represent the sustainable real value of goods, services and assets,
because falling prices would directly lower the value of debt (i.e., bank and pension assets), which in
turn would greatly slow economic activity. Re-scaling (shrinking) economies to more sustainable price
levels that would then naturally promote increased production is not a practical option. The political
fallout from allowing this to occur makes it unfathomable in a monetary regime in which the money
stock and price level is easily managed. Thus, it is wise to be bet against falling prices.
Bank on Inflation
While it may be wise to bet against falling prices, why should we bet on rising prices? The short answer
is: because thats the way we have always rolled and inflation is even more necessary now.
Inflation is entirely man made, created and administered by monetary authorities. Again, contrary to
popular belief, aggregate demand cannot produce sustainably rising prices. Without bank system-
manufactured inflation, population growth, innovation and economies of scale (i.e., productivity gains)
would naturally drive lower the nominal prices of goods, services, labor and assets (though their values
to society could remain the same, increase or decrease based on social preferences).
The current policy goal to inflate in the US, Japan, and most advanced economies in Europe with the
possible exception of Germany should not be so startling. In economies where economic expansion is
predicated on nominal asset price increases rather than production, generating inflation must be a
policy objective. Note the unlikely consistency and stability of the US CPI growth rate, above. It is a
triumph of monetary management over natural pricing. Particularly interesting is the threat of deflation
in 2008 (the dip in the slope) and the impact of the Feds successful policy response to it (circled).
Quantitative Easing was then and remains now meant to induce inflation. Indeed central banks exist to
inflate, continually and unobstructed by social needs, wants, benefits or costs. Just look at the data.
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8See Important Disclosures at the end of this report.
Inflation, of course, is the loss of purchasing power of the currency in which we consume, save and
invest. It is understandable that labor and pensioners might accept the loss of the purchasing power
value (PPV) of their wages and saved wages when their homes and financial assets appreciate more than
their PPV is decreasing. But what happens when their PPV is diluted at a higher rate than their assets
appreciate? A case may be made that it still would not matter to them because most of the work force is
also indebted (home mortgages, auto and student loans, credit cards, etc.), and without currency
inflation they would not be able to service and repay their obligations. Inflation has become socially
acceptable because so few of us are net savers and those that are invest in levered financial assets.
And so it was not surprising to note Chairman Bernankes recent testimony that the Fed considers
inflation to be a part of the Feds mandate for price stability. From a policy perspective, price inflation
equals price stability (see the graph above). However, the goal to inflate is an absolutely startling
admission in the context of a zero-bound interest rate environment, which changes everything.
Theory Applied
The Fed (the BOJ, etc.) is effectively telling the markets that if it is successful in executing its policy to
produce higher inflation, then near-record low market yields on all types of fixed income obligations from Treasuries to high grade credit, mortgages to municipals, high yield junk to levered loans would
be vulnerable to either significant price declines or very negative real returns. Further, assets from
homes to operating companies, with values that rely on the perpetuation of positive real returns on
credit assets, including equity margin loans, are also quite vulnerable to significant re-pricing.
With that as a backdrop, please compare the graph of inflation over the last forty years on the previous
page with the chart below showing the inflation expectations of BoA Merrill clients:
It seems inflation is not only the way advanced economies have rolled and remains a very strong policy
imperative currently; it is also entirely unexpected in the markets.
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9See Important Disclosures at the end of this report.
Should equity investors be worried or excited about the need to inflate? We think the answer is yes! ()
Inflation will be the means to de-lever systemic balance sheets and it will affect different equities in
different ways, at different times and in very different magnitudes. We believe the implied mandate,
long precedence and demonstrated current willingness to inflate will ultimately sustain and increase the
money stock, which in turn portends further nominal gains.
Since the NASDAQ crash in 2000 and the housing crash in 2007 (market manifestations of leverage
bubbles bursting), governments, banks and financial asset investors have been bound by mutual
incentives not to acknowledge the elephant in the room: nominal asset prices generally do not equal
sustainable real value, adjusted for necessary future de-leveraging.
Necessary monetary inflation may ensure aggregate nominal asset prices will increase, or at least not
fall for an extended period; HOWEVER, this is where the capital markets and the global commercial
marketplace seem to take separate paths. In extremis at times when the leverage cycle is peaking, as it
did in 2000, 2007, and perhaps today it should become obvious to all that aggregate demand is a
second order driver of the general price level. The money stock takes priority. How else could
governments, banks and households continue to service their obligations and support themselves?
As we can see in the daily papers, the only economic policy that seems to have any remaining efficacy is
managing capital market and economic expectations. (That and rotating relative currency devaluations
initiated by central banks, that allows their exporters report a few quarters of improving nominal
earnings.) There is no sustainably positive economic impact in any of it, which implies that monetary
authorities have become powerless to positively affect their economies in any meaningful way beyond
illusory gains. Meanwhile, aggregate leverage is increasing in most advanced economies.
Inflating just enough notto produce the general fear of inflation is producing malaise, characterized by
widening wealth and income gaps driven by the relative success of those closest to credit and levered
assets in relation to those further away (or relative to those choosing not to leverage). The former
generally produce far less than the latter, and the trick for monetary authorities is to continue executingaccommodative policies amid declining real production and the general perception that nothing
exceptional is occurring (and to not be blamed for widening income and wealth gaps). Nevertheless, the
Fed cannot taperunless banks are willing to re-leverage rather than de-leverage. We expect any form of
monetary or credit tightening to be summarily reversed once asset prices fall and balance sheets suffer,
which they would quickly do. It is boxed. It will keep going and it will likely need to increase its purchases
over time.
Our level of confidence is high. For better or worse (better generally for the investor class, worse for
everyone else), the economic model for advanced economies over the last thirty years has been asset-
centric rather than production-based (and levered-asset centric at that). Over the last twenty years,
sustainable wealth from production has moved east. Production efficiencies have moved to emerging
economies (precisely why they are emerging), while nominal balance sheets in advanced economies
have expanded. Meanwhile, human and natural resources have continued to be consumed out of
proportion in advanced economies, thanks to the great leveraging that has allowed advanced economies
to exchange their unreserved digital credits for foreign labor, natural resources and production.
The point of economic and investment criticality today is the need to reconcile global value among two
great forces: a) the accelerating momentum of economies with sustainable production and natural
resources with b) the perception of economic omnipotence (and diminishing inertia) within credit-based,
asset oriented economies. We think this reconciliation already has traction but has not yet been officially
or broadly acknowledged.
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10See Important Disclosures at the end of this report.
We believe the product of this reconciliation should be a shift in the perception of value among assets
from those that may offer nominal gains in line with indexes today (beta), to those that would benefit
most from systemic de-levering in real terms. As inflation is the only practical means of necessary de-
levering, and since real and financial assets are not currently pricing-in inflation, significant risk-adjusted
Alpha today is buried in the process of de-levering through inflation.
Conclusion
Truth is tough. It will not break, like a bubble, at a touch. Nay, you may kick it about all
day, and it will be round and full at evening.
- Oliver Wendell Holmes, Sr.In the current environment, in which general expectations for global inflation remain subdued, we do
not expect Western commercial interests ranging from large, listed corporations to corner restaurants
to take the bait by levering their balance sheets further in order to grow their nominal revenues. The
graph on page 6 shows why a unit of debt is nowhere near worth a unit of revenues, even with todays
low interest rates. Financial asset investors may continue to benefit in the short term while stocks andbonds remain well bid, but production and labor in over-levered economies should continue to wither.
When we take it to its logical conclusion, central banks cannot withdraw debt support (on a net basis)
and so our baseless currencies seem highly likely to fail to provide sustainable purchasing power. (This
happens asproducers demand more currency units for their labor and resources, not when consumers
drive prices higher by competing with each other for finite supplies of labor and resources.) Continued
inflation of all global currency stocks is likely.
This implies to us that fundamental expectations of the inevitability of price inflation across borders and
in all currencies must change, from unlikely to highly likely. When might this happen? We think it would
have to be when politicians and monetary authorities believe it is in their best interest to let perceptionschange. After all, there are no currencies not controlled by central banks, no competing currencies in
which the global marketplace may find sanctuary. Neither are there global capital markets denominated
in truly independent scarce currencies. Where is wealth supposed to go? Who will pay for natural and
human resources? Micro-economies occurring around kitchen tables that collectively form true macro-
economies (sans political incentives and policy mandates), will pressure authorities to act.
From a risk-adjusted value perspective then, we believe businesses and financial assets sponsored by
levered investors, or businesses that rely on revenues from consumption by over-levered consumers,
are particularly vulnerable. Their performance relies on the continuation and acceleration of
unsupportable, irreconcilable household leverage. The only way to avert declining asset values and,
ergo, bank system insolvency, will be to increase the general perception of future inflation.
We believe significant future Alpha will be harvested by allocating capital today to currently under-
levered assets or assets that do not rely on others increasing their leverage. A sound bottom-up
valuation approach should begin here. In order of expected performance, we think the best places to be
presently are: 1) unlevered treasure pure stores of global purchasing power, regardless of time,
currency or future price numeraire; 2) less-levered price inelastic industries, and; 3) businesses with
sustainable sales and margins independent of inflation rates, priced within currency regimes in which
inflation expectations are likely to shift higher.
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11
Finally, this piece marks QBAMCOs final distribution. We, and many of our investors, will be joining the
team at Kopernik Global Investors, a new yet very pedigreed value-oriented investment firm. We hope
you have benefitted in some small way from these reports and we wish you all a very pleasant rest of
the summer. Until we meet again,
Lee Quaintance & Paul Brodsky
QB Asset Management Company
FOR INFORMATIONAL PURPOSES ONLY
THIS MATERIAL IS NOT AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO PURCHASE SECURITIES OF ANY
KIND.
THIS REPORT MAY CONTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING STATEMENTS INVOLVE INHERENT RISKS
AND UNCERTAINTIES, AND WE MIGHT NOT BE ABLE TO ACHIEVE THE PREDICTIONS, FORECASTS, PROJECTIONS
AND OTHER OUTCOMES WE MAY DESCRIBE OR IMPLY. A NUMBER OF IMPORTANT FACTORS COULD CAUSE
RESULTS TO DIFFER MATERIALLY FROM THE PLANS, OBJECTIVES, EXPECTATIONS, ESTIMATES AND INTENTIONS
WE EXPRESS IN THESE FORWARD-LOOKING STATEMENTS. WE DO NOT INTEND TO UPDATE THESE FORWARD-
LOOKING STATEMENTS EXCEPT AS MAY BE REQUIRED BY APPLICABLE LAWS.
NO PART OF THIS DOCUMENT MAY BE REPRODUCED IN ANY WAY WITHOUT THE PRIOR WRITTEN CONSENT OF
QB ASSET MANAGEMENT COMPANY LLC.
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