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Summary
The French mathematician Benoit Mandelbrot (1924-2010) is most famous for introducing the world to fractals shapes that look the same under any magnication. You can zoom in on a fractal a thousand times and it will retain the same pattern and detail. You can get completely lost in them and their timeless beauty (log into http://mathworld.wolfram.com/Fractal.html for additional details). It turns out fractals occur everywhere in nature, from leaves to lightning and from snowakes to seaweed, but it took Mandelbrot to point them out. Sometimes we become so accustomed to looking at something that we fail to see its true patterns. On the other hand, sometimes it helps to change your scale and perspective to see the true pattern emerging. Unlike fractals, Prot Margins are a phenomenon where an appropriate focus matters. At the right scale (i.e. long term in scale and broad in its scope), trends become apparent that may not necessarily be so obvious when caught up in recent noise. The chart on the right shows Avocas GPM indicator. GPM is our measure of Global Prot Margins, a 50 year dataset which we have built up using prots data relative to GDP from national accounts as well as exchange rate and price data taken from an array of national and international agencies. GPM has clearly had a strong run in recent decades. So what does this mean? In nature, gravity limits the height of trees, and likewise in the nancial world there are numerous forces, cyclical and secular,
Source: AMECO, OECD, and national statistical agencies. The chart shows the trend in aggregated national operating surplus as a percentage of GDP
limiting the growth of Prot Margins. In everyday life, we call this phenomenon Mean Reversion. In Avoca, Prot Margins that are substantially above the long term mean make us nervous. As we shall see, Mean Reversion will inevitably reduce Prot Margins in the not too distant future. Reversion to the Mean of Prot Margins will have implications at the company, sector, country and economy wide levels. This will inevitably have implications for Avoca and other investors in terms of individual name selection, portfolio construction and risk management.
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Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
October 2012
One nagging doubt remaining from the work we did at that time on the Avoca portfolio was the question of the sustainability of Prot Margins at the economy wide level. If one of the principal sources of Prot Margin maintenance for our portfolio was Labour cost savings then surely for the economy as a whole this becomes unsustainable as one persons cost saving is anothers loss of income. Or put another way, how could it be possible for the economy as a whole to cost cut its way to higher levels of protability? Three years on, with Prot Margins perceived to be at or close to all time highs, we have decided to re-visit the entire question of Prot Margins with a more in-depth look at the issues including hopefully answering important questions such as: What are the factors that drive Profit Margins for the economy as a whole? Where do Profit Margins sit today relative to history? and How likely is it that Profit Margins might decline in the future and what might the catalysts for any such decline be?
In attempting to answer these questions, we will take a broadly top down approach to the problem focusing rstly on the Theory of Prot Margins before examining the evidence from the available data as to what has actually occurred. Finally, we attempt to draw some useful conclusions from our research, focusing on its potential implications for macro views, and Avoca portfolio construction and risk management.
There are undoubtedly other factors that will also aect Prot Margins such as; productivity (e.g. imagine the eect on global Prot Margins if a low cost reliable source of energy such as ultra-ecient solar power could be invented); the mix of sectors in the economy (e.g. an economy dominated by naturally high margin sectors such as pharmaceuticals, software or energy will have higher Prot Margins all else being equal) and the degree of competitive intensity (monopolies will naturally make for higher Prot Margins).
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25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
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Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our 2 authorisation and regulation by the Financial Services Authority are available from us on request
October 2012
1972
1986
1980
1996
1990
1984
1988
1994
1998
1976
2006
2000
1974
1978
2004
2008
1992
0%
Source: OECD and national statistics agencies (broad margins show prots before depreciation, taxes and some other expenses these are not subtracted because of inconsistencies between countries in how they are handled broad margins are comparable across countries)
The level of tax imposed by a government on prots will obviously signicantly impact Prot Margins. Higher levels of globalisation, the relaxation of capital controls and greater tax competition have all undoubtedly contributed to Capitals taking a greater share of the economic pie over the past 30 years or so. Greater levels of global capitalism have certainly benetted owners of Capital. b) The relative supply and demand dynamics of Land, Labour and Capital Positive or negative shocks which aect either the supply of or demand for Land or Labour should impact the returns to Capital. As an example, one would expect that were a severe oil shock such as happened in 1973 to re-occur there would be an inevitable reduction in global prot levels as economic resources would be redistributed to oil producing countries. The graph below shows the impact of recent oil price moves on US Prot Margins. The three major spikes in oil prices, beginning in 1973, 1978 and 2007, all coincide with downward falls in Prot Margins. US after tax Prot Margins versus Nominal Oil Prices
160 140
The results threw up some thought provoking anomalies, like the generally high margins in Portugal, Ireland, Italy, Greece and Spain (we are not claiming any cause and eect!). Other countries Prot Margins were less surprising, such as low margins in Japan and high margins in oil or mineral exporters like Norway and Chile. The importance of a countrys political system is clearly seen in the chart. The really high Prot Margin countries are those with a high degree of income inequality due to political factors, including some former Eastern bloc countries, Mexico and India. In addition, one thing that will also strongly support Prot Margins is a monopoly, and Mexico for example has quite a few of those. This is a case where the government referee may be biased towards Capital. The impact of taxation Closely related to the capitalist or socialist nature of society is the level of taxes that are imposed on capital by government. The following graph for example shows the eective tax rate on Corporate Prots in the US over the past forty years.
2002
2010
12 10 8 4 2 0
Jul 11 %
1982
120
100
US$
80
60
40
20
0
Jul 71 Apr 70 Jan 79 Jan 74 Jul 86 Jul 96 Jul 06 Jul 76 Oct 82 Oct 92 Oct 02 Oct 72 Apr 75 Oct 87 Oct 97 Apr 80 Oct 07 Oct 77 Jan 69 Jan 89 Jan 99 Apr 90 Apr 00 Apr 85 Apr 95 Apr 05 Jan 09 Jan 84 Jan 94 Jan 04 Apr 10 Jul 81 Jul 91 Jul 01
Source: U.S. Department of Commerce and Bureau of Economic Analysis, West Texas Crude Oil price from Dow Jones and Federal Reserve Bank of St Louis
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25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
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Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request 3
October 2012
Another way of looking at Economy Wide Prot Margins The Kalecki equation
Michael Kalecki (1899-1970) was a Polish born economist who at various stages in his career held economic tenures at Cambridge and Oxford before settling in the later stages of his career as a professor in Warsaw in what was then communist Poland. Today he is better known amongst the economist community for the Kalecki equation, a way of looking at economic data that has proved to have useful insights for studying economy wide Prot Margins. Kaleckis insight was to view business prots in terms of the net spending (or saving) of businesses, households, government, and the foreign sector. The full derivation of the Kalecki equation is included in Appendix 1 and can be summarised as follows: Prots = Investment +Dividends H(s) -G(s) -F(s) Where H(s) is the household saving rate, G(s) is the government savings rate and F(s) is the foreign savings rate (better known as the current account decit). The Kalecki equation inputs for the US for 2011 were as follows:
10%
8%
6%
% of GDP +3.2% +5.5% +3.2% -7.6% +3.1% (US current account decit)
4%
2%
0%
Foreign Savings
Source: US NIPA, Flow of Funds 2011
Recession
Data run to Q2 2012. On current estimates, margins are down to 9.5% from their 10.3% peak in Q4 2011. Source: U.S. Department of Commerce, Bureau of Economic Analysis, and Federal Reserve Bank of St Louis
Like most strong patterns, there is a good reason why Prot Margins and the cycle are interlinked. As a recovery progresses, demand for Land, Labour and Capital rise, causing the costs of these inputs to rise. This eats into Prot Margins before the economy actually starts to slow. In fact, Prot Margins tend to peak approximately half way through the cyclical upswing. Given that we are now three years into the current economic cycle, and the average period between recessions since WWII has been six years (including 2 unusually long recession free periods between 1982-1990 and 1991-2001), there are clear reasons to believe that Prot Margins may have reached a cyclical peak for the present cycle.
Plugging these inputs into the Kalecki equation, US after tax Prot Margins for 2011 as a percentage of GDP were: Prots= 3.2% + 5.5% - (3.2%) (-7.6%) (3.1%) = 10.0% GDP Dividends and investment both sent money back into the economy, supporting prots. After their credit boom debt binge, households in 2011 decided to pay down debt (i.e. net savings) to the tune of 3.2% of GDP a negative for prots all else being equal. The foreign sector was also a net drag on US prots in 2011. Since the US is a net importer of goods and services, the prots on such goods and services accrued to overseas companies rather than US ones. The big driver of Prot Margins in 2011 obviously was the government sector, which bankrolled prots to the tune of 7.6% of GDP. We started by asking if Kalecki could tell us why Prot Margins have had a relatively good time through the Great Recession. The answer is that public sector largesse has undoubtedly supported Corporate Prot levels. Here it gets potentially scary, because we know that scal consolidation is the current game plan for Europe and is also potentially looming as we know on Capitol Hill.
75 St. Stephens Green, Dublin 2, Ireland Phone +353 1 479 3103 Fax + 353 1 479 3129
25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
www.avocacapital.ie
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request 4
October 2012
A nal thought - Mandelbrot and the potential implications for Prot Margins
Basic theory (supported by the available evidence) highlights a number of drivers of economy wide Prot Margins. Before concluding as to where Prot Margins go from here, it is useful to visit Mandelbrot again whose musings about the nature of nancial markets have relevance for the question of examining the behaviour of Prot Margins. Joseph and Noah When he was not busy writing about nature in equations, Mandelbrot found time to study nancial markets in detail. He described the nancial world as being dominated by two broad eects: the Joseph eect and the Noah eect. The Joseph eect refers to the common biblical allusion of 7 years of feast followed by 7 years of famine. This is also better known as Reversion to the Mean. The Noah eect is slightly less intuitive. It refers to the fact that sometimes as in the bible it does rain for 40 days at a time (here in Ireland we didnt need the bible to learn that). Another way of describing this is that sometimes apparently unusual events happen and when they do, they have a tendency to cluster together. Examples of these Noah like phenomena that have been documented in nature include oods, hurricanes and earthquakes. The underlying phenomena at work causing these cluster eects are usually feedback loops of some degree. In the nancial world it shows up in stock market returns that are not normally distributed otherwise known to us as fat tails. The relevance to our discussion is that while under economic theory Prot Margins should be intuitively mean reverting, the mean itself
1889
1884
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1954
1869
1899
1969
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1894
1984
1909
1999
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1904
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1879
1874
1979
Source: Dumenil G. and Levy D., The U.S. Economy since the Civil War (1994, data updated in August 2010)
The early spike coincides with the post-Civil War era, when the rule of law was fragile (prompting President Lincoln to install military governors in many states). Lawlessness and corruption tend to enrich the few in power (Capital) instead of enriching the many (Labour). Clearly war has, on at least three occasions in the past, supported Prot Margins in the US and the Great Depression was a cardiac arrest for them. Neither wars nor depressions could have necessarily been foreseen with any certainty, but both happened, and both impacted Prot Margins hugely (popularly known today as the Black Swan eect). The implications of the above are philosophical and practical in nature for us. Prot Margins, like many nancial markets are not represented by classic bell curve distributions. They can be subject to long periods of relative calm and low volatility with the potential for extreme outcomes on occasion. The challenge to us as investors is to remain cognisant of the potential for underlying volatility and its potential impact on our Margin of Safety in making any investment decision.
www.avocacapital.ie
75 St. Stephens Green, Dublin 2, Ireland Phone +353 1 479 3103 Fax + 353 1 479 3129
25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
2009
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October 2012
Prot Margins in the future? Our sectoral analysis below suggests that when analysed on a sector by sector basis, the answer is most probably no over the medium term - certain sectors have benetted greatly from recent trends such as globalisation and the inevitable forces of capitalism will draw more resources towards Labour and away from Capital over time. The above graph together with the previous evidence for long term US Prot Margins also highlights how vulnerable global Prot Margins are to potential negative supply shocks- the 1970s oil shock for example caused Global Prot Margins to decline by a quarter- a salutary thought given the prospects of further tensions in the Middle East in 2013 (even if the global economy is less dependent on oil now versus then). 2) Certain sectors have benetted disproportionately from globalisation National accounts data helped us assess where global Prot Margins are relative to their historical perspective which we believe is an extremely valuable insight. However, for our investment implications we focussed more on market data, including rms in the S&P 500, FTSE etc. Here we analysed Prot Margins for over 2000 companies in 20 sectors (and numerous sub-sectors) over a 30 year period. One factor we were interested in quantifying was the impact of globalization on Prot Margins. We believe certain sectors, which we have termed the globetrotters, have globalized particularly aggressively over the last twenty years. The Globetrotters shown in the light blue bars include Capital Goods, Semi-conductors, Retail, Software and Technology equipment sectors. It is no coincidence that our analysis shows all these sectors to have grown Prot Margins, with two of them among the top three gainers. We have highlighted these sectors in the chart. EBITDA Margins in 2011 vs 30 year averages with changes
Average Margin versus Latest Margins
Energy Software & Services Semiconductors & Semiconductor Food Beverage & Tobacco Pharmaceuticals, Biotechnology Materials Technology Hardware & Equip. Retailing Health Care Equipment & Service Media Household & Personal Products Consumer Services Capital Goods Globetrotters Other Sectors
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1995
Source: AMECO, OECD, and national statistical agencies. The chart shows the trend in aggregated national operating surplus as a percentage of GDP
Prot Margins, despite having experienced a cyclical downturn following the Great Recession, remain well above their recent historical norms. In fact given the extent of the global downturn since 2007, one would have expected that Prot Margins might have gone through the oor over the past 5 years. The fact that they have not suggests that there must be very strong secular forces at work as well as the extreme scal and monetary policies supporting the global economy post 2008. Secular factors that have caused Prot Margins to behave in this manner over the past 50 years, and in particular to have maintained Prot Margins at elevated levels over the past 5 years, are myriad but undoubtedly include globalisation, the increasingly capitalist nature of society, lower global corporate tax rates, declining global interest rates and increased productivity. The question for us is will these secular factors continue to support
2005
2010
1975
Commercial & Professional Service Transportation Automobiles & Components Food & Staples Retailing Telecom Consumer Durables & Apparel Utilities 0 5 10 15 20 25 30 35 -2 0 2 4 6
Average (Bars)
Latest (Dots)
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October 2012
accompanied by an increase in the capital intensity of the sector or it should over time have been competed away by new entrants and new supply to meet the extra demand. This did happen to an extent for Energy, a 4.9% increase in EBITDA margin was accompanied by an increase of 0.8% in the Capex/Sales ratio. Exploration cost increases did partially oset increased margins although not to the degree one might expect. However for Materials, an increase in margins from 24.1% to 26.4% was accompanied by a decrease in Capital expenditure intensity from 11.5% to 11.3% of Sales. Taken together, the Free cashow for these 2 sectors increased from 9.9% of sales to 13.3%, a 33% increase. The owners of Land have also done well over the past 30 years. 4) Getting more granular In order to help develop practical implications for our research on Prot Margins, we have drilled down further into Prot Margin data on a sector and sub-sector basis in order to examine the trends in individual companies Prot Margins over the period of our study. By way of illustration, our graphs below show the evolution of EBITDA margins and Return on Invested Capital (ROIC) over the past 25 years for the 25 largest companies in the Diversied Metals and Mining sub-sector. Each dot on the graph represents the results from a particular company in that sector for that particular year. EBITDA Margins for Materials Sector
40 35 30 25 20 15 10 5 0 -5
1991 1997 1988 1994 2000 2006 2009 1985 2003 2012
Big
Small
Note: Materials Sector = Diversied Metals and Mining Sector. Source: Avoca database, published company accounts and Bloomberg. Green indicates the largest 50% of companies by revenues.
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
October 2012
Conclusions
Our approach to looking at Prot Margins involved two broad approaches, aggregation of country and time series data to identify the bigger macro picture and a disaggregation of data at the sector and company level to allow us to identify trends that might provide useful insight for portfolio construction and risk management. Our conclusions are as follows: General insights 1. Unlike fractals, understanding the nature of Prot Margins is greatly inuenced by perspective. A broader, and in particular a more long term perspective, is fundamental for understanding the nature and drivers of Prot Margins. 2. Prot Margins are much more complex than meets the eye. When analysing Prot Margins, trends, start and end dates matter as does sample size, sector and country composition. Most research we have seen on Prot Margins has been conned to country or sector level analysis. Avoca needed to build its own index to understand the global trend which is shown for the rst time in this newsletter. There are large variations in trends in Prot Margins at country and sector level, and these trends can be quite long term in nature. This hinders attempting to directly prot from Mean Reversion because for very long periods there may be no obvious mean. Prots do not necessarily behave in a sine wave like manner.
1988
1994
2006
Big
Small
Note: Materials Sector = Diversied Metals and Mining Sector. Source: Avoca database, published company accounts and Bloomberg. Outlying high values tend to be for rms concentrating on copper mining.
2009
2000
1985
2003
1997
2012
1991
It can be clearly seen that notwithstanding a decrease post the Great Recession, Prot Margins and ROIC in the diversied metals and mining sector remain elevated today. There are broadly three schools of thought on the above: The above rise in Prot Margins and ROIC is as a result of a nite supply of Materials meeting exponentially increasing demand from China and other developing regions scarcity and demand has caused Prot Margins and Return on Invested Capital to go to a permanently higher plateau (the super cycle theory). After a long period of supply lagging demand, ongoing capital expenditure will result in supply catching up with demand bringing ROIC for Materials down to more normal levels. (Anecdotal evidence would suggest that despite the current downturn there is still substantial ongoing late-cycle capital expenditure in the Materials sector in economies such as Australia, South Africa and Chile). Materials have benetted from an investment bubble in China in particular and the above excess Prot Margins and ROIC are the harbinger of a coming bust in the Materials sector.
3.
4.
Macro insights 1. Margins are high by historical standards and face a number of short term headwinds. These headwinds include: 2. An overdue cyclical correction which has consistently occurred in Prot Margins mid cycle following a recession; An extremely high sensitivity to Government policy (scal and monetary); and Traditional sources of cheap Labour appear to be starting to demand a greater share of the economic pie.
Two of the above three points (i.e. the second and third bullet points) would point to a mild to signicant slowdown in Prot Margins and ROIC for the Materials sector in the short term at least. Such concerns regarding the sector are possibly among the reasons why the Materials heavy FTSE 100 has lagged other major indices recently (4% YTD versus +12% for the S&P 500 and +22% for the DAX at the time of writing).
The higher than usual sensitivity to Government policy is a particular worry for investors as political actions are much more dicult to prepare for than company or sector dynamics. The scope for accommodative Government policy that would continue to support Prot Margins is hampered globally by weak Sovereign balance sheets.
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25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
www.avocacapital.ie
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request 8
October 2012
3.
In Avoca, as Value Investors, our focus will always be predominantly on bottom-up, detailed micro-research. Such bottom-up research can however on occasion be very protably augmented by knowledge of historical Prot Margins relative to current levels, particularly on a sector by sector level. Knowledge of long term trends may on occasion help us identify risks that might impact on the Margin of Safety that we require on all investment decisions.
75 St. Stephens Green, Dublin 2, Ireland Phone +353 1 479 3103 Fax + 353 1 479 3129
25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
www.avocacapital.ie
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
October 2012
Note: This is consistent with, but a slightly dierent expression of the well known economic equation that output (Y) is comprised of Consumption (C) (by households and businesses), Investment (I) (by households and businesses), Government spending (G) and Net Exports (NX) more commonly expressed as: Y= C+G+I+NX. If we ignore for the moment any ability to print money or create credit (an important distinction today admittedly), then any decit or excess spending by any of the above categories (H,B,G,F), must be funded by savings from one or all of the other categories. This makes intuitive sense in that for example if the government wants to spend more than it earns, then it will have to borrow that money from the increased saving of one or all of households, businesses or the foreign sector. Another way of stating this is that Savings (NS) for the economy as a whole must equal zero. NS= H(s) + B(s) + G(s) +F(s) = 0 Equation 2
Business Saving B(s) can also be dened as Prots less Investment less Dividends or B(s) = Prots- Investment Dividends Equation 2 above then becomes H(s) + (Prots Investment Dividends) + G(s) +F(s) = 0 Rearranging, this becomes Prots = Investment +Dividends H(s) -G(s) -F(s) Equation 4 Equation 3
The Kalecki equation for the US for 2011 highlights the (intuitive) fact that Corporate Prots are heavily supported today by the level of Government decit spending. Another way of looking at the above is that if the Government decit were to suddenly contract, then US business prots would have to contract unless: households were suddenly to start disaving (i.e. households were to start spending more through consumption or investment); the US current account decit were to disappear (in eect foreigners were to start spending more); or business investment or dividends were to increase (in eect businesses were to start spending more). Again, this is intuitive, and highlights why the equity market may be as focused as it has proven to be on upcoming issues like the US scal cli.
75 St. Stephens Green, Dublin 2, Ireland Phone +353 1 479 3103 Fax + 353 1 479 3129
25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
www.avocacapital.ie
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
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October 2012
75 St. Stephens Green, Dublin 2, Ireland Phone +353 1 479 3103 Fax + 353 1 479 3129
25th Floor, Heron Tower, 110 Bishopsgate, London EC2N 4AY Phone +44 20 3100 2300 Fax + 44 203 100 2399
www.avocacapital.ie
Avoca Capital Holdings is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request
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