Understanding Facebook’s Stock Restructuring

Facebook

This week Facebook announced that it will introduce a new version (or “class”) of its stock. It will essentially be doing a 3-for-1 split, with Facebook stockholders getting two shares of the new version for every one share of the old version that they own. Why would Facebook go through these kinds of financial contortions? And what are the implications for investors?

The purpose of the change is to allow Facebook founder Mark Zuckerberg to retain control of the company. Ordinarily when someone owns a stock, the financial investment comes with the right to vote on issues such as who should be on the company’s board of directors. As companies issue more shares of stock over time—perhaps to give stock grants to their employees or fund acquisitions of other companies—the voting power of their founders decreases.

Zuckerberg was especially at risk of losing voting control because he has pledged to donate most of his Facebook stock to charity. But because the new class of Facebook stock won’t have voting rights, he’ll now be able to sell it without losing voting power. This idea was also the impetus behind Google’s very similar move in 2014.

While Facebook’s stock restructuring clearly makes sense for Zuckerberg, it may not be so good for other investors. The reason stock typically comes with voting rights is to try to ensure that a company’s leadership is working in the shareholders’ best interest. With a smaller financial stake in Facebook once he’s given most of his stock to charity, Zuckerberg might be incentivized to make decisions (for reasons such as enhancing his reputation) that hurt shareholders rather than help them.

The counter-argument is that by not having to worry about losing control of Facebook to activist investors who may be too focused on the short term, Zuckerberg will be able to stay focused on the company’s long-term goals. Given his history of bold and (in hindsight) financially shrewd moves such as the purchase of Instagram in 2012, investors might be willing to give Facebook’s founder the benefit of the doubt.

Why the Manufacturing Recession Still Matters

Manufacturing

The sharp rebound in stocks since February supports the view of market optimists: The U.S. is not in or on the cusp of a recession. The broad U.S. economy continues to expand, albeit at a sluggish pace.

However, allow me to take the “glass half empty” view, and note the manufacturing sector has yet to recover from the slowdown that began in late 2015.  And this has important implications for investors.

The broader implications of a sluggish manufacturing sector

Although recent surveys point to some stabilization in the sector, signs of an actual rebound in manufacturing activity are more scarce. Indeed, the latest industrial production number, released in mid-April by the U.S. Federal Reserve, showed industrial production has now contracted in 12 of the past 15 months and is down 2% year-over-year, close to the worst rate of growth since 2009.  Despite an abrupt spike in oil prices and a pause in the dollar’s rapid ascent, manufacturers, miners and factories continue to struggle.

Still, for many investors the response is: So what? Manufacturing is a relatively small portion of the overall economy, they say. The much more important consumer sector is holding up, with households continuing to spend at a decent, if uninspiring pace.

All true, but a rebound in corporate profits is much less likely in the context of falling industrial production. Put differently, falling industrial production is not necessarily indicative of an economic recession, but in the past it has been consistent with a profits recession.

A vital link between industrial production and corporate profits

One reason that industrial production matters for corporate profits is that the composition of the stock market is more geared towards manufacturing, utilities, mining and other “Old Economy” activities than the broader economy. This is why the correlation between industrial production and profits growth has remained stable over the past two decades, despite the overall trend in the U.S. towards a more services oriented economy.

What that relationship suggests is that profits rarely rise while industrial production is falling. Historically, when industrial production is declining year-over-year, non-financial profits typically fall, at an average rate of around 4.5% year-over-year according to Bloomberg data. Absent more financial gimmicks and buybacks, earnings growth is unlikely to improve without a broad-based acceleration in the U.S. economy.

The drop in industrial production also suggests two other conclusions. First, falling industrial production contradicts the argument that the drop in earnings is all about energy. While the collapse in oil company earnings has played its part, the ongoing U.S. profits recession, now in its fourth quarter, reflects a broader sluggishness in the U.S. and global economy.

Second, investors have recently been focusing on the rebound in value stocks. While value as style has indeed done better as recession fears have faded, maintaining the rally will require value companies to demonstrate some improvement in depressed earnings and historically low profitability. That is much less likely in an environment in which manufacturing activity is still contracting. If the value rally is to continue, that will need to change.

In short, future gains in stocks depend on an upturn in earnings growth. In the meantime, investors ignore the manufacturing recession at their own risk.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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Is the Technology Sector Overvalued?

Largest US Companies

The technology sector has become a more significant part of the US stock market in recent years. It’s now the largest sector in the S&P 500 index, and four out of the ten biggest companies by market value—Apple, Microsoft, Facebook, and Alphabet (the parent company of Google)—are technology companies. A fifth, Amazon.com, is a retail/technology hybrid. For some investors this growth brings back painful memories of the dot-com bubble of the late 1990’s and the subsequent crash. Are technology stocks once again overvalued?

There are a number of key differences between the current situation and the dot-com bubble. While in the 1990’s many technology stocks became worth tens of billions or even hundreds of billions of dollars with minimal profits, large technology companies today are much more profitable and valuations are generally more reasonable. And the technology sector overall hasn’t even performed that well. Over the past five years technology has the third-lowest returns among the ten sectors of the stock market, ahead of only materials and energy.

There are also dramatic valuation differences within the technology sector. Using the price-to-earnings (or “P/E”) ratio, a common valuation metric, there are certainly some tech companies that seem to have high valuations. Alphabet (P/E ratio of 33), Facebook (P/E ratio of 89), and Amazon.com (P/E ratio of 509) all have stock prices that are fairly high compared to their profits, especially for such large companies. But there are also large tech companies closer to the other end of the valuation spectrum. Apple and IBM have P/E ratios of about 11 while Cisco and Intel have P/E ratios of about 14.

So is it safe to at least say that the companies like Alphabet and Facebook are overvalued? Not necessarily. Alphabet, for example, is working on projects such as self-driving cars and anti-aging technologies. If these kinds of potentially revolutionary projects pay off, its current stock price could end up seeming like a bargain. The same is true of other companies with similarly grand ambitions such as Facebook (which is working on artificial intelligence and virtual reality), and Amazon (which is working on drone delivery and other logistics innovations).

For investors, however, these potential innovations aren’t unequivocally good. Innovations that benefit one company often come at the expense of others. Apple’s success with the iPhone, for example, hurt companies such as Nokia, Microsoft, Dell, and HP. Similarly Facebook’s dominant social network has hurt companies such as Alphabet and Yahoo. That reality suggests even if valuations aren’t outlandish for the technology sector overall, at least some of the large tech companies with high valuations will inevitably prove to be disappointments.

Sectors to Follow in Q2

Avocados

The first quarter of 2016 was a tale of two quarters. In Part I, from the start of the year to February 11, markets plummeted. Oil prices bottomed at $26.21 a barrel, a 13 year low, and the S&P 500 index was at its lowest level in two years. Then in Part II, things turned: Markets rallied broadly and the S&P 500 recovered over 12 percent over the following six weeks.

What’s in store for Q2?

As we head into the second quarter, the big question is: Will we see a repeat of Part 1 or Part 2? And what sectors may be best positioned for the next three months? Here’s a quick look at some of the most notable winners and losers from Q1:

DEFENSIVES

The best performing sectors in the first part of Q1 were telecom and utilities, according to Bloomberg. This should come as no surprise, as those so-called defensives historically tend to perform best when the broader market is falling. Then, in Part II, riskier sectors had their moment. Materials, tech and consumer discretionary returned 15 percent or more and financials, industrials and energy were close behind, according to Bloomberg data for Q1. But all 10 sectors showed strong performance, including the defensives.

This is an important point, because the tailwinds for defensives are still in place: Still low interest rates, high uncertainty about the economy’s strength, weakness from abroad, and a relatively strong dollar — even if its relative appreciation has slowed amid dovish commentary from Federal Reserve Chairman Janet Yellen.

Also, share buybacks are at notably high levels. Defensive mainstay consumer staples along with technology (technically not a defensive) has accounted for more than half of the recent buybacks, meaning their prices may be supported. (In other words, prices are presumably supported due to supply-and-demand dynamics. Fewer shares available means people pay more to get them.)

And don’t forget the ingredients for geopolitical risks: The continued uncertainty surrounding the U.S. election, a potential “Brexit” of Britain from the European Union and a possible (albeit unlikely) yuan devaluation in China, just to name a few. Now is a time when quality could be important.

Bottom line: The defensive sectors — telecom, utilities, staples and real estate investment trusts (REITs), have the potential to continue to perform well.

ENERGY AND MATERIALS

Both of these sectors rebounded in Part II of the first quarter as oil prices appeared to stabilize — for now. It seems very unlikely these sectors can continue to perform well without a sustained rally in the price of oil, which is very much dependent on reducing the supply glut.

Multiple expansion explains a lot of the gains in the energy sector. In other words, investors were willing to pay more for the same amount of earnings. Remember: You pay for the companies’ earnings, not oil itself when you invest in energy stocks.

Here, the picture seems far worse. At the start of the year, energy earnings were projected to be down 44 percent YoY for Q1. Now, a week before earnings season really starts, and that number now reads a 99 percent decline in earnings. Despite this, the price to equity ratio (P/E) for the sector is up over 7 percent. Energy trades at the highest 12 month forward P/E relative to all other S&P 500 sectors: 51x earnings. The expectations for 2017 earnings growth are at 83 percent, as of Bloomberg Consensus Estimates at the end of Q1.

Bottom line: I’d be cautious about expecting oil prices to double through 2017. Meanwhile, the earnings picture for energy and materials does not look encouraging.

TECHNOLOGY AND HEALTHCARE

It’s very surprising that two sectors with some of the strongest balance sheets, revenue growth and stable earnings according to Bloomberg data, are the two worst performing sectors year to date. The two sectors are technology and healthcare.

Both were favorites of hedge funds and long-only managers for years, because they led the pack during the period of overall earnings growth for the entire market for Q4 2013 through Q3 2014, according to a 2014 Novus Hedge Fund report. This is still largely true, it should be noted.

However, when sectors become “crowded” they also become prone to unwinds when investors pull their positions, and many areas of tech and healthcare have suffered from this phenomenon recently. It helps explain why so much money has headed into the value corners of the market, like energy and materials, despite their awful earnings pictures.

Bottom line: Over time however, higher earnings typically lead to higher stock prices, so as long as technology and healthcare maintain their track records of revenue growth and headline earnings growth, they could become top performers again. But I would caution that the healthcare sector faces headwinds as we are in an election year and the sector faces increased regulatory scrutiny.

A final note: Whether the second quarter looks more like Part I or Part II of the first quarter, the most sensible approach is diversify — but be selective about where to seek opportunities.

Heidi Richardson is Head of Investment Strategy for U.S. iShares and a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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The Social Security Collection Strategy That Expires Soon

Chairs

A Social Security collection strategy used by many couples to maximize benefits will not be available to new users on April 30. This tactic, known as File and Suspend, allows the higher earner of a couple to file for Social Security retirement benefits but suspend taking them. In doing so, the spouse and any eligible dependents can collect benefits on the higher earner’s record while the individual benefits accrue an 8% annual increase, or delayed retirement credits (DRCs). The higher earner then collects his or her increased individual benefit at age 70, potentially maximizing Social Security benefits for his or her family.

Social Security Benefits

How does the end of File and Suspend as we know it affect me?

First and foremost, it’s important to note: Anyone currently using this strategy will be unaffected by the change. And some lucky folks can still get in on it.

Specifically, if you’re age 66, or will be on or before April 29, 2016, or if you’re already full retirement age and not collecting Social Security benefits, you may want to consider whether File and Suspend is an appropriate strategy for you. Not only might you maximize your retirement benefits, but you retain an option to request a lump-sum distribution of all suspended benefits, if so desired.

That is, at any point before age 70, you can request full payment of the retirement benefits that accrued while collection was suspended. (But keep in mind that you forfeit any DRCs).

If you request suspension after the deadline, you lose the ability to request any retroactive payments, even the six months available to those who do not request suspension at all.

For those without a “lucky birthday” — that is, if you will not be 66 by April 29, 2016 — you may want to take a closer look at your retirement income strategy overall. Social Security is just one part of a successful plan — not the entire solution. Remember that annual Social Security payments averaged $16,000 for individuals and $25,000 for couples in 2014.

The Social Security changes that go into effect this month highlight the need to carefully assess how much income you’ll need in retirement and how you’ll fund it. The sooner you start planning, the closer you’ll be to a fulfilling and financially fit retirement.

For more information visit socialsecurity.gov.

Rob Kron, Managing Director, is the head of Investment and Retirement Education for BlackRock’s U.S. Wealth Advisory group. He provides practical information on topics that are important to every saver and investor of every age.

 

The above commentary is based on Social Security laws in effect as of April 2016. Congress has made changes to the laws in the past, and can do so at any time in the future.

This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. 

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

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The Key Ingredient Needed for Future Returns

Kitchen

Rising price-to-earnings multiples and increasing payouts to shareholders – dividends and share buybacks – have fueled U.S. stock market returns since 2009. But in today’s low-return environment, company earnings will be critical for generating gains.

My latest chart of the week helps explain why earnings growth is the key ingredient needed for future returns.

Companies have long been rewarded for returning capital to shareholders. Buybacks have shrunk share counts, contributing to rising multiples, while dividends have soared, with many companies using debt to fund payouts. Such strategies make sense in a low-yield environment, but the trend is unsustainable. The ratio of payouts in the form of buybacks and dividends to operating earnings of S&P 500 companies is now at 120 percent, as the chart above shows. Companies cannot continue to pay out more than they earn without increasing their corporate leverage.

Dividends Buybacks Earnings

Going forward, the market tailwinds from debt-fueled dividend growth and buybacks will fade, and we see limited scope for further increases in U.S. equity valuations. This implies lower equity returns, with the path of corporate earnings now key. For sustained earnings growth, companies need to increase capital expenditures at the expense of payouts.

So will we see U.S. earnings growth in the near term? There are signs we could see positive U.S. earnings surprises later this year, driven by stabilizing oil prices and a halt in the U.S. dollar’s rise. Also, the bar for upside surprises is unusually low given depressed earnings expectations. The potential for a U.S. earnings recovery later this year is one reason why we like U.S. stocks. For more on opportunities within the U.S. market, read my full weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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The Benefits and Drawbacks of Market Tranquility

VIX 5 Year

After a bumpy start to 2016, the stock market seems to have calmed down. While the S&P 500 index of large US stocks moved by more than 1% on almost 60% of the trading days in the first two months of the year, it did so only three times in March. Meanwhile the CBOE Volatility Index (often called the “VIX”), a measure of expected stock market volatility, has plunged to well below its long-term average of about 20. For investors, this tranquility provides both an opportunity and a potential pitfall.

When the ups and downs of the market are so subdued, it’s easy to get complacent about the amount of risk you’re taking in your portfolio. This can be especially dangerous after the stock market has risen dramatically (as it has since the middle of February) since the rally can cause higher-risk investments to become a larger portion of your portfolio. As a result a subsequent bout of volatility can be especially gut-wrenching.

Such a return to inclement markets is a distinct possibility. While a calm stock market isn’t unusual—stock market volatility often stays relatively subdued for years as a time—there are a number of factors that could make the current episode short-lived. The global economy remains weak, the Chinese economic slowdown could accelerate, and political risks abound. Any of these could trigger a renewed bout of stock market turbulence.

The current period of calm markets therefore provides a good opportunity to examine your portfolio and verify that you’re taking the right amount of risk based on your financial goals and your ability to handle market downturns. If you need to make a change to your portfolio to get to the right risk level, it’s better to do so when markets are benign than when you’re forced to at an inopportune time.

Do you believe in central bank magic?

Rabbit

As a mental exercise, try reconciling the following sets of facts: Since the February lows, global equities have rallied nearly 15 percent, emerging market stocks by 20 percent, WTI crude by approximately 35 percent and equity market volatility has fallen by over 50 percent. But during that same period, emerging market economic data has consistently disappointed, earnings have remained challenged and one of the best measures of U.S. growth is stuck in negative territory.

To be fair, there are credible explanations for the recent rally. China’s currency has stabilized, the U.S. labor market continues to expand, and the oil supply appears to be moderating.

But most importantly, central banks have added still more stimulus. To my mind, it is the last development that matters the most. Apart from more monetary pixie dust, it is not obvious that the fundamentals have improved as much as the drop in volatility suggests.

Historically, equity market volatility has been driven largely by financial market conditions and expectations for growth. When growth becomes too sluggish, often a precursor to a recession, volatility is generally higher. Even more importantly, when credit markets are struggling, equity markets rarely remain immune. Therefore, it is worth considering whether either has improved enough to justify the sharp reversal in investor sentiment:

Growth has stabilized in the U.S. but remains a risk elsewhere

In the United States, the economic data suggest stabilization, but not acceleration. My favorite leading indicator, the Chicago Fed National Activity Index (CFNAI), has been negative for six of the past seven months. Meanwhile, despite rebounding a bit in March, European economic surprises have turned negative since January, while a similar emerging market index has collapsed.

Financial market conditions are looser, not loose

High yield (HY) spreads—the difference between the yield of a high yield bond and a Treasury note of similar duration—are down 2 percentage points from their February peak, as investors buy high yield bonds. Moreover, real (after inflation) interest rates are below where they started the year and the dollar is weaker, a de facto monetary easing. However, it is worth highlighting that conditions are still far from easy. HY spreads remain above average and roughly 200 basis points wide from their 2014 lows. Most broader measures of financial stress have followed a similar pattern: a significant improvement from the February peak but still indicating some pressure.

All of this tells me that conditions have improved, but not enough to justify the sharp drop in volatility. Equity volatility, as measured by the VIX Index, is roughly 30 percent below its long-term average. That appears inconsistent with a still murky growth outlook and less than benign credit markets.

Does this mean that volatility needs to rise? Not necessarily, but to remain at these levels you need to assume central banks will continue to lean aggressively towards accommodation. While this is technically possible, it is becoming more difficult. As we’ve recently witnessed, some monetary prescriptions, notably negative interest rates, come with unwelcome side effects. Also, as investors have come to expect more stimulus, or in the case of the Federal Reserve a glacial tightening pace, it becomes more difficult to provide a positive surprise. In addition, it will be harder to lift valuations from these levels; developed market P/E ratios have reverted back to their 2015 highs.

In short, to keep markets this quiet going forward, central banks will need to conjure still more magic tricks.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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