Today on Top Traders Unplugged, I’m speaking with Alan Sheen, Founder and CIO of Dalton Street Capital. Alan has an interesting background in science and engineering, and also spent time in the military, which allowed him to later thrive in rules-based investing. He’s also the first Australian manager to be on the podcast. Listen in to today’s episode to learn about Alan’s journey from the Australian military to starting his own investment firm, why investors should look at volatility not as risk but as an opportunity, and what an investor’s own personal car says about their investment strategies.

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In This Episode, You’ll Learn:

• What Alan’s childhood was like in Australia
• Why Alan studied aeronautical engineering
• How Alan equates gas-turbine engines with robust investing
• How Alan’s experience in the military helps him as an investor
• How Alan was influenced by Darwin’s “The Origin of the Species”
• Quantitative investment’s prevalence in Australia in the early ’90s
• The influence the VIX Index had on Alan’s career
• How Alan’s hedging strategy turned into a managed futures strategy
• Why Alan use an equity portfolio as collateral instead of cash
• How volatility can be opportunity and a friend
• How Berkshire Hathaway has benefited from a volatile market
• The importance of an investment manager to personalize their hedge funds

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Links Mentioned:

• Sensation Seeking and Hedge Funds

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

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Niels

Hey everyone, and welcome back to another edition of Top Traders Unplugged, where today I'm joined by Alan Sheen, who is the Founder and CIO at Dalton Street Capital, based in Sydney Australia, and, I'm pretty sure, the first Australian manager on the podcast. So, first off, Al, thanks so much for coming on the podcast with me today. I'm very excited to be able to speak to you today and about our conversation in general.

Alan

Thank you very much, Niels, the feeling's mutual.

Niels

Good stuff. Now, I want to kick-off, as usual, by framing what we're going to talk about today by getting a better understanding of your journey into the rules-based world of investing, which even today, I think, is not fully appreciated by enough investors. So, why don't you take us back to how it all began and how you got to where you are today.

Alan

Well, I'll probably have to go back to almost childhood just to give a bit of an understanding about my thinking behind what I planned to do as an adult, so to speak. My background is that I was born and raised in a very small country town. It was under 2,000 people, in a state in Australia called New South Wales. We call it the Outback. A lot of people think of Crocodile Dundee and where the goings-on, and the crocodiles, and everything was filmed. Ours was a little bit like that but more kangaroo, sheep, and cattle.

I enjoyed that upbringing. I was very, very good at math and so on, not so good at the social sciences and the English part. I guess, notwithstanding that, I spent the majority of my time on the sporting field. I think with a lot of kids or children that grow up in small towns, there's not much to do, so you throw yourself into sports. That was everything from well-known sports here in Australia like Rugby League and Rugby Union, and in the summertime, it was generally water polo, which is really just Rugby Union in the pool. A lot of people don't realize what's going on underneath the water.

Yeah, so my focus was that whilst I did well at school in math and science, I was very much focused on my sport, and I thought I'd go about pursuing a career as a professional sportsman, as I'm sure you don't have to convince too many young boys to focus on. But, fortunately, my father, who was an amateur sportsman but also had an engineering background, suggested that I do as my two older brothers did at the time which was to go into engineering. Luckily, I guess, his advice was sound because I had a career-ending injury at only twenty years of age, or I should say a sporting career-ending injury. So, it was very good advice on the part of my father.

Niels

Absolutely, so, from small town, interested in math, engineering, what happens next?

Alan

To actually apply what I was interested in, I left the small town and moved to the city and undertook studies in aeronautical engineering. My father was in electrical engineering. I had one brother mechanical and one brother electronics, so it made sense for me to go and do aeronautical engineering just to spread the love across the engineering field.

I actually did my studies through the military here in Australia. There are a couple of advantages to that, actually. In the military, they actually provide you with your education for free, and at the same time, you're paid a full-time salary to do that. So, whilst it was, I guess, a challenge whilst my contemporaries and friends were having two months off in the summer. At university, I was out running around, learning how to be a person in the military, and learning how to march and shoot and do all those activities that you learn in the military.

I think, ultimately, it worked out really well. I was assigned, after my studies, to a research and development unit in an area of the Air Force that, I guess, in some respects, is kept relatively secret. I spent eight years, at the start of my career, researching gas turbine engines, or jet engines, for another word. It was, actually, a wonderful experience and not too different from the experience that I have today.

Really, our role is when people hear that, "Oh gosh, you're working on jet engines, or you're doing research and development on them, that you must be purely trying to make them go faster." Nothing could be, actually, further from the truth. The primary role in research and development of gas turbine engines is to make sure that they don't stop, first and foremost, because that's quite an important aspect to the passengers and pilots on the plane. As an intended consequence, but also sometimes as an unintended consequence is that they would, actually, perform better and be more fuel-efficient and many other aspects that you'd like to see in any mechanical device.

I think, and I guess I look at what I do today as it is not too dissimilar. I'm basically applying math and science to (and I hate to use this word), but to engineer client portfolios; to, first and foremost, make sure that they don't stop, make sure that they don't lose their capital, number one. As an intended consequence, and as we know in our industry, sometimes an unintended consequence, they do go faster, they do make a little bit more money over and above what the investor has allocated. So, to me, I feel as if I've been doing the same thing since I left school.

And another aspect that I learned, particularly in the gas turbine engines, what a lot of people don't realize is the simplicity of a gas turbine engine or a jet engine. In actuality, there is only one true moving part in a gas turbine engine, and that's the turbine shaft. Hanging off that turbine shaft is the turbine veins, and the compressor veins, and the combustion chambers, and everything is actually hanging off that one moving piece.

I think that really alerted me when I started considering applying my skills to finance, that I should be looking for the simplest outcome. Really, when you think about it, jet engines have changed our lives. We don't have to sit on a ship, traveling months at a time to go from, let's say Australia to England. Or from England to Australia as a convict, unfortunately. It has changed our whole lives, and I looked at the initial models that I built inside the finance world, and I was very cognizant of the fact that whilst it was intellectually challenging and it certainly used your intelligence to come up with very complex algorithms, I just fell back onto my original training and just said, "Occam's razor. You want to go with the simplest idea."

Niels

Yeah, absolutely, that's quite fascinating. Just staying with the military, just for a few minutes here, what would you say that your experience inside the military... How would you say that it has helped you compared to not having it at all? Is there something really specific that you took away from it other than the specifics of learning about jet engines, of course?

Alan

I think I... I have a friend of mine who is a lawyer, and he's incredibly argumentative, and he always uses the excuse, "Well, of course, I'm argumentative I'm a lawyer." And my comment always is to him is, "no, no, you were argumentative when we were children, that's why you decided to become a lawyer and use that skill set."

I grew up... My father spent time in the military before he went into his field of choosing. And I grew up in quite a structured family. We all have a certain mentality about us. I guess that's, again, I'm not a certain way because I chose the military or engineering, I was that way, and it worked well for me. I think that helped me become a success in sports as well.

I do say that the clients, sometimes... I have heard someone on your podcast say this before, that, "I learned all I ever needed to know about systematic and quantitative investing even before I set foot in the field," because systematic and quantitative investing, at the end of the day, is about discipline. We can actually carry that through to fundamental investing. It doesn't matter how good your model is, how well you know your company, how close you are to the CEO if you don't have the discipline to deploy that knowledge in a systematic manner you might as well throw out the model.

So, the military was a great experience for me. It tested my intellectual knowledge, it tested my discipline, and another couple of aspects from the military was that I don't feel any stress in this industry. We can have massive days for us, against us, clients booting us up when we're having a tough time, or even if we have situations where we're really struggling to develop models sometimes, and I just don't feel the stress. I think having spent time in the military where you're put in situations where (it sounds cliché but) your life and the life of your cohort is a risk. When you're sitting in an air-conditioned office, in a suit and tie and really just losing a couple of dollars or making a couple of dollars here and there, to me, it's an enjoyable experience, and there's no stress what-so-ever.

Niels

Yeah, well, speaking about stress, I guess dealing with jet engines and, in particular, the fact that you're trying to avoid them stopping mid-air, I guess it could also teach you about thinking in probabilities rather than possibilities. That leads me into something I've seen you mention, which is also how you got involved in the quantitative investing. It wasn't really from just reading financial books. I saw references to people like Charles Darwin, inspiring you. So, back to the probabilities versus possibilities, behavioral finance seems to be something that is important to you. So, can we talk a little bit about that?

Alan

Absolutely, it's also that another aspect is alignment of interest. One thing that I love about our industry is the alignment of interest. Some people don't charge any base management fee, some people charge a small one, and we have a performance fee aligned to the interest of the client.

I had that experience in the military. Once you fix or do some modification on that jet engine and you sign it off, when that engine goes back into the aircraft, you, as the person signing it off, jumps in the back seat with the pilot. So, therefore, that is true alignment of interest. That was very revealing to me because I thought, "Now I think this is fair, how can I sign off on this and do the work and then send some chump up into the air and go, 'Well, good luck with that. I hope to see you back on the ground at some stage.'" No, no, you'd be in your flight suit and heading up there with them.

So, it's definitely alignment of interest. It's very similar to what we do now. I think I learned a lot about that probability is the exact right word. I think that what I found difficult when I came out of engineering and went into finance is this desire, this almost religious experience of trying to predict; that people were trying to predict where the market's going, where the dollar's going, where earnings are going to be. I found it absolutely stunning that this is how people thought.

I just thought, well, no, no, we just work on probabilities. We have rules or principles of engineering that we have to follow; otherwise, the plane falls out of the sky, or the bridge falls down, or the building falls over. I was stunned when I came into the investment market and just realized that the mentality was "have a hunch, bid a bunch," it was quite extraordinary. I just liked the idea of if I can (I hate to compare it to a casino but) just increase my probabilities very slightly and do that many times over, we can produce a very successful outcome for our client capital.

Niels

Do you think (staying on the topic of behavioral finance) if more people knew about that and studied it a bit more, that more people would ford to the side of how we look at how you should become an investor, meaning being a rules-based investor rather than doing it on your intuition?

Alan

I think so. It's coming back to my experience reading the Origin of Species by Charles Darwin. That probably gives you a little bit of insight into my personality that I enjoy reading those types of books. I don't know if you've had the opportunity to read it, Niels, but it would have to have the world's longest sentences in it. It's quite an incredible book in that sense. So, it is hard going.

My biggest takeaway... I was just reading it for interest, and I wasn't thinking so much about finance until (it's under the natural selection chapter, I think it's probably ninety or ninety-five pages, depending which version of the book you have), it was just a very simple diagram of what... I think a lot of people don't realize in the origin of species, everyone thinks it's about human beings. It has nothing to do with human beings. Darwin speaks about plants and pigeons, predominantly.

So, he has this diagram of the breeding of pigeons, but it could be anything, he's allowed you to think of it as anything. You start with a black and a white pigeon, and you mate them. At the bottom, out of that first mating, comes a very dark gray, or what you'd expect to be out of a black and white pigeon. He goes through regenerations and generations, and after the tenth generation, he's there looking and observing the pigeons.

Physically they look very different in the sense of their colors. But once he tests their behaviors, they're exactly the same as those first two pigeons. That's when I started thinking about, "OK, we have a bit of an issue in finance, of what I could observe very early on, and that is that if you look at the top manager for one, two, three, years running and pretty much guaranteed they're going to be the bottom manager for the next two, three years running."

I say, "What's going on here?" There has to be some behavioral basis to it. I think what I came to, I guess, to my conclusion, was that humans, no matter how far we've evolved, no matter who we mate with, no matter how intelligent we think we've become, our behavior doesn't change.

The interesting aspect of the diagram in the Origin of Species, in natural selection, is that it appeared to be, I guess, ten generations. But, in the fine print of that page, Darwin had written that this indicates ten thousand generations. So, for all intents and purposes, his takeaway, as humans, even though he doesn't mention it specifically in the book, but he mentions it later in subsequent writings is, we're still acting as though we're running around the Africa savannah two hundred and fifty thousand years ago. Our behaviors have not changed, and those behaviors are driven by fear and greed. That formed the basis of the model that we run today.

Niels

Yeah, and certainly, also, the whole concept of trend following, that we often talk about here, on the podcast, yet it's still very important for people to kind of accept that these are things that are very unlikely to ever change.

Now, clearly, you have an entrepreneurial gene that allowed you, later in life, to set up your current company. But, before we go to that, there is a little bit of a gap from the military and to the founding of Dalton Street Capital. So, maybe you want to tell us a little bit about what happened in the middle there, and then we'll start talking specifically about how you've gone about setting up your current firm.

Alan

I went around using what limited amount of contacts I had trying to secure a job in investments. The only job I was able to secure was a job as a fundamental investment analyst. This was '94 and, I guess, particularly in Australia, at the time, Quant wasn't known of. People sort of looked at you very, very funny. Of the people who were interviewing me, I only came across one person who was an ex-engineer and also had a degree as a doctor, as well. We hit it off straight away. He was the only person that I ever came across with that background for many, many years.

But, notwithstanding, I was offered a role, it was a family office, and I was offered a role, and two years into this journey of fundamental investment analyst (which this person had an engineering background and very science bent), I was still fundamental. What I found is I just found it very, very difficult coming from a background of, I guess, engineering principles, rules that have stood the test of time, not letting emotions, or feelings, or opinions get in the way of constructing, I guess, whether it be an aircraft engine or modification, the concept of (what's the best word I can use) the pseudoscience. I know that's almost offensive, but I saw it as pseudoscience.

After two years of being a fundamental investment analyst, and looking at companies, and listening to company executives tell me how wonderful they were, and their companies were, I just thought that this doesn't make sense to me. We're abdicating our responsibility to make good investment decisions and research based on people's opinions. I actually resigned. I submitted my resignation, and I said, "Look, this doesn't make any sense to me, and I'm heading back to engineering."

It was just fortunate, at the time, that I was doing studies in mathematics (again, this probably says a bit about me), just for fun. I met a couple of guys who were Quants. I'd never heard of them before in my life. They were talking about this new index (this was '96) this new index called the VIX Index. "It's incredible. Have you seen this index, Al? It's based on fear and greed." I went, oh, I just read about fear and greed and behaviors like anchoring, incredible human behaviors that, no matter how well we know them, or how much we know that we're actually displaying them ourselves, we just cannot escape them.

This is work by well-known authors like Kahneman and Tversky and Bray, and less well-known authors like Phil Tetlock. And I thought, "Well, hey, this is really interesting." So, I think after (it was a night class), I went into work the next day and quickly rescinded my resignation and hoping that they were kind enough to let me stay there and undertake this thing called Quant.

I just immersed myself in it and, thinking back to my days in engineering, and thinking to myself, "How can I come up with an idea?" The genesis of it was that we were looking at putting in place a hedging strategy for our equity funds at the time. There is an unusual phenomenon that occurs here, in the Asia Pacific region, it was interesting, I was talking to Mike Adam. As you know Mike the “A” in AHL, and he was telling me (this was only the start of this year) that he's been in the industry for, gosh, thirty, forty-odd years and he's really only found, what is it, two ways to make money. He found those two ways in the first two years. He spent the last thirty-eight, and millions of dollars, and hundreds of millions of man-hours trying to find the third and couldn't find it. It appears as though the third is something along the lines of what we do where we apply, I guess, another version of behavioral finance, but it is actually unique to this region.

Niels

OK, so, when did you start formulating what has become the strategy that you then continue to trade at Dalton when you founded that?

Alan

What it was, I'd developed this model that was meant to be a hedging model for the equities that we were holding in Australia, but it was so good it over hedged and wiped out all the profits of the equities basket. I thought, "Well, that didn't work the way you thought it did, but it's as simple as how about if you invert the algorithm, how does that look?" It did, it was no longer a hedging strategy, it was a managed futures strategy. It was just a short-term, behavioral based, managed futures strategy. I didn't know it at the time, though.

Niels

That's what I was going to ask you. Did you know that there was something called managed futures?

Alan

I didn't know, for many years, that there was a thing called managed futures. I was completely oblivious to this. I think, also, working in a very small, family office, [contributed] as well, as it was very insular. I guess I was focused, and look, I was probably focusing on looking in rather than looking out, as well.

I still remember one unique aspect of our strategies is that we use, instead of using cash as collateral, we use an equity basket as collateral. That was really an unintended consequence of the person that I was working for, and their money, they just, when I came up with this strategy, and they didn't know a whole lot about futures, and I said, "Well, if we want to trade these futures we need to put cash on deposit at the futures broker."

"Well, I'm not going to do that, I'm not going to put that at risk. We don't carry a lot of cash."

So, I went back to the broker, and I asked, "Can I put my car up? Can I put up my apartment, at the time, up? What will you take as collateral?" I knew the broker a little bit, and he said, "Well, I know, Al, that you run an equity portfolio." Which I had been doing for a number of years. He said, "Well, I'm happy for you to put that equity portfolio up. We'll take a bit of a haircut on it, but if you want to allocate that, that's fine." Fortunately, I was able to put that up.

Again, I had no knowledge of the relationship between managed futures and equities, for example. I had no idea that they were uncorrelated. I had no idea that they became negatively correlated in periods of high volatility or very low volatility. I think we all know this in this industry, sometimes these happy accidents occur and we just are lucky enough to stumble across them.

Niels

I'll probably come back to this whole part of the collateral a little bit later when we dive into the strategy. But, as I mentioned, at some point, you decide to go your own way after a long career at bigger shops.. So, I'm interested in always finding out a little bit more about the thought process that went into that decision, and also a little bit about how you decided to structure the company the way that you did because, as far as I'm aware, you didn't start it completely on your own, so to speak, so why don't you tell us a little bit about that.

Alan

Yes, well, I spent most of my time at either family offices or fund managers. So, I was running this managed futures strategy aside many asset managers who were traditionally long only equities, or long only bonds. So, I was always the unusual person, well one, because I was Quant, but two because I was always inside a traditional shop.

Look, I'd done relatively well out of it. It was a fortunate structure whereby whilst I worked at a couple of firms (the last firm being Credit Suisse, heading up the Proprietary Trading Desk), I always kept the ownership of the intellectual property. So, if I joined a new firm, I would join the firm with two documents, essentially: the signed letter of employment and a legal letter saying that I maintained all the rights and ownership of the model.

I must admit, I missed out on a couple of jobs at some very well known firms because of that. I understand why, but fortunately, at places like Credit Suisse, they were happy enough to take that on board. So, I had done this for, gosh, about nineteen, twenty years and I was thinking, "OK, I have a young family, and maybe it's time that I just start managing my own money." I was fortunate enough that I had numerous relationships over the course of many years in the investment markets, and I was introduced to a friend of a friend who was saying, "Well, hang on, we're about to set up a boutique incubator, and this is a specialist boutique incubator, so, we will only partner with managers who have performance fees and have very, very tight capital constraints."

This was a person who had been running, I think it was, the largest or the second-largest boutique incubator in Australia, but it was a lot of long-only equities, a lot of long bonds, you know, the traditional. This wasn't performing as well as it used to.

So yeah, he saw the opportunity to set it up just purely for, I guess, for alternates, for a better word. So, we were the second fund to join this firm. There's now three. A second group joined about twelve months ago.

I guess I've always had a bit of an entrepreneurial spirit. I've always had a second job, so to speak. So, at school, I used to have jobs: everything from cleaning telephone booths to finding golf balls and handing them back to the people who lost them and getting them to pay for them. Even when I was an investment manager, I'd travel to places like... I remember an instance when I went on holiday to Vietnam, and I was heading just outside Ho Chi Minh City, a little town called Bin Hoa. I saw these square... gosh, this was back in the late eighties, I saw these square terra cotta pots lined up along the sides of the road, for next to nothing. It was in the range of fifty U.S. cents, or something.

So, I managed to figure out where these were being manufactured. I found one of the manufacturers and handed him (I still remember the exact figure, it was $14,000.00 U.S.), and I said, "Oh, I look forward to receiving a forty-foot container in Australia in a few months." I went back to Australia, and I thought, "That was the fastest way I'm ever going to lose $14,000.00 in my life."

Sure enough, on time, this container arrived full of terra cotta pots. I loaded them in the back of (we call a ute in Australia) a pickup truck, and went around to all the nurseries and garden shops and everything I could think of and sold this forty-foot container of terra cotta pots. I did that many times over. I think it's just in my blood, maybe that I enjoy that sort of activity.

So, when the opportunity came to, basically, fund my team of people and also work with some really great guys, and also outsource the aspects of the business that, frankly, I think a lot of us, as investment managers, don't have a lot of interest in. You set up your funds managers for business, and you're working away, and your bins overflowing, and you're wondering when the janitor's going to come in a clean it, and then you go, "Oh, I forgot, I'm the janitor. I need to empty the bin."

So, it was a great opportunity to partner with a firm called Prodigy Investment Partners, and they take care of everything from risk, compliance, operations, all of our IT systems, and also sales and marketing, and also they've helped us with the working capital as well. So, like most of these boutique incubators, I think a concern for early investors in funds, as you know Niels, is, "Is this firm a viable firm?"

That's, I guess, an answer that we can actually give potential new investors, that yeah, we have an agreement in place that we are fully funded for a significant period of time. They've already shown that they have done it for many, many years with the first boutique that they partnered with. So, that's part of the reason I was keen to set up my own business, keen to manage my own money, but there was a great opportunity to work with great people and allow me to focus on the investments rather than the, I guess, the background work, for a better word.

Niels

Yeah, I think actually, I think that is a good point. I found, certainly, in my career that a lot of great traders aren't necessarily great businessmen. So, having some people alongside you, not just to bounce ideas, but to take some of the workload off is pretty important.

A lot of peers in our industry will be listening to our conversation, for sure, and I think, certainly, it has become much harder to start new firms in our business in recent years. So, I'm curious a little bit if you can share maybe some of the things that you found. Because this is only three or four years ago, so it's relatively fresh in your mind, I'm sure. [If you could share some of the biggest challenges that you came across, or have come across, and maybe also a little bit about how you dealt with them, so to speak. I think that could be useful for many people listening.

Alan

I think the second greatest challenge is just, I guess, getting asset allocators to understand what we do, that it's not a black box. In fact, this is a more transparent box than you'll ever, ever receive with a fundamental manager because we certainly can't see into their minds and, I guess, look for any sort of replication of what they do on a daily basis.

Also, it's really just... and I think this is part of the reason why you set up the podcast, Niels, is the misconceptions regarding the way we manage money, the way we manage risk, and what is science and what is pseudoscience? The other aspect, as well, is having the investor commit for a reasonable period of time. I know a lot of my contemporaries, including yourselves, I think we often say, "Look, you need to be invested for a minimum of three years, preferably five, and if you want to really achieve good returns, you need to be in for ten. That's how you receive your returns.

There was a wonderful study, and I never remember who it was, Peter Lynch who conducted the study, or Fidelity that conducted the study, when Peter Lynch was running the Fidelity Magellan Fund, through those years his average return was twenty-nine odd percent. When the study was done of what the average investor return was, I think it was a tiny fraction. Does that seem like a credible story, Niels?

Niels

It does. I don't know the specific returns, but there have been many studies that show that investors, unfortunately, never get the full outcome of a strategy or a market for that matter.

Alan

No, no, and most recently, I've been... And this is one of the great challenges because we don't constrain our volatility; we don't target returns; we don't target volatility. What I try to explain to people is volatility is not risk, volatility is opportunity. What we need to understand is, I guess we have a lot of famous investors. Let's use Warren Buffet, he's an easy target to use.

I still remember that (I think in the tick boon), Berkshire Hathaway dropped close to fifty percent over the course of a couple of years. Buffet was featured on the front cover of Forbes or Fortune saying he's a has-been, he's done for. I think the stock price dropped to the rock bottom price of about $40,000. Sure enough, now it's somewhere over $300,000, and he's had a number of drops of that magnitude. I think, who has actually enjoyed that gain?

I think, in his case, he seems to have, I guess, a group of people who really do idolize him, and I think he's built an amazing brand. But then, when it comes to what we do, and the way we explain what we do, we can't really tell the folksy, down-home stories about how we've made money, or how we love management, or we love the product. It's really challenging. It's a real challenge for us.

Essentially, the take away was that managers that drive high powered sports cars, generally, generate way more investment risk, deliver lower returns, lower sharp ratios, and lower alphas. So, you're more likely to see a top-performing hedge fund manager driving a Volkswagen or Volvo instead of a Ferrari or Lamborghini. I still read it, every now and then, just to jog my memory, in case I see a lovely sports car driving by, and I think, "Oh, it would be nice to be driving one of those." But I quickly read that paper. I think it was in the Journal of Finance, just to remind myself, no, I'll stick with my current car...

Ending

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