2006_12 strategy

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DWS MARKET EDGE

Please carefully read important notices in the last pages of this report.

Korea/Tactical Strategy

Comes 2007, Looms Sinister Twilight Stock Selection, more than ever, will be paramount to performance

Two pillars of the market’s rally since 2003 could start wavering… While most analysts are penciling in 1,600 as “given” for 2007, I do not believe that the market can stabilize around 1,600 any time soon, possibly not until 2008. I expect to see next year’s peak level – about 1,550 based on my reference case – coming in the latter half of the year, not in the first. Two pillars of the market’s unprecedented rally since early 2003 – namely, “global code convergence” and “super-liquidity” – could start wavering in 2007, though not crumble to the ground. Code convergence takes a recess – “value activists” will hibernate “Societal” arbitrage opportunities at a company level – exploited and facilitated on the back of code convergence - have been largely whittled away due to increased share buybacks and subsequently higher market value of shares. Activist efforts will likely diminish amid a transitory setback or (perceived) regress in corporate governance-led equity culture shift. This will likely paralyze or halt the process of code convergence, albeit temporarily. The effect of “super-liquidity” will be less than “super” Liquidity effect will also start to lose its sizzle. Local source of stock market liquidity will dwindle – in a form of “discretionary cash flow displacement” - forced upon households by higher home prices and housing costs. International liquidity in the Seoul bourse will also be affected by the possible repositioning of global liquidity. I am zeroing on signs of trend reversal of carry trading currencies. Corporate earnings likely to disappoint “under microscope” Corporate earnings will likely come short of meeting investors’ expectations. The jury will be out on US inflation – the largest consumer market in value chain for Korea – and the proper level of interest rates, as well as the corporate pricing power next year and beyond. This bodes ill for the market, likely making it unwilling to capitalize cyclical earnings with a low discount rate, thus a high P/E. Moreover, based on my reference premise that corporate earnings momentum will be under threat from a margin squeeze, the market’s rather sanguine perception of earnings visibility could deteriorate faster than expected, the minute a slowdown in earnings growth is detected. Stock selection will be ever so paramount to performance On the basis of a possible stretch of valuation from both absolute and relative perspectives, I remain underweight (at best neutral) on Korea and its IT shares for the next three to six months. The scarcity of corporate profits and liquidity will make investors “Darwinistic”, meaning the demand for perennial growth stocks will increase. Largely “cyclical” from a global context, Korean stocks do not offer many safe havens. I suggest that an investor stick to core “stalwarts” that can weather a cyclical downturn and are well protected from structural margin pressures, while hedging market risks. My “stalwarts” include NHN (035420.KS), Megastudy (072870.KS), SK Corporation (003600.KS), Doosan Heavy (034020.KS), and Hite Brewery (000140.KS).

December 7, 2006

Tactical Strategy

Alfred Park Head of Research +82-2-768-4143 [email protected] [email protected]

Focus Names - NHN (035420.KS) - Hite Brewery (000140.KS) - Megastudy (072870.KS) - SK Corporation (003600.KS)- Doosan Heavy (034020.KS)

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DWS Market Edge KOREA STRATEGY

DDOOMMEESSTTIICC LLIIQQUUIIDDIITTYY LOOKING INTO RETAIL INVESTORS’ NEED, STATE, AND ACTION

Context, Premise, and Basis of my Analysis

“…When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals. We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues. We shall be able to afford to dare to assess the money-motive at its true value. The love of money as a possession (as distinguished from the love of money as a means to the enjoyments and realities of life) will be recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease... But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight…” – John Maynard Keynes

John Maynard Keynes made this daring (and challenging) statement in 1930. Pricked with conscience, I must admit that I had acknowledged it, but only with some sense of indifference, and that it has not been long since I got a grasp of what it really meant. And it is regretful to face the fact that this is precisely the core of things that encircle our lives though we may desperately mutter against it. It is more than just likely that we are entrapped in an era of avarice.

The price of assets in Korea have all soared, in concert, to or around their respective new highs. The current trend and pattern are extending and expanding in an unprecedented manner, almost as if we have an unlimited access to no-cost funding. We crunch our numbers, searching across all asset classes throughout the world, trying to find reasons - cyclical and secular - to justify the higher price levels to be sustained in the future. Deeper I delve into the matter, harder it becomes for me to find sound fundamental reasoning. I usually end up with a number of technical and psychological reasons that appear to be more explanatory.

I would like to decisively emphasize that that the current rally, especially since the latter part of 2005, is “primarily” the offshoot of a shift of reference point in liquidity (and some societal changes). There is not a lot of evidence that adequately supports a major evolution of corporate business fundamentals (minus the governance issues) as some experts claim. It requires a lot of time, among other things, for deeply-rooted fundamentals to change. On the other hand, psychological and technical factors are much more capricious in nature. This is the focus of my analysis in this report.

Inarguably, Koreans place an unparalleled priority on housing over any other goods or services in maintaining or reaching their desired life style and dispose other expenditures around it. And they are extremely averse to taking on debt. Therefore, the housing market is a de-facto centerpiece of the domestic liquidity flow into goods, services, and/or financial markets in Korea. The retail investors’ scope of spending/investment decisions is largely determined by the state of the housing market, and this explains the “forced” buying of stocks by retail investors since the first quarter of 2005, when rental income yields and sales price change of housing properties hit the bottom. I categorize this phenomenon as a “forced” buying of stocks on the rebound as opposed to a “discretionary” buying – which distinctly contrasts from the investing pattern and timing of “value-shooting” international investors. Taking the best of both worlds, I identified a “can’t-miss” buying opportunity on broad-market terms in the 1st quarter of 2003 and rode the horse as far as it would take us. However, over the last week or so, I identified the sources of concern - on the basis of factual evidence, material and circumstantial, and grassroots eyewitness accounts – which are calling for a more intensive initiative to find, identify, and verify the factors that had created the current state of the market since 2003.

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Housing Market – De facto Centerpiece of Domestic Liquidity Puzzle

The housing market (and perhaps more seriously, price of a land lot) in Korea, particularly of the higher segment, is flirting with an overstretch of demand. A residential apartment may be priced on the basis of a unilateral belief that it is (and will be) an invincible investment vehicle with little consideration for its practical utility. The greater fool theory does not seem to have its place in the current scene yet as a person not owning a house is regarded as a fool. An owner of a million dollar apartment does not seem to care much about the fact that he is sleeping on $200~300 a night, a charge that would hold sticks with a first-class hotel.

The most dangerous market among all asset classes for “fools” is likely real estate because of easy access to financing. For as long as I can remember, real estate has been the asset of choice since, for most people, it represents most of their wealth. Only a few people have assets outside their homes in Korea. Mortgage debt has exploded right along with housing prices. Residential apartments in Kangnam (South of Han River) are on course of nearing 20% YoY this year in terms of price inflation, at a time when headline inflation is gauged at 2%. Right now, I clearly see that there is no shortage of greater fools.

The cost of borrowing will steadily increase. And as rates rise, demand will inevitably fall as fewer people qualify for financing. Finally, when the average house becomes too expensive for the average family to afford, then the last fool will have bought in. We may be at the very onset of the last group of fools getting ready and set to rush into the housing market.

So goes the theory on and forth. Despite all said, oddly enough, I am inclined more toward a possibility that this scenario will not be played out any time soon because it entails a set of certain conditions and/or situations. The housing market in Korea will not be taken down for the count any time soon. I believe that the social propensities, demographics and economics (of distinction) in Korea will likely override the ultimate rationality for now. Darts thrown by policymakers will largely miss the intended target and likely land and punch into the stock market. Two very important underlying facts support my reference scenario, in which I urge an investor to start paying more attention to the trend in housing prices for his/her tactical equity strategy:

FACT (1): The average household in Korea is still in net cash. Particularly, the top 20% (18% to be exact) income groups that are largely responsible for higher housing prices may care very little about a couple of percentage points hike in mortgage rate. I suspect that the average monthly income for these top 18% income households is estimated at about KRW5.8mil~KRW6.3mil, due to understated tax-returns for the highest income group that earn over KRW6mil per month and account for 8% of aggregate households. Theoretically they can stretch their credits to KRW120mil each under the very conservative assumptions of mortgage rate at 8% and debt-to-income (DTI) at 20% applied by a bank. The total sum would then amount to KRW350tril, easily dwarfing the current mortgage balance of KRW210tril.

FACT (2): Households with a monthly income of KRW3.5~4.5mil represent the income group that purchase a home with the primary purpose of dwelling (as opposed to investment). They make up about 14.5% of the aggregate. These 2.3 million households stand to currently have, on the average, a net monthly cash flow of about KRW380K at disposal. Assuming their average loan amount is KRW100mil, a 2 percentage points increment in debt service burden should manifest the stress for these income groups. However, good or bad, we live out our days between memory (of long ago) and foretaste (of the recent). And those that have yet to pull the trigger would likely feel – understandably – that the cost of their self restraint (from buying a home right now) can turn out to be possibly very high. In such a case, they may end up competing for an available good against higher income groups as well as among themselves. Households with a monthly income of KRW2.5~3.5mil - constituting 22% of the aggregate - that have to overstretch in order to buy a home, might as well participate in this competitive bidding. Of course, the leading signs of rising Chonse (lump sum deposit in place of monthly rent) and/or monthly tenant rent would normally precede this corollary.

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Fact 1 and 2 together, it seems highly likely that - while the affluent will continue shopping - households with a monthly income of KRW3.5~4.5mil will be the main anchor of yet higher housing prices, the basis for my reference scenario. Figure 1 shows clear-cut disparities in non-living expenditure increases during the last 3 calendar years since the end of 2003 among different income groups. These disparities in non-living expenditures, consisting of income tax, debt service expense, fund transfers, and other sundries, indicate that it is the affluent income groups that pushed up housing prices, taking on more debt to efficiently finance their purchase. Note that households in KRW2.5~3.5mil income bracket has not “stretched” their external finance for the purchase of a home. They also have a positive cash flow of about KRW110~130K.

Bearing in mind that these middle-to-lower income households have not been savvy enough to beat the market, it is also important to take into account the social climate and perspective of these income groups surrounding the housing market in Korea. The incumbent government has publicly announced on many occasions that the rate at which housing prices have increased is not a sustainable figure and that it is committed to securing the availability of affordable housing through stable supply and preemptive cooling measures. The scorecard has it that it not only failed to make good on its words, the government now cannot escape a public censure as the Secretary-General and Press Secretary have been accused of “renege.” As shown in Figure 2, the housing market has been rather interest-rate inelastic under the incumbent Roh Administration, countering an accepted theory of economics. Panic and wrath are what these “would-be” homeowners are seemingly stricken with. And any pensive person would concur that these two represent the most prominent psychological properties that hinder a person from making a rational judgment.

Fig 1: The affluents are responsible for bidding up home prices over the last three years…

Source: NSO, KB

Fig 2: Housing prices have been inelastic with interest rates, countering an accepted theory of economics

Source: BoK, KB

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A Home or Stocks? – Hardly a Dilemma for John and Jane Doe

Is it economically sensible to purchase a real property at the current price as a long-term investment vehicle – for keeps? Before we delve into the details to answer this question, it is important to note that my eyewitness accounts (as of late) indicate an average hard-working family - easily prone to delusion – that is looking for a home would be largely disturbed by any (I mean, literally “any”) further strength of housing prices to the already impressive showing. In addition to the fact that people have become increasingly myopic in their (investment) decision-making, they may subliminally act on their desire for self-redemption - which they tend to believe they can achieve - by overturning their preceding indecisiveness or inaction. The mounting unrest from expectation of gradual increases in mortgage rates may actually lend an impetus to middle-incomers’ bidding. They would rush in, lest they may have to forgo owning their own nest, for however long, they do not know. So it is these middle-class income groups - as opposed to the affluent - that would likely keep the strength of housing prices to continue on unabated awhile.

The very element that lies right in the core interest of this particular group is, of course, interest rate. Housing price trend is currently one of the most watched indicators for Bank of Korea (BoK) in directing its rate policy although ST Lee, the governor of BoK, openly downplayed housing prices with respect to BoK’s future stance in his last public statement. Nevertheless, as shown in Figure 3, BoK has been a prisoner, rather than an initiator, of events - ex post facto. It is noteworthy though to see that BoK may have changed its stance or, at the very least, degree of such since middle of this year, giving mixed signals. I believe that BoK must be “decisively” peremptory in its rate policy – through hard-line actions and adroit spin-doctoring – in order to punctuate any overstretch (of middle-class) and/or speculation (of the affluent), and thus attain the “measured pace” of housing price inflation. BoK’s expected tightening, if tepid or (seemingly) non-committal

by any degree, will backfire by fanning peoples’ anxiety that rates might continue rising – slowly, but surely – and shove them to line up at a bank before “it’s too late”. And this will definitely hurt the stock market, manifesting itself in a form of “discretionary cash flow displacement” if all else is equal at a company level. My central scenario is built on this corollary.

By “discretionary cash flow displacement”, I am referring to a higher allotment of a monthly cash flow for housing cost at the expense of available liquidity for stock market investment. Inarguably, the average person in Korea places an unparalleled priority on housing over any other goods or services in maintaining or reaching his/her desired life style. There has been a positive cascade of the market liquidity in the Seoul bourse, even with foreign investors scaling back and sidelined since the 3rd quarter of 2005 due to increased market participation from local retail investors. Have the retail investors, all of sudden, arrived at a newly-found conviction that Korean companies will be highly profitable for extended periods of time and that their stocks are worth holding over the long haul? Have companies changed from “bad” to “good” in 2005?

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Fig 3: BoK has been a prisoner, rather than initiator, of events – ex post facto

Fig 4: Positive cascade of market liquidity despite heavy selling by international investors

Source: KSE, Daewoo Sec

Source: BoK, KB

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I Say They Should Wait, but The Does Probably Haven’t Heard about Admiral Stockdale…

Local retail investors’ liquidity injection into the equity market has been facilitated through contractual installment funds (“CIF”). Numbers of diverse funds were rolled out and well received by investors and the media alike with some sort of “adulation” as if they are structurally and mechanically superior to any other investment scheme. I personally do not know what added-value anyone would possibly attain from “blind-fashioned”, indifferent dollar-cost-averaging (perhaps other than putting oneself a strait-jacket so that he could not do anything irrational or stupid, in which case he should, logically, have his money in an asset allocation fund), but CIF truly swept the market in a grand fashion as the investment vehicle of choice. As of the end of September, there are 7.42 million accounts aggregating KRW26tril under management.

The reality is that trees do not grow up to the sky, as Jim Rogers put it. It is therefore essential for us to know just where we may be, as of today, along the “S” curve. I started off with the following assumptions that I believe are logical and realistic: (1) Households with a monthly income of less than KRW 2.5 mil are probably scant of living expenses with a negative cash flow, hence are excluded; (2) The rest of the households accounting for 54% of the aggregate have an average monthly cash flow of KRW600K and put aside 40% of their cash flow for active investing (10% of which is for direct stock purchase and other “fluid” investment activities; (3) Monthly average inflow during the last 12 months is KRW1.1tril, excluding two abnormal overshoot months, January and April of this year. My logical estimations would place the number of accounts at 8.6 million and the aggregate monthly contributions at about KRW1.6tril at the uppermost limit, indicating that we have consumed up to 70~80% of what we have “theoretically” to cap out from a mid-cycle standpoint.

Having laid out the causal nexus among the real estate and stock market in terms of liquidity, my argument of a weaker market, at least transitorily, requires only one thing if all else is equal at a company level; critical mass acting as the first domino. Many people naively assume that critical mass is one more than half. Quite the contrary, we all know that critical mass is reached when 10~20% of the whole is affected. I see the first dominos in KRW3.5~4.5mil income groups, 14.5% of the aggregate.

According to my historical and empirical studies, it takes, on the average, 10.1 years for a newlywed to buy their first home. Delving into it, I discovered the time duration between marriage and the time of the first home purchase had decreased at an annual rate of 1.3% over the last 16 years, and most marriages were registered - 50,512 couples – in December 1996. By charting together a monthly count of marriages registered and the housing price trend with an appropriate time lag, I can verify that my studies have been approached from the proper angle. The two charts in Fig. 6 demonstrate that the peaks and troughs of marriages registered would

Fig 5: We may have consumed up to 70~80% of CIF demands…Slowdown in inflow is expected

Source: Asset Management Association

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and did correspond precisely with the peaks and troughs – in terms of growth slope – of housing prices. The studies also corroborate that the Roh Administration might have misfigured the whole thing as its “focus” was on controlling demand over increasing supply. In my opinion, the incumbent administration and its predecessors alike also largely ignored the issue of price control.

Figure 7 should give consolation to those who missed out on the bargains of the late ‘90s, and I strongly feel they should wait – after all, they have already waited this long. However, it is the long-term forecast that may not come as tangible and palpable to the typical retail investor/”would-be” home buyer in Korea. Plus as I mentioned earlier, since these people are in a very vulnerable and unstable state of mind, any hints of stronger housing prices could turn even the most rational ones temporarily delirious. Looking at what’s right in front of my very eyes, housing prices, in all likelihood, have that last up-leg to go. First, if we take the monthly count of marriages as a surrogate for pent-up demand, either January or February of 2007 should be the peak month. Second, there seems to be a seasonality effect in housing prices in which the monthly rolling price change tend to be higher (to both directions) in the months of February to April. Third, a rise in Chonse was a precursor to my prediction of higher housing prices, and it is occurring as expected. Last, but not least, I strongly assert that it will take a whole lot more on the part of the incumbent administration than lip-synching a simple “roadmap” – for the supply pipeline - to help restore public confidence. The incumbent administration needs to put forth more efforts to educate and even “spin-doctor”, something they showed they weren’t so good at.

The market seems to overlook the fact that the price of a lot in Seoul rose by 7.35% YTD as of October, a monthly average in excess of 0.5% against a monthly average price increase of 0.97% for an average home in Seoul. It marks the first time, since 2002, in which an annual increase in the price of a lot rose by more than 7%, substantially higher than the headline inflation rate. Construction companies would hence think very hard about the profit viability of any residential project, exerting some pressure on future supply, despite the government’s supply directive.

Fig 6: Marriage count and housing prices (with a time lag) precisely correspond with the peaks and troughs

Source: NSO, KB

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All things considered, I am bullish on housing prices at the expense of the stock market over the next three to six months. Some would resort to the “interplay” between the housing and equity markets to establish their rationality for higher home prices as well as stocks. I see very little trace of “interplay” among the two markets. In order for this fiesta to take place, the market has to carry the current momentum to clear the 1550~1600 mark and therefrom bring forth a “profit recycling”. If the market indeed glides on the current momentum and nears 1550 before companies demonsrate that they can be the master of their own circumstance in 2007, the fiesta will be short-lived and likely turn into a fiasco.

Fig 7: Housing prices should peak in the 1st qtr of 2007 despite the government’s ambitious future supply directive

Source: NSO, KB, Daewoo Securities

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IINNTTEERRNNAATTIIOONNAALL LLIIQQUUIIDDIITTYY “GOLDILOCKS” VERSUS TICKING BOMB?

Revisiting Valuation from an Asset Allocator’s Standpoint

In the wake of my proposition, in which the retail investors would likely be “forced” to scale down on their equity investments, I shift my attention to what other market participants would likely do. Considering that a local institutional investor is more or less just a proxy agent for local retail investors, I believe that corporations and more importantly, international investors will continue to play a key role in directing the market’s short term direction. Given that these investors are proponents of relative value, I circle back to the question I previously asked; Is it economically sensible to purchase a real property at the current price as a long-term investment vehicle – for keeps?

Unbundling asset returns, I look at components of <yield> and <normalized growth> to arrive at an asset’s primary - central value. Residual portion of an asset return, not accounted for by these two components, consists of the difference in “perception” between normalized growth and perceived growth plus over/under valuation. While a singular-dimensioned investor is now being disturbed by the top right chart in Fig. 8, dynamic value-proponents probably would have rolled the dice already with the approach illustrated in the lower two charts. Output of this approach is highly explanatory of the onset of international investors’ directional positioning by the end of the first quarter of 2003 and the last quarter of 2005, as seen on the top left chart.

Fig 8: International investors, who are value proponents, have decisively turned net sellers since Dec. 2005…

Source: Daewoo Securities, KSE, KB

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Warning Flags across the Pacific and Atlantic

All points to the likelihood that international investors are not quite yet willing to step in to absorb a possible downdraft, which I expect is in the offing. Although I anticipate the market to be fairly well floored on the basis of undervaluation – ex-cash - at a company level, a risk of over-extended lockup has become all too visible to ignore. Consider the following:

1. If a conflict between the now Democrats-led US and China (and Middle East to a lesser extent) heightens, the record-low volatility of both equity and currency markets may turn around. We may see a whole new disposition of the market liquidity as carry trading, which is simply a bet on low volatility, gets unwound. Any scent of trend reversal will lead a sharp adjustment of carry trading currencies. The Korean stock market has benefitted much from the $128bn-deep Yen carry trades worldwide.

2. On the same note, there may be a component of artificial strength in the Korean won against the Japanese Yen (and Euro to a lesser extent). I duly interpret it as an implicit form of Yen carry. The strength of the Won has been a keeper of gross margin for the Korean companies that are highly dependent on Japanese imports.

3. Strong corporate cash flow, equity retirement from the stock market, and low cash calls are largely responsible for the market’s strength across the Pacific. I see an increased possibility for a slowdown in productivity and higher wage hikes, let alone strong prices for core commodities, which can together erode the profit structure of Korean companies. I also anticipate a flood of cash calls in China and other developing countries

4. I see that the market is at a juncture where investors will likely start demanding companies to take on more risks and deliver justifiable results, in order to make up for their thinning wallet – that is, the market is entering the “execution” time. Any disappointments will not be tolerated as much amid uncertain liquidity profile of the market.

5. Korean stocks still offer a very attractive value on ex-cash basis at a company level. Manifestation of a company's true - primary - value has yet to come full circle. However there seems to be a perceived risk of a transitory setback or regress in corporate governance-led shift of equity culture in Korea.

All of the above, which have yet to be felt by many in the market, are waving a warning flag when a normalized expected annual return from owning a Korean stock is now some 1.4% lower than LIBOR. I am addressing in earnest these factors as reasons to be cautious about the market as coming events usually cast their cloud before them.

Market’s Funny Bone

Figure 9 puts my argument in perspective. In terms of valuation, from the last quarter of 2002 to the last quarter of 2005, the Korean stock market was in a comfort zone for a value shooter. It became even more attractive, or rather irresistible after the 2nd quarter of 2004 because corporate earnings had started to accelerate and earnings visibility was rising. Code convergence, which swept through Korea, enlightening both corporations and investors, was an icing on the cake that turned a cyclical-rally into a structural re-rating.

Knowing that it was indeed right in hindsight, albeit preemptive, to go bullish from the 3rd quarter of 2002 and thereafter (I remember that many investors were very pessimistic and would eventually capitulate in the 1st quarter of 2003), I look objectively at what the market is prepared to offer us today, under the set of normal circumstances on the same set of principles.

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Unlike the early part of 2000, market valuation is not stretched “out of context”. But anything further above the current index level, if not accompanied by equally imroving company fundamentals, will push the market to the vicinity of madness, in which people will come up with a creative and wacky pretext to campaign for the “this time is REALLY different” headline. The high yield and junk bond spreads have risen, albeit slowly, and this theoretically means – if stocks continue rising – that there are no “uninsurable” risks in a business venture, while uninsurable risks are “inherent” in any business venture.

I believe that there are basically two scenarios that can play out over the next 6 months. We will experience either: (1) an imminent correction; or (2) a painful aftermath if the market reaches 1600~1700, as many analysts maintain. My response to these corollaries is very simple. Either way, the risk/reward profile is asymmetric to the downside unless the growth of corporate earnings outstrips the pace of share price increase (which is an offshoot of liquidity). Given that I expect a slowdown or recess in the technical factors - most markedly, the liquidity issue, I weigh the possibility for corporate earnings to catch the market by “pleasant” surprise. What the market is telling us at present simply contrasts with this proposition.

Fig 9: The Korean market was in a comfort zone for a value-shooter from 4Q/2002 to 1Q/2005… And now?

Source: Daewoo Securities

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IINNFFLLUUEENNCCIINNGG CCOORRPPOORRAATTEE EEAARRNNIINNGG TOP-DOWN AND BOTTOM-UP IMPLICATION

Heading for a US Recession? Zeroing on the Currency Markets for a Clue

Export-driven Korean corporations are heavily dependent on overconsumption by the US, which accounts for more than 30% of the world’s total private consumption. Although Korea’s exports to the US - as the amount of total - dropped, bulk of it to other countries, particularly China, are finally destined for and end up at shopping malls in the US. The following are just a few facts to illustrate the magnitude of US overconsumption:

1. Americans eat more than 800 billion calories of food each day. That’s 200 billion more than needed, enough to feed 80 million people; and they throw out 200,000 tons of edible food each day.

2. The average individual daily consumption of water is 160 gallons while more than half the world’s population live on 25 gallons.

3. More than half of available farmland is used for beef production; about 80% of corn and 95% of oats are fed to livestock.

4. There are more shopping malls than high schools.

5. On average, one American consumes as much energy as 2 Japanese, 30 Indians, or 400 Ethiopians.

People argue that the US is no longer of primary importance in analyzing the Korean economy, market, and companies. I strongly disagree for the simple fact that the US is the primary consumer market at the end of the value chain, where the produced goods end up. The US economy’s share of the world output actually rose by almost 4% points over the last 10 years, with share gains by China coming at the expense of Japan. The decrease in Korean exports to the US does not mean that there is no longer an explanatory relationship between these two economies. Rather, it represents a reposition of the supply chain, which I will further elaborate on the following page.

As shown in Fig. 10, US private consumption has been supported by foreign imports, displaying a higher correlation since the end of 2000. As retail sales retrieves to a more sustainable level, US imports should slow as well. Volume aside, import prices are set to drop sharply, or otherwise, the core CPI should rise. The corollaries of this static imbalance would have to dampen the output over the next several months. As such, the year-to-year growth of Korea’s exports for the month of December could drop to a single digit.

Fig 10: US import prices and thus nominal imports should drop further, as foretold by US retail sales…

Source: US Census Bureau, Bureau of Labor Statistics, Daewoo Securities

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Furthermore, the US yield curve is currently inverted and should be viewed as a harbinger to a recession because the inversion normally creates a disincentive for banks to lend, thereby reducing liquidity. The yield curve spreads (or swap spread for the same token), when adjusted for normalized real growth, are as close a proxy for pricing power – a company’s capacity to raise prices. It is the easiest and simplest, but most-powerful indicator we have. As shown in Fig. 11, the pricing power proxy, which is the market’s implied inflation discount, adjusted for liquidity premia - a macro-level synonym for a company level pricing power - has foretold the level and trend of what I here call “Inflation Pulse” - the price of a unit of consumption that consumers are currently paying minus the price consumers are willing to pay in the future.

According to my estimates, inflation pulse has retreated to a very subdued level of about 1%. I expect it to sharply turn around and head to a more reasonable level of over 2%. The outcome of the market responding to this inflation scare is more than casually probable as the US dollar appears to have weakened in a rather precipitative fashion since Novermber 22. Could this perhaps be a premonition to the heightening conflict between the US and the rest of the world that have subsidized the US economy, mainly China? Albeit unclear, I believe that it could certainly be the case as I simultaneously see that the indirect bidders’ takedown in the US treasury auctions also slowed. I maintain my view that the problem is not the US dollar’s overvaluation against the Chinese Renminbi, but rather against most of the world’s currencies.

Fig. 12 explains the interplay between the US economy, dollar, and other economies. On the account that Korea has diversified its export markets, away from the US, I extract the difference between the slope of US yield spreads and global yield spreads, adjusted for Korea’s geographical exposure in terms of export destinations, and carefully tracked its slope and pattern. Korean stocks tend to respond to it upon and after confirmation. And more importantly, global spreads lag US spreads and do so with an accelerating slope on both directions. I believe that this adequately answers to those in the market that are campaigning for the “decoupling (of the US and Korea) story”. This phenomenon is actually a reposition, in manifest, of the global market’s new value-chain and its appropriation, which is often mistaken as “decoupling”. We tend to get lost in the elapse of time when backtracking to the origination or provenance of something. After all, a stellar performance of Korean stocks since the 1st quarter of 2003 traces all the way back to the overnight rate kept artificially low by the US, which was only possible by the dollar’s status as the world reserve currency.

Fig 11: The risk of static inflation at the expense of future purchasing power looms large in the US…


14


The strength of the Yen, if confirmed and continued, will be a punctuation factor for the Korean stock market, if it breaks south of the next support at 115 level. Not only will it bring about the possible unwinding of carry trading positions as I mentioned earlier, the strength of the Yen against the Korean Won will erode the gross margin of Korean companies in a number of sectors. Excluding oil, Korea imports well more than 20% of total from Japan, and these imported goods from Japan, unlike Korean goods in world markets, are hardly replaceable. I feel that there is little BoJ can do to keep the Yen low amid Japan’s 58 consecutive months of economic expansion, passing (albeit arguably) Izanagi Keiki of the late ‘60s. The apparent easing of US Treasury Secretary Hank Paulson’s stance on his strong dollar policy should work in favor of the Yen.

I made an effort to measure how much of an impact JPY/KRW would have on corporate gross margins on the basis of ex-post nominal revenue growth, currency-adjusted cost burden, and labor and overhead cost of a Korean company since August 2004. I took the end of August 2004 as the starting point on the premise that it statically offered a very efficient state of the market and that any value creation/distruction would be duly reflected in the market price under the condition that guarantees the absence of arbitrage. KRW strengthened by 31% against JPY since then and the market, if all else remains constant, is overvalued by 8% on this basis, as of November 30 closing.

Fig 12: Adjusted global yield (swap) spreads, lagging US spreads, are hinting at the KOSPI’s recess as well…


Fig 13: KRW’s strength against JPY, a keeper of corporate margins, slows down, pressing the KOSPI?…


15


Sector Highlight: Counting on Technology Companies for Rally in 2007?

What will be the winners and laggards in this less-than-sanguine market environment, going forward? I would like to extend the scope of my analysis to the sector and company level with the preceding premise.

According to the market, most analysts point to IT shares to lead the rally further in 2007. It seems that local investors always have a high expectation or even a “soft-spot” for IT sector and its member companies. I have been underweight on the IT sector for quite some time and maintain that the underperformance of the technology sector, the largest “discretionary” goods sector and “fattest-tailer” in the Korean market - which commenced from more than 2 years ago - may not be over yet. In my opinion, the IT sector may rebound from some dip-buying by long-term investors, but would have to wait some time before it can regain its leadership position.

My argument for a falling pricing power – of which, we went into details on pg. 13 - will hurt the “very discretionary” technology goods. The left chart in Fig. 14 is a graphic illustration of an inevitability, not of a casual coincidence. As such, I expect numbers of more negative than positive newsflows in the pipeline over the next several months. Fig. 14 (right chart) indicates that we are just at the starting point of another round of falling prices for technology goods. As retail prices fall, the negative newsflow will incresingly weight on the valuation of the related companies as the “fear factor” kicks in. And this might bring about a breakage of “interplay” in the US market . According to my observation at arm’s-length here in Seoul, it appears that the majority of local investors anticipate that Windows Vista will stimulate a PC upgrade cycle in a leap, and as a result, Vista-related upstream beneficiaries, most directly Hynix and Samsung Electronics, will stand on their ground as the main anchor of the rally to come in 2007.

Grassroots Thoughts on Windows Vista–led Bailout Proposition

Against their waning purchasing power, American consumers would likely be choosier and more prudent in making their decision for “discretionary” purchases. A PC is as discretionary a product as any. For several years, PCs have had far more horsepower than the average user needs. This has been great for consumers (at the expense of PC manufacturers) because their computers last longer than they used to. If you want a PC for basic computing – office applications, web browsing, e-mail, instant messaging, digital photography and playing music or DVDs - almost any machine currently out on the rack will do.

Fig 14: “Discretionary” tech’s underperformace not quite over yet, with a new round of price cuts in the offing…

Source: Daewoo Securities, IDC

16


Given the cost and hassel of upgrading to a new system, businesses will likely continue to use Windows XP for years. To my understanding, majority of corporations all over the world just got around to using Windows XP a year or two ago. There aren’t rational reasons as to why coporations, that account for 61% of PCs used worldwide, would be compelled to upgrade to Vista anytime soon. A shift from XP to Vista is hardly a major transition; i.e. from typewriter to a word processor or from a fax to email. However you look at it, the adaptation to the new system is entirely discretionary, not compulsory. Furthermore, I can’t help but think that Vista’s visual sophistication and revamped multimedia can actually be initially a drag on a worker’s productivity, notwithstanding its functions designed to increase productivity if expertly used. Only 15% of corporate IT managers replied that they planned to upgrade their operating system to Vista in 2007, according to a ZD net survey.

Component Windows XP Windows Vista

CPU 300MHz or higher processor clock speed recommended

800MHz or higher processor clock speed recommended

Memory 128MB of RAM or higher recommended (Typical: 256MB)

512MB of RAM or higher recommended (Typical: 1GB)

Graphic Super VGA (800 x 600) or higher WUXGA (1920 x 1200) or higher*

Hard Disk 1.5GB of free space 15GB of free space

Product Full (US$) Upgrade (US$)

Windows XP Home Edition $199.00 $99.00

Windows XP Professional Edition $299.00 $199.00

Windows Vista Home Basic Edition* $199.00 $100.00

Windows Vista Home Premium Edition** $239.00 $159.00

Windows Vista Business Edition*** $299.00 $199.00

Windows Vista Ultimate Edition**** $399.00 $259.00

* For basic home needs such as e-mail and Internet access

** For the best home computing and multimedia/entertainment

*** For small and mid-sized organizations

**** For work and entertainment, this is the most complete solution

Windows Vista made its debut with five new, distinct features; better security/“bug” protection, more efficient software set-up/maintenance, improved search function, more sophisticated graphics, and revamped multimedia. It comes in two flavors for home users – Basic and Premium. Besides better protection and security features and some changes to the “look and feel” of the product, there are relatively few major differences between Vista Basic and XP.

Since most PCs on the market will be able to run the basic edition, PC vendors will try to “clear” their inventories via price cuts and Vista upgrade service before PC manufacturers introduce heftier and pricier 2007 models, making leftovers on store shelves near-obsolete. So a steep decline in PC prices is an unavoidable harbinger to a “full-fledged” Vista-era.

It would not be a matter of “buy” versus “not buy”, but rather a matter of “ buy now” versus “wait ‘till later”. Over a longer horizon beyond 2007, Vista will likely be a success due to their high utility functions in Business and Ultimate editions for SMEs as “segmentation” is forced upon the business world by the influence of demographics and market dynamics. However, the steep decline in PC prices coinciding with an inflation scare in midst of “execution time” will be a definite burden on valuation.

Fig 15: Windows Vista System requirements and Price Comparison

Source: Microsoft

17


Fig. 16 displays a stark contrast of the current state between tech and machinery companies in the US. Growth of new orders for US consumer tech firms slowed while inventories started to build up at a faster rate since February this year. The slower growth of new orders, failing to offset the relatively higher growth of inventory buildup, will bring about voluntary price cuts on the part of manufacturers and vendors alike. Technically, growth of new orders appear to be continuing south while inventories are building up at a rate of over 5%.

Eventually, we will see China’s growing demand for PCs, flat panel displays, and other consumer techie goods, to offset the slowdown in US consumption. But with the average monthly income at a shade over $1,100 for urban households and rigid consumer lending practice, we may have to wait until the time is ripe. While China‘s demand is still a distant proposition, US consumers may soon feast on a warehouse-clearance sale. The red queen is still well and alive!

Fig 16: The slower growth of new orders for techie goods fails to offset the relatively higher growth of inventories

Source: US Census Bureau

18


Have Korean Companies Evolved into a New Breed?

The combination of an abundunt domestic and global liquidity, as well as the improved company-level corporate governance have fenced well with the risk of a market correction up until this point. Having touched upon risk factors with respect to domestic and global liquidity in the preceding sections of this report, I see an increasing likelihood of company-level factors to be scrutinized and tested as well. To look inside the core competency (or lack thereof) of Korea Inc in a highly competitive global arena would require a dedicated research report that treats company-level issues in isolation. Therefore, I could only provide herein the digest of my viewpoints in an effort to verify my argument.

In spite of stellar growth over the last 4 decades, much of Korea’s success can be attributed to its export-driven growth strategy, in which large Korean firms would import foreign technologies to produce exportable goods while smaller firms resorted to imitating foreign products through reverse engineering. The main objective - to be achieved within this strategy – is to upgrade production capabilities with customer satisfaction being a secondary concern. This situation likely reflects the nation’s stage of industrialization, where emphasis is placed on manufacturing in order to compete globally on the basis of volume production and low prices. Overstretch of manpower utilization and responsive market entrance through cross-functional integration have been the pillars of this strategy.

A mounting social insecurity and unrest, which is the offspring of the risk of higher housing prices - the very first premise that I started off with - is again the factor that may expose the company-level risks. How would anybody be able to increase his (already high) productivity if he is always on the internet or messenger, preoccupied with the newsflows about the housing market? Would he be able to remain content and dedicate all of his resources to his responsibilities at work when housing prices are jumping higher while his monthly paycheck stays flat? My grassroots observation is not too far off this illustrative assumption. Disturbed by the overall social security issue, majority of salary workers in Korea could become more restless, insecure, and disoriented.

Off with this observation, Korean companies need to place more emphasis on finding and fostering “innovation managers” who have the initiative and means to help bring their affiliated companies into a post-industrialization growth mode, compliant with a more rapid and customized market. The nature of value chain for most products is becoming far more “market-pulled”, putting a primacy on the characteristics of final consumer markets in every chain. Economic rents are way too dynamic for Korean firms to assume that they are at haven for stable profits. The traditional way of doing business – churning out – cannot and will not be sustained in the contemporary global markets because the changes are simply too fast, too segmented, too volatile, and too specific. In my view, there are three crucial tasks for Korean companies to look into and address. First, Korean corporations, especially SMEs, must change their way of thinking and shed their tendency to hold on to their “obsoledge”. Second, they must stop the brain drainage. Third, they must fill the information/knowledge gap between top management and managers on the field. For now, these tasks appear mountainous and Korea Inc is still vulnerable to extrinsic factors or events and subsequently, the possibility for exploitation of its weakness is slowly mounting with the global market evolving into a (very big) hedge fund-like form.

19


Casual Valuation to “Writ of Error”

Korean corporations have shown a very stable pattern of EVA generation since 2002, but it is largely attributed to capital retrenchment. Food and beverage companies, in particular, have not improved their growth prospects or profit structure peak-to-peak or trough-to-trough. Korean corporations, in general, have yet to show their willingness, readiness, and understanding of the need to embark on a “new innovation”-type offensive restructuring to secure the foundation for future profit generation. “Societal” arbitrage opportunities (having to do with value activism) from a large dividend pool, which had formed as a result of accumulating retained earnings in cash, have been largely whittled away.

Looking at the market valuation illustrated in Fig. 17, we can see a very consistent pattern, in which the year-end status of market’s Market Value Added would dictate the market’s continuation or reversion in the ensuing year (as marked by colored arrows). The collapse in 2001 as well as the breakout in 2005 were discernable and anticipated on the basis of the market’s misreflection of Economic Value Added at the end of the preceding year. The market’s intuitive capacity has risen to a point where a forward-looking anticipation is now required for an investor to be able to attain “alpha”. Before 2002, market behavior had been largely technical, conceptual, and sporadic.

I aggregated the performance figures of fourteen representative industrial companies, which I use as a market surrogate on the basis of their fat tail effect - Samsung Electronics, KEPCO, POSCO, SK Telecom, Hyundai Motor, KT Corporation, Hyundai Mobis, Shinsegye, Samsung Heavy, Kia Motors, Samsung Electromechanics, Samsung SDI, SK Corporation, Honam Petrochemical.

The current enterprise value is slightly overvalued compared to their static earning power, as at the end of 2002. The only difference is that while their EVA generation was markedly trending upward in 2002, Korean companies are now into the 2nd year of slowdown in EVA generation, with their 2007 performance perhaps following the “down” pattern. The anticipation of a continued slowdown, if confirmed in the 1st quarter of 2007 (and I think it will), will likely put the valuation issue under the microscope. I am not certain if Korean companies’ EVA generative capacity will improve on a peak-to-peak basis in the coming cycle. On the same note, the proposition of Korean companies having turned into perennial value-creators - as many analysts maintain – remains subjective to further inspection and verification over the next year or two.

Fig 17: Increased efficiency will have the market under closer scrutiny…


20


Furthermore, analysts’ consensus for EBIT expansion for this group may be a little too sanguine at over 16%. After sets of number-crunching, I believe that next year’s EBIT expansion will be somewhere in the neighborhood of 12%, making today’s value at a mid to high end of my forecast range of the KOSPI for 2007. How could analysts be so off? Fig. 18 shows that the consensus at the beginning of the year is apt to significant errors and is more often than not vastly off from the ex-post results. The consensus for operating profit in the early part of 2005 turned out to be some 23% off from operating profit for 2005, ex post. In terms of YoY growth, this discrepancy translates to a growth of 18% transforming into a negative growth of –5%!!! My lowering of the bar to 12% as opposed to the market’s 16~18% is by no means a big cut. Subscribing to the market dynamics rooted in the context of behavioral finance/investing, the prospects of the market to test the downside first in 2007 is becoming more visible, given the movement of major currencies against the greenback and extremely low volatility of both equity and currency markets.

Fig 18: Subscribing to our behavioral investing observation, we don’t take the consensus as the holy grail…

Source: IBES, Daewoo Securities

Operating Profit

Consensus versus Actual

Net Profit

Consensus versus Actual

Fig 19: …and the estimates continue to be revised down, as we speak…

Sales

Operating Profit

Source: IBES, Daewoo Securities

21


Korea is No Longer a Standout in Emerging Markets

More importantly, back in 2002, the Japanese stock market and its de facto “siblings”, ASEAN stocks weren’t signaling many positive indicators. On the contrary, as I have already mentioned, Japan’s current streak of economic expansion breezed past the Izanagi Keiki and the “feel-good” factor is pervading throughout the ASEAN region. Economic recovery of the ASEAN bloc normally originates in Japan because Japan imports a whopping 15% of total from ASEAN nations with Indonesia, Thailand, and Malaysia leading the way. As of December 4th, stocks of Indonesia and Philippines gained 47% and 31% year-to-date, respectively. The Malaysian and Thai markets easily outpaced the Korean market by more than 5% YTD.

What’s more alarming is the fact that these attractive ASEAN markets are not even my favorites among emerging markets! Although it is laden with problems including the government’s reluctance for major economic reforms, high unemployment, poor infrastructures, and opaque corporate governance, Brazil seemingly offers a very attractive value at a reasonable price, displaying a stable pattern in profit margins and return on invested capital at a very humble valuation under my reference scenario of stable commodity prices (Brazil is highly dependent on commodity exports – accounting for 40% of all exports). Private companies like Petro Bras and Cia Vale do Rio Doce are major value appropriators in their respective value chain and banks are improving their fundamentals on the back of declining interest rates. On the macro front, Brazil is not as highly geared to the US economy or heavily exposed to the US dollar, boasts of a public surplus, and is adopting the political consensus in favor of pro-market policies. Korea, in this context of relative valuation, certainly is not one of the favorites to win the contest.

Fig 20: Korea is no longer a standout among emerging markets (Market Cap Weighted Average of Leading Indices)


22


BBOOTTTTOOMM--UUPP SSTTRRAATTEEGGYY STOCK SELECTION WILL BE PARAMOUNT TO PERFORMANCE

Are You Willing to Capitalize Cyclical Earnings with a Low Discount Rate?

Started with Keynes, I may as well end this report with Keynes, appropriately supporting my proposition;

“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past, the ocean is flat again.” – John Maynard Keynes

Having shared my take on the market, I do not wish to be mistaken as being “bearish.” I still maintain that there is a fairly good possibility that the KOSPI will reach 1,600 – and that’s more or less in line with the market consensus (though I still think that the forecast level of higher than 1,700 is a bit of a stretch). I only differ from the market in terms of timing and pattern.

While most analysts are penciling in 1,600 as “given” for 2007, I do not believe that the market can reach and “stabilize” at 1,600 any time soon, possibly not until 2008. Another difference is that I expect to see next year’s peak level – which I think will likely hover around 1,550 – coming in the latter half of the year, not in the first.

As I see it, the jury will be out on US inflation and therefore the proper level of long interest rates, as well as on the corporate pricing power and the level of global growth next year and beyond. This suggests to me that the market will not be so willing to capitalize cyclical earnings with a low discount rate, thus a high P/E, and the multiples will likely remain low at the cyclical end of the market. Moreover, on my reference premise that corporate earnings momentum will be under threat from a margin squeeze, the market’s rather sanguine perception of earnings visibility could deteriorate faster than expected the minute slowdown in earnings growth is confirmed.

Equity Hedge

Unhedged Macro

L/S

L/S

L/S

L/S

Fig 21: Investors will become increasingly Darwinistic near the peak and trough….


23


The Scarcity of Profits and Liquidity will Force us to be “Darwinistic”

The (relative) scarcity of corporate profits and market liquidity will make investors increasingly “Darwinistic.” In the real world of business, it has been well proven that the gap between the perennial leader and the second-tier followers widens as competition heightens. The same phenomenon applies to the market. The increased competition for available funds in the market usually lead to “Flight to Quality” at the expense of the “Less-Qualified”. This is the reason why the correlation of two companies wearing a similar outfit normally decreases near the peak and trough, in retrospect. Fig. 21 illustrates my strategy to optimize my portfolio return by implemeting different investment strategies at different stages of the market.

In such an environment, growth and defensive stocks should outperform. In fact, I expect that global value stocks’ outperformace over global growth names that have lasted for more than 6 years may come to an end. I plan to investigate into what’s implied on growth stocks’ (very strong) outperformance over value stocks since August 2006.

Korean Stocks Are Either “Cyclical” or “Micro”

The difficulty here is that Korean stocks do not offer much safe haven. They may be “pigeon-holed” as “growth” stocks, but technology and drug stocks in Korea are, in reality (from a global perspective), “cyclical” or “micro cap” stocks. The bulk of the technology sector is exposed to handsets, display, and semiconductors, three areas of high cyclicality and margin uncertainty. Therefore I remain underweight here and the broad market as well.

In conclusion, I re-address three critical points:

1. Still herded around by momentum and concept, majority of investors in Korea are inherently capricious in nature when it comes down to investing. In the absence of conviction firmly rooted in fundamentals, they act “retroactively” on events forced upon them. Strong house prices amid rising interest rates are the “event” that will force upon them to scale down their exposure to the stock market, in the form of “discretionary cash flow displacement.” I reckon that retail investors hold more than 25% of the market’s outstanding shares, directly and indirectly;

2. The global code convergence opened the gate in 2003~2004 for “value-conscious” strategic investors – private equities and hedge funds alike - to exploit a “societal arbitrage” opportunity by squeezing out extra returns from the “dividend pool” - retained earnings in cash and liquid securities - that companies had been idly sitting on. Retained earnings less legally mandated reserves can be theoretically “dividended” out through gradual increases in regular dividends, special dividends, and/or share buyback over time. Assuming they can squeeze out a portion of this dividend pool, up to 30% of market cap over the corporate earnings cycle of 4 years, it translates into a de-facto “free” annual return of 7%, irrespective of future business performance (I was very bullish on POSCO, Hyundai Steel, Samsung Corporation, and a number of selective smaller caps on this basis since the end of 2004). Over the last two years, we witnessed – as expected – increases in both share buybacks and market value, leaving this bottom-up tactic less attractive to a point of obsolescence today. In addition, there seems to be the risk of a transitory setback or (perceived) regress in corporate governance-led equity culture shift. The Lone Star “debacle” may have brought it to surface;

3. Today’s more efficient markets provide a condition which nearly guarantees the absence of arbitrage in a global landscape. Korean stocks are not only vying for funds with Taiwanese stocks, but with all emerging stocks and bonds, Aussie and Kiwi bonds, and further South African, Hungarian, Indonesian, and Indian bonds and etc. In addition, there have been profound changes in the way money is being managed worldwide due to the resurgence of global/regional hedge funds. It has become more market-neutral and alpha-oriented, putting an emphasis – in “all weathers”- on wider use of various hedging instruments as well as nimbler trading tactics.

24


Let’s Stick to “Stalwarts” While Waiting for Value to be Rebuilt

I can’t help but sense that we may be entering a “professional league” in which a much less available alpha factor - hardly enough for everyone to go around with - will be intensely competed for, with a handful of consummate investors appropriating most of it at the expense of retail investors. Retail investors that have taken equity investing as a child’s play are in for a big surprise.

I suggest that an investor stick to core “stalwarts” that can weather a cyclical downturn and are well protected from structural margin pressures (reposition of global value chain), while hedging market risks. I remain underweight on Korea from a regional context in the hope that enough value will be rebuilt in the correction.

My core “stalwarts”, for a long time, have included NHN (035420.KS), Megastudy (072870.KS), SK Corporation (003600.KS), Doosan Heavy (034020.KS), and Hite Brewery (000140.KS). I believe that NHN and Hite - still undervalued despite impressive showing of their share price - are worth W143K and W138K per share or over, respectively. Megastudy, SK Corporation, and Doosan Heavy may see some correction due to profit-taking. As I see it, these companies would likely prove any profit-taking to come as awfully hasty and premature.

On a less fundamental note, I see that value is being rebuilt in the current correction for Samsung SDI (006400.KS), Hyundai Motor (005380.KS), and Kia Motors (000270.KS). A correction of about 10% from their current price would make these shares attractive value plays.

25

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As of December 7, 2006, Daewoo Securities Co., Ltd. has been acting as a financial advisor to SK Corp. for its treasury share buyback

program.

This report has not been distributed to any third party including institutional investors and other interest groups prior to the public release of this report.

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2006_12 strategy

Economy & Finance