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Friday, January 4, 2008

DMG Research Guide to Investment Ratings by Terence Wong

ALL FIGURED OUT - DREAM THEMES 2008
It has been volatile, but 2007 is proving to be yet another generous year for the stock market. With the Straits Times Index (STI) shooting up by over 120% from 2003-06, many thought 2007 would be the year the market takes a breather. But it stumped all critics by once again defying gravity. The STI surged to record highs and at one point, flirted with the 4,000 point mark – more than 3 times higher than this millennium’s trough in 2003. Despite the spike, valuations have remained reasonable all through, supported by strong corporate earnings and solid growth prospects. In fact, over the past 2 years, Singapore’s economy has been firing on practically all cylinders, growing at a pace of a developing nation.

Looking into 2008, the bright domestic economic drivers appear to be weighed down by the increasingly challenging external environment. The road ahead will be bumpy, with great uncertainty on where the market is heading. If you, like many investors out there, are seeking answers and direction, look no further. Our title says it all - we have 2008 all figured out! Read on to see tomorrow’s themes and how you can profit from it.

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Executive Summary
Home Team fights on. We believe that the Singapore economy will expand 6% in 2008, driven by domestic growth and strength in regional economies. While growth in financial services and property are expected to taper off, the construction and offshore & marine sectors will more than compensate. Worries about US and China are warranted, but domestic drivers should be strong enough to fend them off.

Domestic defensives in face of uncertainty.
Home is where the heart is, and where the money can be made. As such, investors can consider hunting domestically for potential winners, especially those with solid yields.
Our home defensive favourites include Frasers Centrepoint Trust and Suntec Reit.

Oil’s unabated strength.
The Oil & Gas sector has been enjoying one of the best runs in decades. With oil prices expected to remain high in the near future, we see no disruption to the party in 2008. While we still like the big blues like Keppel Corp, we believe second-tier players ASL Marine, Tiong Woon Corp and Courage Marine will outperform the sector.

QDII booster for S-shares.
With QDII funds expected to flow through our shores, there will be support for some Chinabased companies, or S-shares. We favour companies riding on rising consumerism (Synear Food and China Sports International) and agriculture (China Farm Equipment) in China.
Tech may surprise, but not just yet. Technology, the whipping boy in the past few years, may turn out to be a dark horse. The industry is still looking shaky, with consumer confidence in the US just starting to dip and the US dollar continuing on its decline. But valuations are looking attractive, and if consumer confidence and the dollar were to turn around, there will be a re-rating of the sector and this will benefit the likes of Venture Corp and Armstrong Industrial Corp. This, however, will unlikely happen in the near term.

Evergreen themes.
In this paper, we have also identified 2 themes which will be around for years to come. Alternative energy stocks have seen more downs than ups, despite all the hype surrounding them. But like dotcom companies, there will be winners and investors will just have to fall back on basics to pick them. Sovereign wealth funds will be another important theme in the coming years as they flex their financial clout.

Market beaten down to attractive levels.
Following the sell-down in the recent months, the Singapore market is looking cheap. The STI is trading at 14x FY08 PER, which is at the lower end of its 10-year PER band. We believe that it has the ability to trade up to its 5-year average of 16x PER, implying a target of 3,903 for 2008.

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Fundamentals - Little Red Dot’s Big Picture
The remaking of Singapore started with much fanfare in 2002 but a confluence of negative factors – SARS, recession and Iraq war – the following year took the shine away. The economy has flourished considerably since the darkest days and is seeing one of the most powerful runs in more than a decade, growing at a compounded annual growth rate (CAGR) of 7.8%.
Based on forecasts by the Monetary Authority of Singapore (MAS), Singapore is expected to revert to its medium-term potential of 4.5-6.5% in 2008. We believe that the Singapore economy should be able to hit the upper end of the estimate, driven by domestic growth and strength in regional economies.

It’s still going to be the domestic market.
First, the bad news. The external environment is looking shaky, with fears of a US subprime crisis-led contagion as well as escalating oil prices plaguing global markets. Closer to home, the key financial services and property-related transactions, which accounted for 28% of the GDP growth in the first half of 2007, will likely slow. But the good news is that domestic drivers like construction will more than make up for the slack.
Hard hats to power growth. The construction sector is expected to be the star performer once again in 2008. After entering the darkest of tunnels, the sun is finally shining on this sector. At its low point in 2004, contract size fell almost 60% to S$10b. But with the current building boom, construction contracts are expected to double to S$19-22b in 2007. In fact, manpower and resources are so stretched that the government is delaying some S$2b worth of public sector projects. Notable construction activities include the two integrated resorts (IR), Downtown and Circle MRT lines, numerous en-bloc projects, and the iconic Ion Orchard.
O&M continues to ride the crest. The offshore & marine sector, which has lost some lustre following the forex fiasco by SembCorp Marine and Labroy Marine, is still expected to grow impressively.

The two largest oil-rig builders – Keppel Corp and SembCorp Marine – continue to shine with strong combined order books of over S$17b running into 2011. It was barely a billion 5 years back.
Good house in a good neighbourhood. Singapore has often been described as a good house in a bad neighbourhood.
This may be a thing of the past, as restructuring in the past few years has strengthened our neighbours’ houses.
Malaysia, Thailand, Indonesia and the Philippines are all expected to grow, with improving consumer spending and numerous big-scale infrastructure projects. There will be demand for project financing, and given Singapore’s status as a project financing hub, it will be abuzz with activity. The surge in raw materials used for these infrastructure projects will most likely go through our ports, giving a boost to trade-related services.

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Risks – Potential Party Poopers
No decoupling for now. There is a possibility that US may fall into a recession. If it were a mild downturn, the strength from Singapore’s domestic and regional drivers should be able to withstand the external pressures. However, if it were a deep and pronounced recession, it is tough to escape unscathed, given that US is still one of the most important trading partners.
Financial sector walking a thin line. The state of banks’ health is a concern. Given the huge write-offs that the big global banks will be making for the fourth quarter of 2007, the full year results that are slated to be released in the beginning of 2008 will not be pretty. And if the losses turn out to be bigger than expected, financial stocks will take a hit, which may then spread to the rest of the market.
China stepping on the brakes. China has made public its plans to intensify its policy tightening measures in 2008 to curb credit growth. China’s attempt to slow its red-hot economy may have an adverse effect on global markets. The Singapore stock market, with an increasing concentration of China-based companies, will not be spared.
More and more expensive in Singapore. Noodles, bread and eggs have all gone up. Transport, housing and electricity are also getting more expensive. The Singapore economy is currently at full employment, with an estimated 200,000 jobs created in 2007. As a result, the cost of new hires is likely to escalate. All these add up to inflationary pressures, that if left unchecked, will have a severe adverse impact on the economy. The Consumer Price index (CPI) looks tame so far, as it has not fully captured the extent of inflation. The full impact will be visible next year.

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Valuation – Still a Steal?
2007 may go down in history as the most volatile year to date. For the first 11 months of 2007, there were 29 trading sessions which witnessed swings of 2% or more and 12 trading sessions which saw triple digit changes. The STI went up by as much as 30%, before giving up more than half its gains to end the year.
The swings in UOB-Sesdaq were even more pronounced. It was the best performing market globally in the first half of 2007, more than doubling between January to June, but has since slumped over 30% from the peak.

At 3,357, the STI is trading at 15.2x 2007 and 13.7x 2008 PER, which is a tad cheaper compared to regional bourses.
This is on the lower end of its 5-year PER band – the STI traded as low as 10.5x to a high of 22.5x PER. From a price-tobook value (P/B) perspective, it is lower than its peers but higher than its historical average. Dividend yield of 4.1% remains one of the best in the region.

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STI – A Closer Look
To value the STI, we have chosen to use the 5-year averages of STI’s PER and dividend yield. We believe P/B is not an accurate measure, considering that quite a few of the component stocks have either adopted an asset-light strategy (eg SGX and even property counters like CapitaLand) or chosen to effectively manage their capital (eg StarHub and M1) over the past few years. Moreover, services companies like Parkway and Hyflux – which trade at lofty P/Bs – have grown in importance. All these factors have led to the market trading above the historical P/B average, a pattern which will likely persist.
From a dividend yield perspective, if the STI reverts to its average of 3.5%, it will be fairly valued at 3,886. Assuming that the STI trades up to the average of its PER band, or 16x PER, our target for the STI is 3,903, giving the index an upside of 16% - not too far off from what is suggested by the “reversion to average yield” method.

DREAM THEMES 2008
Domestic Defensives - Home sweet home
Home is where the heart is, and where the money can be made. With our economy still strong and the external environment increasingly uncertain, investors can consider hunting domestically for potential winners.
Companies riding on the domestic reflation story will continue to benefit from a strong domestic economy. Banks have been hit particularly hard in recent months as a result of the US subprime crisis, but have stabilised in the last couple of weeks. Of the Big Three, UOB should be the biggest beneficiary of mortgage financing of residential projects due for completion in the next two years.
Margins are also expected to head north as the macro climate improves. In the near term, its share price may take a hit as global banks make massive write-offs relating to the subprime exposure, but such knee-jerks should present buying opportunities.
On the property front, we like the retail and commercial sub-sectors, and believe that REITs like Frasers Centrepoint Trust and Suntec REIT will outperform both the market and its peers.
Media giant SPH has a few positive drivers in 2008 – a robust publishing business, higher retail property income and earnings coming through from its Sky@Eleven project, which was sold out shortly after its launch earlier this year. One of the biggest draws of SPH is its attractive yields.
Notwithstanding the high oil prices, transport companies also offer a good shelter for investors should the weather turn nasty in the US. We like SMRT for its organic growth and cost efficiencies. Ridership on its trains is expected to grow a healthy 6% in 2008 on the back of Singapore’s strong economy, which has bolstered employment and discretionary travel (eg shopping on weekends). While growth of 6% may not seem to be impressive, it actually is so due to cost efficiencies. For example, in its 2QFY08 results, revenue inched up 5%, but net profit actually jumped 25%.

Our picks for this theme encompasses the major components of the economy – banks, properties, media and transport – sharing a common trait: mouth-watering dividend yields, which lends support in times of uncertainty.

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Oil – Unrivalled stamina
“People seem almost more relaxed about US$100 than they were about US$60 or US$70 oil.” Daniel Yergin, Chairman of Cambridge Energy Research Association.
With raging demand from fast developing areas (particularly China), crude oil prices came close to US$100 per barrel in November 2007. A couple of years ago, most economists thought this psychological mark will send the global economy into a recession. In fact, high oil price, which is effectively a tax on consumers and businesses, crippled the US economy in 1970s and early 1980s.
However, the global economy has been expanding despite rising oil prices as we are far less dependent on oil in recent years compared to a decade ago due to energy efficiency. Moreover, the rise this time round was due to demand surge, rather than a supply crunch (as the case in the 1970s).
The jury’s still out on oil price trends, with forecasts ranging from US$70 to US$120 in 2008. However, one thing’s for sure – we will be living in an era of high oil prices and it will not revert to the US$24 per barrel 60-year average anytime soon.
Offshore & Marine industry will be a beneficiary of this rising tide. Order books running into billions of dollars are lockedin and run till 2011. The forex debacle at SembCorp Marine and Labroy Marine threw up some doubts on the industry’s internal controls and practices, but these cases seem to be the exception rather than the rule. We believe second-tier players like ASL Marine, Courage Marine and Tiong Woon Corp have the potential to outperform its industry peers in 2008.
ASL Marine is a fully integrated marine company with a strong focus in shipbuilding, shiprepair, shipchartering, and other marine related services, catering to customers mainly from Asia Pacific, South Asia, the Middle East, and Europe.
The strong demand for offshore oil and gas exploration activities is driving up orders for new support vessels. As a result, it is sitting on record ship building orders of S$670m. It is also riding on the back of booming infrastructure development in the Middle East.
Also benefiting from the Middle East is Tiong Woon, the crane provider which has grown both its onshore and offshore businesses. There is currently a global shortage of cranes and this has boosted the demand for the company’s cranes and haulage rates, which has been rising between 15-20% over the past 3 years.
Investors who are more prudent may want to consider Courage Marine, a dry bulk shipping company with dividend yield of close to 10%. Its fortunes have gone up in tandem with the Baltic Dry Index (BDI), which has trebled since a year ago with a big surge in demand for the transportation of commodities to the world’s fastest growing economies – China and India.

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S-shares - QDII sweeps into Singapore
The Qualified Domestic Institutional Investor (QDII) scheme, which aims to liberalise Chinese investors’ investments abroad, will kick-off in 2008. This will boost the Singapore market, which has the highest concentration of China companies outside Greater China.
So far, 4 funds have been established, with mandates to invest in Hong Kong, US, Europe, Singapore and other emerging markets. Deutsche Bank’s joint venture Harvest Fund Management, for example, raised US$4b (S$6b) in October 2007 and will mainly invest in Hong Kong, Singapore and US-listed companies that derive at least 50% of their revenue from China. RMB1.5 trillion (S$300b) is estimated to flow through to overseas assets under the QDII
programme.
There are likely to be limits to the amount that each fund can place in a particular country, debunking any initial rumours that the bulk of the money will go into the Hong Kong market.
Given the sharp surge in Hong Kong, many would expect the market to be a lot more expensive compared to its Singapore peers. But not so, if we were to compare Singapore’s Prime Partners China Index with Hong Kong’s Hang Seng China Enterprise Index (HSCEI). On a forward PER basis, S-shares are only a touch cheaper than H-shares and based on current year earnings, S-shares appear to be more expensive. Locally, the best bargains are found in the lower market cap companies. For example, those with market capitalization of less than S$100m actually go for less than 10x prospective earnings.

However, QDII funds will likely seek the companies with larger market caps, ie those above S$1b. While the valuations appear rich compared to the Singapore market, it is inexpensive relative to their China-listed peers, which are commonly traded at twice the PER. As a group, the billion-dollar S-shares are trading at 34x FY07 and 22x FY08 PER.

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Consumer stocks, which are riding on the back of a burgeoning middle class in China, will likely be big favourites. Among the big caps, we favour Synear Food Holdings, a quick freeze food products player with a national presence – one of the very few SGX-listed China company which can lay such a claim. As the exclusive frozen foods supplier to the upcoming Olympics, 2008 is set to be an exciting year for the company.
Also benefiting from the fervour and sentiments generated from Olympics is China Sports International. The company taps on the fast-growing domestic youth market in China, focusing on “value-for-money” products priced in the range of RMB150-250. With aggressive brand awareness programmes in the lower tiered cities, we expect earnings growth to be strong in the coming years.

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Food – The New Oil
For years, food prices have been getting cheaper and cheaper. But 2007 has been a turning point, with just about every crop and poultry under the sun hitting record or near-record levels. The UN Food and Agricultural Organisation’s food price index jumped 37% in 2007 over the first three-quarters of the year. Like oil, food prices have been rising on the back of growing demand from global consumers. There are two key reasons behind this phenomenon, one which is likely to prevail. First, developing nations are getting hungrier (actually greedier). Back in 1985, the average Chinese consumed 20kg of meat, but has since more than doubled his appetite to 50kg in 2007, thanks to an increasingly affluent society. This results in a greater demand for grain, which is used to feed the chickens, pigs and cows that we eat. But the middle class in developing countries has been growing steadily over the years, so why are prices surging only in 2007? A more important reason is biodiesel, which soaks up a third of US’ corn harvest. More farm land has, as a result, been devoted to corn, sacrificing other important crops like wheat and soybean. This has led to the upward spiral of all crops to lofty heights.
Billions of consumers globally, who have grown accustomed to sliding food prices since, will feel a big pinch on every grocery trip. Farmers, however, will finally reap what they have been sowing all these years. In the US, farmers’ take is expected to be 50% higher compared to the previous year. Payouts may not be as rich in Asia, but the next few years look brighter than anytime in the past few decades. While some of the money will be spent on a much deserved holiday,
the bulk of the earnings will be ploughed back on their farms to improve efficiencies and yields. The importance of agriculture is underscored by the concessions and subsidies given to farmers in key agriculture countries. China is a case in point. While it is taking steps to curb the overall growth of loans, it is actually encouraging banks to lend more for agricultural development.
China XLX, which produces fertilizers in China, will be a likely beneficiary. China is the world’s largest consumer of fertilizers, and its consumption represents approximately 30% of global production. The company has arguably one of the best cost structures in the industry and will stand to win in the event of a deregulation in the industry, which will accelerate M&A opportunities.
However, on valuation grounds, our pick within this sector is China Farm Equipment, the top manufacturer of farm harvesters in Hunan province. With agriculture being a key sector, the Chinese government has spearheaded initiatives to raise the efficiency through mechanisation. Farmers are given subsidies by the government, which encourages them to invest in new modern equipment.

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Technology – The Tortoise and the Horse
The technology sector has been underperforming the market since 2004. Many have placed their bets that 2007 was going to be a turnaround year, but the industry met with immensely testing challenges, including tepid demand growth and a free-falling US dollar. As a result, the SES Electronics Index fell 13% in 2007. However, this particular index is not the most accurate benchmark, as it is laden with stocks from the yesteryear, like GP Industries, IPC Corp, IDT Holdings, and Goldtron. In fact, the best performer among the 14 component stocks is an almost unknown company called Powermatic Data. Our own price-weighted index (we used a basket of 13 tech stocks that are more familiar to investors) suggests that the tech sector appreciated 8% in 2007, a better performance compared to the archaic SES Electronics Index but still pales in comparison to the STI.
With consumer confidence in the US slumping and the dollar digging deeper, tech industry’s fortunes appear to be even grimmer in 2008. But valuations have been beaten down to multi-year lows. Many of these stocks are trading at singledigit PERs, and this may result in more M&As (the tech industry accounted for more than half of 2007’s M&A transactions).
While we remain neutral on the sector, we recognize that a turn in consumer sentiments or US dollar may spark a rerating.
This may happen towards the later part of 2008. If so, the tech sector will be like the tortoise in Aesop’s Fables - slow at the start before catching up in the later part of the race.
We believe 2 stocks will do well in this ‘dark horse’ sector – electronics manufacturing services provider and tech bellwether Venture Corp as well as precision engineering specialist Armstrong Industrial.
Venture Corp, the largest tech manufacturer listed on SGX, is currently trading at just 10x prospective PER, which is as cheap as it gets. During the heady dotcom days, the one-time market darling was trading at close to 50x earnings. On top of slowing growth, investors have been worried about its collaterised debt obligations (CDO). However, from our understanding, its CDO holdings are not directly exposed to the US subprime market and are actually investment grade corporate bonds.
Foam and rubber specialist Armstrong Industrial Corp, on the other hand, is one of the fastest growing tech companies over the past 3 years, and has seen its share price more than double in 2007. We believe that there is still more room to run, driven by its focus on high margin rubber business. Despite the spurt in its share price, valuations are well-supported by its sound fundamentals.

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Alternative Energy - Climaxing with the Climate
I just checked my carbon footprint on the internet and realized that I produce a whopping 16 tonnes of carbon dioxide a year, no thanks to the frequent business trips. That’s 30% higher than our national average of 12.2 tonnes and many times the global average of 4 tonnes. For the record, every being on the planet needs to bring it down to 2 tonnes to save the earth (good reason to tell my bosses that I need to fly less).
Indeed, climate is the talk of the town and hardly a day goes by without hearing about global warming, Kyoto protocol and carbon credits. It is set to get big in Singapore, and will be the talking point for years to come. However, there have been some initial glitches.
Getting burnt from solar. Solar may be the next big thing, but investors will have to exercise loads of caution when buying into such companies. Equation Corp, formerly known as HeShe Holdings, panned a US$150m deal to manufacture solar panels using thin film amorphous silicon technology. This comes barely a month after Rowsley called off its S$2.7b deal to acquire Perfect Field, a manufacturer of thin-film solar panels. It came with a profit guarantee of S$300m per year from FY2008-2010, no mean feat considering that the company eked out less than S$5m a year ago.
Carbon credits yet to take off. There has also been a lot of talk on carbon credits lately. ecoWise Holdings inked a deal to sell 95,000 carbon credits, or Certified Emission Requirements (CER) to Kansai Electric Power, Japan’s second-largest utility company, becoming the first SGX-listed player to sell carbon credits from a renewable energy project.
Commodities trader Noble Group has also established a carbon credit division which is reportedly the largest trader of CER, with a global market share of 15-20%. Oculus, previously a contact lens maker, has dropped initial plans to acquire China hydropower plants in favour of a reverse takeover with Aretae Pte Ltd, an environmental solutions company dealing with carbon credits.
Biofuels fired up. With oil prices hitting record levels, the demand outlook for biofuels have also picked up. This has resulted in palm oil – the world’s most consumed vegetable oil and the most economical – rising 55% in the first 11 months of 2007 to hit lifetime highs. This is a boon for feedstock providers, but a bane for the refiners. Plantation owners like Wilmar and Golden-Agri Resources were the darlings of the stock market, growing to become one of the largest companies on the SGX. On the flip side, companies like Advanced Holdings, which intended to produce biofuels, have pushed back plans indefinitely as a result of the rapidly rising feedstock prices.
As this report goes to print, SGX-listed Enviro-Hub Holdings announced that it will be building a S$50m plant to convert plastic waste into useable fuels and gases. Investors should be patient and wait for results before committing to companies with seemingly exciting new ideas. Climate-related companies will be a recurring theme in years to come, but investors will need to be selective and base their investments on fundamentals and valuations, rather than hope and
hype.

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SWFs on the Prowl
In the past 2 years, it was the private equity funds that were making the noise in the market, snapping up company after company. In the coming years, it will be sovereign wealth funds (SWF) or state-owned funds like Temasek Holdings which will steal the limelight.
The top 10 SWFs hold between US$32b and US$875b. Collectively, the 48 SWFs from over 40 countries are estimated to have US$2.5-3 trillion worth of funds (already more than hedge funds’ US$1.6 trillion), and this is expected to balloon to US$12-15 trillion by 2015. Even states like Libya and Iran, not exactly the poster boys of international finance, are rumoured to be in the process of establishing sovereign funds. With the subprime crisis taking a tremendous toll on banks, these funds have snapped up significant stakes in venerable names like Citi, UBS,Morgan Stanley and Merrill Lynch.

Top Sovereign Funds
UAE ADIA 875
Singapore GIC 330
Saudi Arabia Various funds 300
Norway Government Pension Fund 300
China China Investment Corp 300
Singapore Temasek Holdings 100
Kuwait Kuwait Investment Authority 70
Australia Australian Future Fund 40
US (Alaska) Permanent Fund Corp 35
Russia Stabilisation Fund 32
Source: Economist

The world’s entire supply of shares and bonds stand at approximately US$55 trillion each. SWFs, with trillions on hand, are likely to go shopping for key assets. With fears that these funds will be making purchases for political reasons rather than economic ones (Middle East and China, in particular), Europe and the US are pushing for stronger regulations and greater transparency. This may push funds away from the West and into Asian assets. Singapore, renowned for its high level of corporate governance and transparency, is home to quality companies with solid balance sheets. These should be good enough for some of the oil money and dragon dollars to look our way.
Given that Southeast Asia is expected to grow in the next few years, SWF’s may seek blue-chip Singapore companies with an entrenched presence in the region. SingTel and DBS have already been invited to a “get-to-know-you” conference organized by Dubai International Capital, a US$12b private fund of Dubai’s ruler Sheikh Mohd Maktoum.

Who’s next?

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Final Analysis
The mood heading into the New Year is more sombre than anytime in the last 5 years, no thanks to an ailing US economy, the prevailing subprime crisis, high commodity prices, and geopolitical uncertainties. However, we believe the market may have overreacted in the last 2 months of the year, and this has created buying opportunities. From our estimates, the STI has the ability to rise as much as 16% from the current 3,357 to hit 3,903 by the end of 2008. Driving the market will be the domestic defensives, offshore & marine sector as well as selected China-based companies.
Technology sector may turn out to be a sleeper hit towards the end of the year, assuming the US economy does not capitulate.
The tunnel ahead may be a little darker than before, but hopefully our strategy piece has shed some light and make investing a lot less daunting. For a more detailed analysis of key sectors and stocks, read on. Have a great investing year ahead!

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