JUNO INVESTING ©Comment

Why does South Korea trade at such a discount?

JUNO INVESTING ©Comment
Why does South Korea trade at such a discount?

 

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SPRING 2017

By Victoria Harris, Pie Funds

South Korea has a booming economy, plenty of innovation and improving corporate practices, yet on the face of it, its share market appears cheap. Victoria Harris looks at what’s going on there.

South Korea is home to world-class companies like Samsung, LG, and Hyundai. It has a population of more than 50 million people and is one of the world’s wealthiest countries. However, its share market is one of the cheapest in the world. 

South Korea’s major stock index, the KOSPI, has one of the lowest price-to-earnings (P/E) ratios among other global indices, which makes it highly attractive to investors.  

When compared to indices in other countries, the KOSPI is trading at a 9.5 multiple, a giant 50 per cent discount on the S&P 500 and a 39 per cent discount on the average of its peers’ P/E ratios (see Figure 1). 

So why does South Korea trade at such a discount?

Chaebols and crime

Many investors remain wary of South Korea, given its history of poor corporate governance and shareholder disregard. 

The massive, complex, family-owned corporate entities known as ‘chaebols’ have historically had a bad reputation and have been linked to white-collar crime. 

The cross-shareholding ownership structure of ‘chaebols’ is complex and private, and there are concerns about management being appointed by the controlling shareholders, who tend to ignore the interests of lesser shareholders. 

And recently, high-profile scandals have exposed corruption in the upper reaches of the Korean government, which has made investors wary. 

But things seem to be changing.

South Korea Table.jpg

New leader rings in changes

The signs are that transparency in business and the robustness of corporate governance appear ready to improve. 

The country’s former president, Park Geun-hye, was recently impeached for corruption. The new administration is led by former human rights lawyer Moon Jae-in. 

He’s likely to push hard for laws to strengthen and enforce corporate governance, including broad reforms for chaebols. Moon is expected to carry out a number of measures, including regulations to better protect minority shareholders, and impose stronger anti-trust laws. 

Also on the cards is a significant overhaul in the structure of South Korea’s largest investor in Korean equities, the National Pension Service. 

The country’s institutional investors will also become more proactive and vocal at annual meetings, with the UK’s Stewardship Code more widely adopted. The code is a set of guidelines issued by the UK Financial Reporting Council that aims to make fund managers and institutional investors more actively engaged in corporate governance in the interests of their clients.

Low dividends

South Korean companies’ payout ratios are some of the lowest in the world. The country’s historically conservative financial culture has meant that business managers are reluctant to distribute earnings as dividends. 

They prefer to use cash to grow and expand the business, rather than paying a return to shareholders. 

Cash is king

South Korean companies hold large cash balances. They like having the financial flexibility and extra protection that comes from having large amounts of cash on the balance sheet.

This probably stems from their experience of traumatic crashes, such as the Asian Financial Crisis in 1997-98. 

Cheap, not perfect

However, a cheap market doesn’t necessarily mean ‘buy’. You have to take risk into account. 

The US market is one of the world’s most expensive – for a reason. Its transparency and the fact it’s home to a large number of fast-growing technology firms, such as Amazon and Facebook, make it highly attractive to investors. 

The biggest risk associated with investing in the South Korean market is geopolitical – due to its volatile neighbour, North Korea. 

It’s difficult for investors to factor this risk into their valuation, as it will most likely be a black-and-white outcome. 

But as the chief executive of JPMorgan South Korea said: “Any correction due to North Korea issues usually provides a good buying opportunity.”

In growth mode

The South Korean economy is doing well. Gross Domestic Product (GDP) is expected to grow 3 per cent this year, according to the finance ministry’s five-year economic policy outlook. 

Another sign of an attractive market is its ability to foster innovation and offer a platform for companies to raise capital. South Korea has one of the best environments for technology and has ranked first on the Bloomberg Global Innovation Index for five years in a row. 

This effect has flowed on to its capital markets, which have seen a 275 per cent increase in initial public offerings to 6.1 trillion South Korean Won (US$5.4 billion). 

This healthy business environment should see new, innovative companies continuing to emerge from South Korea.

And despite the KOSPI Index being up nearly 20 per cent year to date, these market improvements aren’t yet fully reflected in that growth. The recent climb in the KOSPI was almost entirely driven by positive earnings revisions and increasing profitability, rather than underlying valuation reratings. 

An improving investing environment and capital allocation will continue to create tailwinds for the South Korean market. Just remember, at the end of the day, while South Korea looks attractive, like any investment, it isn’t without risks.