South Korea: Emerging Markets Medalist or Value Trap?

We see attractive long-term investment opportunities selling at a discount.

Key Takeaway

As fundamental, bottom-up, absolute value managers, taking advantage of market mispricing is our focus.  When our deep research suggests the general investment community has a contrarian view from ours, this has often led to a significant source of alpha generation. In 2015-2016, American Century Investments® was among the few contrarians buying energy and materials names with compelling valuations. Today we are excited about our investments in South Korea where most peer firms are underweight or absent (source: eVestment Alliance, Morningstar).

We believe attractive long-term investment opportunities exist in South Korea relative to the MSCI ACWI ex-U.S. Index and that the so-called “Korea discount” will narrow, providing optionality for investors in light of the government’s ongoing efforts to eliminate the corruption and cronyism associated with “chaebols,” the nation’s influential conglomerates. At over 15%, we currently have the highest exposure there since inception of our Non-U.S. Intrinsic Value strategy more than 14 years ago.

We see compelling investment opportunities and further upside potential, given rapidly changing attitudes toward the powerful conglomerates.

Introduction

Despite having the 25th highest per capita GDP and a highly educated population, MSCI still categorizes South Korea as a developing nation while FTSE and S&P deem it a developed economy. Yet what is undisputable is that the family-controlled chaebols have historically damaged South Korea’s reputation as a destination for investors. Even so, based strictly on valuation, we see compelling investment opportunities and further upside potential, given rapidly changing attitudes toward the powerful conglomerates.

Chaebols Forced to Make Changes

Chaebols are an immense economic force in South Korea. As of year-end 2017, the market capitalization of the top five chaebols (Samsung Group, Hyundai Motor Group, LG Group, SK Group, and Lotte Group) comprised approximately 55% of the MSCI Korea Index. Samsung alone represented nearly 31% of the index.

Chaebols began dominating the South Korean economy in 1961 after the new government implemented industrialized policies to boost exports to lift the economy out of poverty. The government strengthened its relationship with industry by allowing companies to operate in a relaxed regulatory climate and offering them inexpensive loans that helped the government achieve its wide-ranging growth objectives. This resulted in highly concentrated entities offering products across a wide range of industries. The immense expansion of chaebols and the desire by their founding families to retain control resulted in “circular shareholding structures.”

The traditional circular shareholding structure permits founding families to hold a direct minority stake in a company (or companies) that in turn own a piece of another company (or companies), which then circularly owns a piece of its owner(s). The circular structure, combined with the ownership of close family and friends, ensures that control is maintained by a select few and creates a disparity between actual economic ownership and ultimate control. The model has fueled widespread criticism for its lack of transparency and unfair enrichment of controlling shareholders at the expense of minority shareholders. Responding to this criticism, many chaebols have transitioned to holding company structures.

Additional condemnation of chaebols has resulted not only from second- and third-generation heirs serving in leadership roles, but from the wide wage disparity between the conglomerates and small- and medium-sized enterprises (SMEs—which account for 90% of employment in South Korea); SMEs’ inability to compete against them; chaebols’ squeezing of domestic suppliers and misallocation of capital to their affiliates; and government regulations that preclude hostile takeovers. South Korea Ministry of Employment and Labor statistics indicate that workers at SMEs, on average, earn 60% less in wages than their chaebol counterparts.

Perhaps the strongest public outcry over chaebols can be attributed to the history of surreptitious relationships between various government officials and chaebol executives. For example, claims that included alleged bribery and extortion involving a top Samsung Group official and others led to the highly publicized impeachment of President Park Geun-hye during spring 2017 and the subsequent election of Moon Jae-in as her replacement. President Moon is a staunch advocate of chaebol reform.

Narrowing the “Korea Discount”

The government has wasted little time in pursuing improvements in corporate governance. Changes aimed at chaebols include:

Holding Company Structures

Tax incentives and treasury share benefits are driving chaebols to adopt holding company structures by 2019. Replacing a circular cross-shareholding structure with one where the controlling shareholder owns a parent holding company, which in turn owns parts of its affiliates, not only simplifies the ownership but increases transparency and eliminates cross-shareholdings. Samsung Group and Hyundai Motor Group have yet to convert to holding company structures.

Adoption of the Korean Stewardship Code

President Moon is committed to reforming chaebols, in part, by changing how the National Pension Service (NPS) operates. A state agency under the Ministry of Health and Welfare, the NPS serves as South Korea’s primary social insurance program and holds more than $500 billion in assets (about 80% invested domestically), making it the world’s third largest public pension fund after Japan and Norway.

The NPS reportedly intends to adopt a stewardship code, best practices for institutional investors by which they serve the best interests of their participants, including exercising voting rights and being actively involved with companies.

As a shareholder in approximately 50% of listed Korean companies and sizable ownership of chaebol equities, it is clear the NPS yields tremendous clout and can have a sweeping impact on corporate reform and a narrowing of the discount applied to Korean equities.

To make it easier for institutional minority shareholders to adopt the stewardship code and promote engagement with companies and other institutional investors while not running afoul of “insider” laws, the government reportedly intends to ease the regulatory burden on minority shareholders.

Fair Trade Commission Scrutiny

The Fair Trade Commission (FTC) is the South Korean regulator that “formulates and administers competition policies, and deliberates, decides, and handles antitrust cases.” President Moon has appointed Kim Sang-jo, an outspoken champion of minority shareholder rights and chaebol restructuring, to lead the agency.  In 2017, the government amended the Fair Trade Act by introducing financial and criminal penalties for obstructing investigations and failing to report and/or cooperate with the FTC.

Increasing Minority Shareholder Rights

Reports indicate that minority shareholders will be given additional tools to help protect their investments against the misconduct of controlling shareholders. Incorporating a more minority-friendly framework will promote activism with companies and aid in getting companies to treat all shareholders the same, including the potential to increase dividend payouts.

Unlocking Value

Given the significant reforms now underway, shareholders stand to benefit by gaining a vote that matters, better transparency, less complexity, potential share buybacks, more optimal allocation of their corporate capital—which could lead to an eventual narrowing of the “Korea discount.”

As seen in Figure 2, dividend yields, while low today in Korea at 1.6% versus 2.7% for the MSCI ACWI ex-USA Index, are likely to increase as institutional investors adopt stewardship principles and demand higher dividend payouts from their investments. Dividend payout ratios (Figure 3) are slightly above 21%, yet the MSCI ACWI ex-USA Index has a payout ratio of over 41%, highlighting the upside potential for shareholders.

Even without continued reforms that provide optionality, we believe markets are underappreciating the attractive investment opportunities available in Korea. In our opinion, foreign institutional investors are overly concerned about the North Korea issue, clouding their long-term valuation case. The North Korea risk could be minimized in a well-diversified ACWI ex-U.S. portfolio.

As evidence of the valuation case today, P/B ratios of the MSCI Korea and ACWI ex-U.S. indices were at 1.2x and 1.8x, respectively, as of January, 2018—a significant 32% discount (Figure 4). And keep in mind that the average historical discount since 2003 is 25%, which does not factor in the ongoing corporate reforms that should narrow the discount. Compared to the MSCI EM Index at a P/B of 1.9x—which consists of many countries that we would argue have a much higher cost of equity compared to Korea—Korean equities appear even more attractive.

At current valuations, and not including the impact of additional reforms, we believe our South Korean investments offer an asymmetrical risk-reward profile that offers limited downside and significant capital appreciation potential—a major source of alpha generation for our clients.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Portfolio managers are not licensed by the Hong Kong Securities and Futures Commission to perform any regulated function in or from Hong Kong. Furthermore, none of the portfolio managers are located in or operate in or from Hong Kong.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.