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Korea: the Bermuda triangle of value investing?

South Korea is increasingly viewed as the “Bermuda Triangle” of financial markets. Value investors have in recent times been swallowed up by a market that has retreated to levels not seen since the Global Financial Crisis. The lure of low starting valuations have been overwhelmed by the usual chorus of concerns regarding Korea. Reminiscent of Japan in the years following the Tsunami and Fukushima nuclear disaster, macro generalisation and governance concerns have led global investors to overlook important company specific and regulatory developments, setting the scene in our view for the potential for absolute returns over the next several years.

Emergence of an Economic Powerhouse

Forgotten today amid South Korea’s many cited risks is the country’s rise from obscurity over the past 50 years. In the 1960’s, South Korea was poorer than both Bolivia and Mozambique, endowed with relatively few natural resources and left limp after a prolonged war with its northern neighbour. Often described as a First World economy with Emerging World institutions, South Korea is today an unheralded economic success, now richer than countries such as New Zealand and Spain, and sporting world leaders in consumer electronics, autos, semiconductors, shipbuilding, chemicals and other industrial sectors. Their economy has compounded at 7% p.a. since those early days of obscurity. Banking reforms put in place after the 1998 Asian Currency Crisis has placed Korea’s institutions on a much sounder footing and in a position to absorb the worst of the 2008 Global Financial Crisis when it arrived. Indeed Korea’s subsequent economic performance significantly outpaced the majority of advanced economies, many of which are still struggling to recover.

Korea ranks 4th in the World Bank’s1 “Ease of Doing Business Ranking” and top quartile in the World Economic Forum’s “Global Competitiveness Index”2 . The diagram below indicates how well the country ranks among fellow advanced economies on measures such as education, infrastructure, health, regulation and other macroeconomic indicators. The picture look even better when compared against Asian competitors.

Chart 1: South Korea – Competitiveness Rankings

Chart 1

Source: World Economic Forum, Global Competitiveness Report June 2015, p.240

The foundations for Korea’s economic success, an educated population, property rights and, in 1987, a move to democratically elected governments are all widely associated with successful economic transitions. But unique to Korea was the method by which it fast-tracked development under the control of former General Park Chung-Hee who came to power via a military coup in 1961. In order to legitimise the power he’d bestowed upon himself, Park (father of current President Park) led an ambitious growth and modernisation program which included the channelling of development funds and state subsidies through a set of hand-picked family controlled conglomerates – the so-called “Chaebols”. The subsequent rise of these conglomerates has proven a doubled-edged sword, at once forming the basis for outsized economic success, but resulting in an export led development bias and an unhealthy level of corporate influence over government policy. Indeed, Koreans today continue to campaign for “economic democracy”, under which the benefits of success are shared more broadly beyond those chosen few.

Victim of Success

Yet for all Korea’s success, detractors abound. As evidence, Korea carries one of the lowest valuations of any investible stock market in the world. Half of the listed companies on their main exchange trade near to or below stated book value. Macro-economic generalisations and the usual chorus of complaints over corporate governance drown out important company specific and regulatory developments. This disconnect between long held perceptions and a changing reality create a set of investment opportunities in Korea which are relatively unique across the current investing landscape.

Antipodes Partners recently travelled to Korea, meeting corporates representing some ~40% of the country’s market capitalisation, policy makers, fellow investors and other local experts. Set against a stock market which has fallen 13% in USD terms over the past five years, a period when many other markets have enjoyed significant gains including the S&P 500 up ~50%, the mood amongst locals was predictably downbeat.

Korean perceptions continue to suffer from a generally poor record of corporate governance which has prioritised stakeholders over stockholders, the heavy hand of state intervention and exposure to both a slowing Chinese economy, Korea’s largest trading partner, and emerging Chinese competition. We believe these concerns are somewhat backward looking, failing to recognise important “on the ground” developments.

Governance Issues

Whilst corporate governance issues are real, particularly among Korea’s family-run Chaebol’s, the next generation of owners will have much greater alignment with minority shareholders than did their parents. While control will continue to remain important, minorities should enjoy significantly better payouts as the inheriting generation preference cash-flow over the hording tendencies of their forbears’. This will be partly driven by cash-flow consequences of large inheritance tax bills. Subtle evidence of this realignment is already underway and as these changes come to be recognised for what they are, we see significant re-rating potential for some of Korea’s most overcapitalised companies.

There is no better example of this potential than the case of Samsung Electronics. Long criticised for its propensity to underserve the needs of minorities, the company has recently committed to a transformational program of cash returns that will see as much as 50% of free cash-flow returned via share repurchases and dividends over the coming 3 years. For a business which has historically sustained +20% returns on capital, this distribution policy is consistent with businesses of similar resilience.  We believe these returns should rise over time, as the business continues its leadership in critical semiconductor and display technologies. Samsung has a record here of both innovation and cost leadership growing share in each category. Both will be important as the company looks to recover margins in the handset division, which peaked at 18% in 2013 falling back to 10% by the end of 2015.  Particularly exciting will be a new LED technology which will enable the design of foldable screens. Samsung and LG Display hold a significant lead in this field which should stimulate a major handset upgrade cycle beginning in the second half of 2017. With most of the critical components captive to Samsung, it’s well positioned to ride the wave of early adoption.  Trading at just 6x cash adjusted earnings and close to stated book value, Samsung’s valuation imputes few of the virtues of its business model. A long-term record of success in highly competitive industries and now a more responsible attitude to shareholder returns sets the company up for a positive reassessment.

Governance issues have also been at the heart of investor concerns regarding Hyundai Motors. We acknowledge past indiscretions but believe investors have unfairly penalised the company and don’t properly reflect its position as a global top ten auto manufacturer.  Over the past 20 years, the company has transformed itself from an inferior brand to a leading supplier, confirmed by a recent JD Power study placing Hyundai ahead of all Japanese and most European competitors on measures of quality and design.

Chart 2: Defects per 1,000 vehicles

defects

Source: J.D. Power 2015 U.S. Initial Quality Study

That has translated to earnings success, with profits compounding 12% p.a. over the past decade.  Profits in the near-term will be boosted by a new product cycle featuring a richer mix of SUVs as well as hybrid vehicle options. Hyundai is also ramping up investment in luxury brand Genesis, as a serious competitor to rival Toyota’s Lexus.  Hyundai exports roughly 50% of its Korean production meaning profits are tied closely to movements in the exchange rate. The recent weakening of the Won provides some relief from an extended period of currency strength.  Hyundai’s valuation appears to factor the worst of their governance record, but little of their operational excellence. At just 60% of stated book value, with about 45% of book value in cash, Hyundai trades at 50-70% below other listed auto makers. This valuation plus a coming product cycle nicely underwrites an investment in the company at current levels.

Regulation

Regulatory risks in Korea remain, but these are diminishing at the margin as the cyclical burden that is imposed outweighs the structural intention of the measures. For example, in our conversations with Korea’s Financial Services Commission, it became clear attitudes towards banking system regulation were softening as stronger bank profitability is seen to support a healthy credit multiplier. KB Financial (KB) with more than 20% of the Korean retail banking market is set to benefit from the regulator’s more balanced posture.  Korea’s credit growth outlook is somewhat underwritten by the recent strong housing related pre-development sales which should underwrite construction activity and benefit KB directly via strong mortgage share.

KB has also installed cost-focused management, who have stated they can cut staff numbers by 25% and acted last year by striking an agreement with the notoriously tough Korean unions to offer early retirement packages to 25% of the bank’s workforce. Whilst the acceptance rate has not been high, KB management has committed to offering similar packages every year and a cost to income ratio of ~60% highlights the extent of low hanging fruit.

KB is also priced with a significant margin of safety, trading at just 0.4x book value and a 2015 PE ratio of below 8x and an even lower multiple after allowing for one off redundancy costs. That’s a large discount to the multiple investors typically pay for Australian banks. Given a decade of consolidation in Korea’s banking market that now leaves the top 4 banks with ~70% market share, we think the discounted valuation is unjustified.

Chart 3: Price to Book of KB Financial and Commonwealth Bank

cbakb

Source: Factset

Chinese Macro Concerns

Finally, while Chinese macro volatility is a concern, no economy benefits more than Korea’s from the collapse in global energy and commodity prices which has taken place in recent years. This coupled with a weakening Korean Won and unwinding of Japan’s policy-induced Yen weakness should add a tailwind to an already healthy growth outlook.

Korea’s recently signed free trade agreement with China will also ease access to this important market by reducing tariffs on 90 percent of the goods traded between the two countries. The Korea Ministry of Trade Industry and Energy estimate that the agreement will boost annual trade to over $300bn. The deal also paves the way for a more formal agreement to be negotiated in 2017 around China’s burgeoning services sector.

Opportunities for those willing to look to the future

Our sense is that investors are too mired in past prejudices when it comes to the Korean market. Careful inspection of company specifics and a changing socio-economic environment offer signs for optimism rather than despair. Our portfolios are positioned for a reappraisal of perceptions as evidence emerges of the sustainability of business models, improved governance outcomes and a continued robust economic outlook. In short, we see multiple ways of winning from our current portfolio of Korean investments.

To learn more about Korea, including findings from our recent trip, see the Antipodes Partners webinar “South Korea: From neglect to respect”

[1] www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Annual-Reports/English/DB16-Full-Report.pdf
[2] www3.weforum.org/docs/gcr/2015-2016/Global_Competitiveness_Report_2015-2016.pdf