beyondbrics

By Shaun Cochran of CLSA

South Korea is often described as Asia’s perennially cheap market – stock valuations have long been depressed by the influence of the government and controlling families on corporations.

Recently, however, something seems to be changing. Investors have rotated into north Asian exporters to get perceived exposure to economic recovery in the developed market and less inflation risk (Koreans spend less on food and energy than Indians or Chinese). This has led to the inevitable question: is Korea getting a permanent re-rating, or is this just a temporary phase?

We think some of the fundamental arguments for Korea’s cheapness still remain legitimate. Many of Korea’s largest companies are still family-controlled, often with small equity stakes. Even if the family has only, say, a 3-5 per cent stake, management often responds unquestioningly to founding family orders even where technically there is no legal basis for doing so, and as a result have limited incentives to pursue higher returns (below is a table of average dividend payouts across Asia).

Government influence in management appointments and decision making is also still very high, particularly relative to equity stakes. And many companies still exhibit a dangerous predilection towards taking on leverage to acquire scale: a number of high-profile deals have recently completed or are pending.

However, we believe meaningful change is happening. We call it the Chaebolution – a process where the institutional framework and family incentives align such that some of Korea’s largest companies – including the chaebol conglomerates – can finally begin to pursue restructuring.

The pace of change, though, is glacial. It is taking place over decades, not quarters.

While this continues, the Korean market is also working through the process of regaining investor trust after a history of crises. It is in large part these legacy challenges that have driven institutional investors to focus on ‘renting’ rather than ‘owning’ stocks (an industry euphuism for entrenched short-termism). A culture of long-term equity investment is still building.

Financial markets are constantly looking for a ‘catalyst’ – a defining event or events that will tip the balance of prevailing opinion and change the way securities are priced.

Fortunately for Korea there are a number. The most obvious is possible promotion to developed market status in the MSCI benchmark index. If that happens, Korean stocks will inevitably look attractive. A number have the scale to be relevant on a global stage. However, while the probability of promotion is high, the timing is unpredictable.

In the absence of that external kick, domestic fundamentals can also trigger a more gradual re-pricing.

Korea’s population is ageing and the proportion of people reaching the peak age for retirement savings is rising. Future pension liabilities are growing and in response the public allocation of savings to equities is increasing. That is positive for valuations.

So too is the introduction of corporate pensions, which will drive mandated buying over the coming decades.

Another reason for optimism is that Korean companies are moving up the value chain, as witnessed by the rise of brands like Samsung, LG and Hyundai. Over time this means more pricing power and wider margins.

Suppliers are also feeling the benefit – like auto parts manufacturing, where Korea is gaining global share. Korean tech companies are also at the forefront of commercialising a number of next generation technologies such as electric vehicle batteries, LED lighting and OLED display technologies.

Changes like these increase Korea’s growth prospects, and when combined with better pricing and the subsequent wider margins, reduce the cyclicality of earnings.

Putting it all together, there is a strong case for a re-rating of Korea. In fact, there is every reason to believe it is already underway. But there’s a crucial caveat: it is happening slowly.

Without a specific catalyst, investors seeking to perform quarter to quarter will struggle to catch the trend. Even for those focused on full year returns, the incremental upside is unlikely to be substantial.

In the end the change must be driven by individual companies. So it’s when you see chaebolution being driven from within Korea’s most important companies that you should choose to pay more for Korean equities.

Shaun Cochran is head of Korea research at CLSA

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