South Korea is cheap. Despite being one of the wealthiest countries in the world (11th in 2015 GDP, 30th in PPP GDP per capita) and housing some of the world's most successful companies in Samsung, Hyundai, and LG, members of the KOSPI index trade at an average P/E of only 9.7. This compares with an average P/E of ~18 for companies in the S&P 500 and NIKKEI 225, 13.7 for the Chinese SSE Composite, and 12.5 for the Brazilian Bovespa.
Nevertheless investors remain skittish of the country given a history of shareholder neglect and recent high profile corruption scandals in the upper reaches of the Korean government and the massive chaebols, complex family owned corporate entities with a reputation for white collar crime. But times may be changing.
SumZero sat down with with Chan Lee of Seoul-based Petra Capital Management to talk about Korean shareholder law, recent developments in corporate governance practice (which has historically been unfriendly to shareholders) and the current political shakeups that could catalyze the realization of value for under-priced Korea.
Luke Schiefelbein, SumZero: Why do Korean stocks generally trade at lower multiples than stocks of other countries, including other Asian countries with steep language and cultural barriers to Western investors?
Chan Lee, Petra Capital Management: Korean stocks trade at low multiples because of the following reasons:
- Inefficient balance sheets: Korean companies hold too much cash and non-core assets which directly hurts return on equity.
- Small dividends: payout ratio is one of the lowest in the world.
- Corporate governance concerns: managements are appointed by the controlling shareholders who tend to ignore the interests of minority shareholders.
- Transparency issues: cross-shareholding ownership structures of chaebols (i.e., business conglomerates) are complex and opaque
- North Korea: geopolitical risks of the Korean peninsula.
Luke Schiefelbein, SumZero: Why do Korean companies pay relatively small dividends?
Chan Lee, Petra Capital Management: Korean companies are reluctant in distributing earnings due to a conservative fiscal culture. Most managers feel that deploying cash to grow and expand the business is a superior to returning cash to shareholders, and simultaneously like having a big amount of cash on the balance sheet to provide extra protection during economic downturn (e.g., traumatic experiences from the Asian Financial Crisis in 1997-98).
Additionally Korean institutional investors often adopt a deferential attitude towards management, either choosing to abstain or habitually vote for management’s proposals at the AGM. Shareholder activism not yet widely embraced (at least not yet)
Luke Schiefelbein, SumZero: Since many of Korea’s top companies have suffered from scandals and corruption, how are investors supposed to have faith that shareholders’ best interests are made a priority?
Chan Lee, Petra Capital Management: The worst is over. Despite the image problem caused by Korean chaebols, corporate governance of small/mid-cap Korean companies is much better with a simpler ownership structure. In fact, corporate governance and transparency have been improving gradually in Korea; the recent impeachment of President Park is likely to expedite this “improving” corporate governance process, creating a more favorable environment for minority shareholders.
We believe the new administration under President Moon Jae-in will push hard for laws to significantly strengthen corporate governance and enforce better governance at companies, including broader chaebol reforms.
Luke Schiefelbein, SumZero: What will catalyze reform in Korea corporate governance, and how well known are these catalysts to investors (i.e. how much is already “priced in”)?
Chan Lee, Petra Capital Management: President Moon’s new administration is expected to carry out a number of measures to improve corporate governance, including the revision of the Commercial Acts to increase minority shareholder protection, and enforce stronger anti-trust laws. Moreover, a significant overhaul in the structure of National Pension Service (NPS), Korea’s largest investor in Korean equities, and the widespread adoption of the stewardship code by Korean institutional investors will also make them to be proactive and vocal at the AGMs.
The KOSPI is up over 15% YTD but the rally was almost solely driven by positive earnings revisions and increasing profitability rather than valuation re-rating. Hence, we believe the above catalysts are not priced in yet.
Luke Schiefelbein, SumZero: What is the culture of entrepreneurship like in Korea? Do you expect the country to continue to produce new and innovative companies?
Chan Lee, Petra Capital Management: Korea has one of the best environments for technology and innovation. The country has ranked first on the Bloomberg Global Innovation Index for five years in a row. Korea notched top scores worldwide for manufacturing value-added products, as well as for tertiary efficiency - a measure that includes enrollment in higher education and the concentration of science and engineering graduates. Korea ranked second for R&D intensity (high-tech density and patent activity) and ranked sixth for researcher concentration. Given this kind of business environment, we expect new innovative companies will continue to emerge from Korea.
Luke Schiefelbein, SumZero: Is it possible or easy for foreigners to invest in Korean equities. What is the process like?
Chan Lee, Petra Capital Management: For new foreign investors to invest in Korean equities, the initial process is somewhat cumbersome as they must first register with the Financial Supervisory Service in order to obtain a foreign investor ID. Foreign investors also need to appoint a standing proxy as well as a local custodian bank. Once the above process is completed, foreigners can easily buy and sell Korean equities.
Luke Schiefelbein, SumZero: Are there any companies in particular that you think will benefit from possible changes in Korean corporate law and perception?
Chan Lee, Petra Capital Management: I think Korean companies that are competitive but undervalued due to lack of capital allocation are the ones to benefit most from these changes. GS Home Shopping (KOSDAQ:028150) is a very good example. The company generates $100 million annually in net income but its current market cap of $1 billion is exceptionally cheap considering $1 billion in net cash on its balance sheet. Other strong companies we have our eye on are SamHo Development (KRX:010960) and Kyungdong Invest (KRX:012320).
Luke Schiefelbein, SumZero: What steps can Western investors in particular take to get comfortable investing in Korea?
Chan Lee, Petra Capital Management: In general, many Korean companies are complex to analyze because they often own several non-core business units and subsidiaries. It is also very important to properly analyze the qualitative aspect of management and understand the industry dynamics in order to avoid any potential value traps.
I believe that accumulating local expertise and experiences are crucial for Western investors to get comfortable investing in Korea. Interested parties can feel free to email me for more detail on other companies we recommend, as well as additional information regarding our macro outlook for Korea.