Warren Buffett has a history of uncovering value in unexpected places. A classic example of this is his investing in Korean markets, which began in ~2004, and continues today. He recounted his experience in a 2005 speech to Harvard students, “Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified … The strategy was to buy the securities of twenty companies … $100 million was quickly put to work”. As Alice Schroeder's 'Snowball' biography reveals, this included teaching himself Korean accounting conventions, which were radically different from those used in the US.
In Korea, a separate class of shares with blended characteristics of stocks and bonds trade over the counter. These shares are called 'Preference' or 'Preferred' shares, and contrary to what their name implies, carry less rights than common stock. They were conceived to keep majority family control of the large 'Chaebol' conglomerates, and effectively are equity shares in the firms without voting rights. To compensate shareholders for their diminished rights, preference shares generally carry a higher dividend yield. They also trade at very discounted prices compared to their respective common stocks.
Ori Eyal is the Portfolio Manager of Emerging Value Capital Management, a Long/Short global value fund. Ori has a background in emerging market investing at Deutsche Bank Asset Management, Deephaven Capital Management, and Aquamarine Fund. He believes that Korean Preference Shares are underlooked, and his fund has invested in a basket of the stocks. SumZero sat down with him this week to discuss his idea.
Luke Schiefelbein, SumZero: What about Korean preference shares initially caught your eye as a value investor? What catalyzed your entrance into the position?
Ori Eyal, Emerging Value Fund: The Emerging Value Fund, which I manage, is a Global Value Fund. My job as PM is to search the world for the most unique and attractive value investment opportunities and then use these to build our investment portfolio. One of the most unique and compelling investment opportunities that I have found is the Korean preference shares.
Over 100 of the publicly listed companies in South Korea have listed both common and preference shares. The preference shares in Korea are very different than preferred stocks in the US and most other countries. They are legally required to pay a higher dividend than the common stocks, have a claim on company assets, cash flows and profits, and are treated fairly whenever corporate events take place. In many ways, they are an equivalent security to the common shares of these Korean companies.
What caught my attention is that many of these preference shares trade at a 50% or even higher price discount to their respective common shares. I know of no other case in the world where pairs of essentially equivalent securities trade at such a high price discount/premium to each other.
What makes this opportunity even more attractive is that the South Korean stock market is among the cheapest of all developed markets and is very well positioned to provide strong returns to investors. By investing in the Korean preference Shares, we enjoy 3 overlapping sources of return: First the Korean stock market return. Second, the gradual narrowing of the price discount between preference and Common shares. Third, a higher dividend yield.
Our preference shares basket enjoys three overlapping sources of return:
Korean stock market return
Return from narrowing of the price discount between preference and common shares
Higher dividend yield from preference shares
Very high returns
Since we started investing in Korean preference shares in 2013, we have earned over 130% return while the average preference shares price discount narrowed from about 70% to about 50%. Over the next few years this, still huge, price discount should further narrow generating an additional 120% - 150% return. Importantly, the risk of permanent capital loss in this basket approach is minimized since we invest in a diversified basket of 15 cheap, profitable, dividend paying preference shares. Therefore, I view this investment opportunity as compelling from a risk-reward standpoint.
Schiefelbein: What is the market missing? Can you explain the 50-60% average price discount between the preference shares and their respective common shares? Why have Korean Preference shares historically traded at such a large discount?
Eyal: Most Korean preference shares were originally issued several decades ago when the Korean government pressured chaebols (Korean business conglomerates) to raise equity and de-lever their capital structures. The chaebols wanted the extra equity capital, but they also wanted to retain control of their companies — hence the new non-voting stock shares (Korean preference shares).
When first issued, Korean preference shares traded at only small price discounts to their respective common stocks. Over the years this price discount has fluctuated dramatically. The price discount reached extreme points twice in the past. First, during the 1997 Asian financial crisis and then again following the 2008 great financial crisis as liquidity fled the Korean market and investors panic sold securities for almost any price they could get. Today, many preference shares in Korea still trade at a 50% or higher price discount to their respective common stocks. Since they must pay a higher absolute dividend amount, dividend yields for the preference shares are much higher and usually range between 2% to 5%.
In 2015, the management of Samsung Electronics, Korean largest company, confirmed my investment thesis in their Q3 comments to investors. They said: “…many shareholders have expressed a view that buying back and cancelling preferred shares, which are traded at a discount to common shares is a more efficient use of capital as we can buy and cancel more number of shares with the same amount of money, thus increasing the effectiveness of any future capital return to the remaining shareholders. The company shares the same view. Therefore, we plan to increase the portion of preferred shares for repurchase and cancellation under this buyback program, as long as the price discount to common share is greater than 10%”. Please note that they view any price discount above 10% to be a buying opportunity. For reference, our basket trades at an average price discount greater than 50%, confirming that huge upside remains.
Schiefelbein: What key metrics should investors be paying attention too when selecting which preference shares to purchase?
Eyal: At Emerging Value Fund I track all the Korean preference shares and have done extensive research on most of them. I also leverage my network of contacts both in Korea and globally to support my research. Using our proprietary systems I follow the key metrics for each preference share so that I can select the most attractive preference shares for our basket and adjust the basket constituents as relative valuations and business performance metrics change over time.
When selecting Korean preference shares for our basket, I look for 8 key criteria:
- 50% - 60% price discount between the preference share and common stock.
- Sustainable dividend yield.
- Reasonable trading liquidity.
- Good business with competitive advantages.
- A history of profitability and positive free cash flows.
- Strong balance sheet.
- Trustworthy and capable management team.
- Extremely cheap price relative to the intrinsic value of the business.
While clearly not all preference shares in Korea meet these criteria, I have found about 30 preference shares that meet this high standards for investment.
Schiefelbein: What is contained in your basket of preference shares? Do you have specific views on each stock or is this more of a macro trade?
Eyal: The following table shows seven out of the fifteen Korean preference shares currently in our basket. Several of these are analyzed below in more detail. Across all the preference shares in our basket, the average price discount is above 50% and the average dividend yield is 2.5%. I estimate that we are able to buy the businesses in our basket for about 40% of their intrinsic business values on average.
LG Household & Healthcare Preference Shares (051905 KS):
LG Household & Health Care (LG H&H) manufactures and distributes cosmetics, household & personal goods and Coca-Cola beverages in South Korea. It has a leading market share in all 3 business segments. The company was spun off from LG Chemical (now LG Corp) in 2001 and has since been focused on western style brand management and shareholder value creation. LG H&H management is well regarded and shareholder friendly. Over the years the company has allocated capital wisely by investing in its core businesses, repurchasing stocks and completing multiple value creating acquisitions. I view LG H&H as one of the best businesses in Korea. It enjoys strong consumer brands and significant growth drivers both domestically and internationally.
The preference shares of LG H&H trade at a 43% price discount to the common stock. By investing in LG H&H’s preference shares we are paying about 14 times free cash flow, a cheap price for an excellent, well managed consumer brands business with significant growth prospects. The preference shares also pay a 1.2% dividend yield.
Doosan Preference Shares (000155 KS):
Doosan Corp is an industrial conglomerate operating in a number of disparate businesses, including electronic components for cell phones, heavy-duty excavators, machine tools, fast food, and building nuclear power plants. Doosan’s management has been working to streamline the conglomerate structure. They are selling non-core assets, recapitalizing weak subsidiaries, and improving operational and financial performance. I expect these actions will unlock shareholder value over time. Doosan’s preference shares are effectively trading at 50% of NAV with a 7.5% and growing dividend yield.
Kolon Industries Preference Shares (120115 KS):
Kolon Industries is a diversified chemicals and materials manufacturer with business lines in industrial materials, chemicals (petroleum resins), films and fashion materials. The company has significant market share in multiple niche markets including petroleum resins, polyester tire cord, airbags, and fashion item materials. Economies of scale, strong customer relationships, and intellectual property provide Kolon with a sustainable competitive advantage.
The common stock of Kolon trades for about 8X EV / EBITDA. While the common stock is cheap, the preference shares of Kolon are extraordinarily cheap. They trade at a 59% price discount to the common stock and pay a 3.6% dividend yield.
Schiefelbein: How are you accounting for geopolitical risk as your thesis plays out?
Eyal: South Korea, the world’s 14th largest economy, has achieved impressive economic growth and development since the end of the Korean war. Today, South Korea is a developed, capitalist, democracy. It is home to leading global companies including Samsung, LG, Posco and Hyundai. The Korean stock market is cheap, trading for 10 X earnings and about 1.1 X book value.
Excellent macroeconomic position:
- Budget surplus
- Low debt / GDP
- A+ credit rating
- Low inflation
- Strong GDP growth
- Young, energetic, educated and innovative workforce
Tensions between North Korea and the US flared last year as the rogue state accelerated its development and testing of various missile systems, including those that could, hypothetically, strike the US and its allies with a nuclear war head. With diplomatic efforts showing no results, president Trump must either accept and try to contain the new military capabilities of North Korea or else launch a massive air-strike which would likely lead to war involving the US, North Korea, South Korea, Japan and possibly China.
I continue to think that a full scale war is an unlikely scenario, but must admit that the probability of such a war has increased. If a war broke out, North Korea would lose and its regime would likely topple, but not before it could cause great damage and loss of life to South Korea. There is also a small risk that North Korea strikes with various weapons of mass destruction.
To protect our portfolio from this risk, I established a partial short position in EWY, the South Korean ETF. We are still net long South Korea, via our preference shares basket and our investment in Samsung Electronics, so this is only a partial hedge. Even in a scenario of all-out war on the Korean peninsula, I am confident that the US and South Korea will win decisively and will recover from any temporary damage. Therefore, in the unlikely event that war breaks out, my plan is to wait for the Korean stock market to drop, then remove our hedge and wait for the recovery.
Schiefelbein: Is there any risk to shareholders from the strong Chaebol culture in South Korea?
Eyal: After extensive research, I found that owners of Korean preference shares are almost always treated fairly with owners of Korean common stocks. Further supporting this viewpoint is the fact that many preference shares in the past (and a few today) traded at little or no price discount to their respective common stocks. Clearly, investors in the past viewed Korean preference shares as roughly equivalent to Korean common stocks and they did not think that preference shares in Korea deserved a large price discount.
In recent years, Korean authorities have taken multiple steps to protect the rights of minority shareholders and to improve corporate governance in Korea. These steps are very favorable for preference shareholders since they ensure the protection of our rights.
Corporate governance and transparency in Korea have improved significantly following the revisions to the Commercial Act, imposition of gift taxes on contracts to group affiliates, and aggressive legal action against abusive controlling shareholders. In addition, recent corporate law amendments in Korea now prohibit poison pills, require super majority board approval for related party transactions, and place strict independence and corporate governance burdens on directors.
Schiefelbein: What other risks are associated with your thesis? What could go the most wrong?
Eyal: While most of our investments at Emerging Value Fund are in individual companies, we do occasionally prefer to purchase a basket of related securities. This happens when we are confident that a certain sector or class of securities will, in aggregate, perform very well, but are less certain about each individual member of the group. I think that Korean preference shares perfectly fit this definition. By investing in a basket, we minimize stock specific risks. While not every company in our basket will be a star, I expect that, on average, our preference Shares basket will perform very well over the next few years.
Schiefelbein: What is your expected return for this investment?
I make the following assumptions for our preference share basket:
- 5-year holding period.
- Average price discount narrows from 50% to 25%.
- Stock market appreciates 7% per year.
- 2.5% annual dividend yield.
- Conservatively ignore profit from trading between the different preference shares.
These assumptions lead to the following expected returns:
- 50% from price discount narrowing.
- 40 % from common stock price appreciation (7% per year for 5 years).
- 12.5% from dividends (2.5% X 5 years).
- Total Return = (150% X 140% ) + 12.5% –1.0 = 122.5%.
Importantly, the risk of permanent capital loss is minimized since we invest in a diversified portfolio of 15 cheap, dividend paying, preference shares. As such I view this investment as compelling from a risk-reward standpoint.
Schiefelbein: Have you identified any catalysts for this investment?
Eyal: In addition to simple mean reversion, I believe that there are four catalysts that will close the high price discount between Korean common stocks and Korean preference shares over the next few years:
- Improved corporate governance and minority shareholder rights.
- Rising Dividend Yields.
- Normalization of the Korean stock market and reduction of market inefficiencies.
- Bargain hunting value investors.
Schiefelbein: Where else do you see value in the market today? Where else does your fund focus?
Eyal: While stock market volatility was muted in 2017, geopolitical turmoil remained high. The multiple wars in the Middle East and North Africa persisted with no end in sight. Russia ramped up the fighting in Ukraine while partially withdrawing forces from Syria. China publicly berated North Korea while continuing, behind the scenes, to prop up the rogue regime which exchanged threats and insults with the US on a regular basis. Venezuela was unable to avert its economic implosion. Western Europe carried on with its slow economic recovery, now approaching year 10, while failing to make meaningful progress in negotiating a Brexit deal. Global investing, with so many active trouble spots around the world, requires careful analysis of the countries and economies where we choose to deploy our capital.
At Emerging Value Fund I have always adhered to the idea of “researching the country, not just the company”. My analysis has shown that many countries that, in the past, were viewed as attractive investment destinations are now headed in the wrong direction.
In contrast, I are certain that, despite occasional setbacks, the US, Israel, and South Korea are headed in the right direction and currently are among the best countries in which to invest our capital. These three countries are true capitalist democracies, enjoy favorable demographic trends, and are the world leaders in technological innovation – the driving force behind today’s economic growth. With technology comprising an ever growing portion of the global economy and with more and more “old economy” sectors getting technologically disrupted, economic success in the future will be based on the ability to innovate and stay ahead of the advancing technological curve. Israel, South Korea, and the US are the best positioned countries to do so.
Schiefelbein: What is your background?
Eyal: I am the the Founder and Managing Partner of Emerging Value Capital Management (EVCM) with over 16 years of experience in global value investing. EVCM manages a global, long-short, value hedge fund which invests based on my global investing framework.
Prior to launching Emerging Value Capital Management in 2008, I worked at Deutsche Bank Asset Management in New-York. At Deutsche Bank, I was in charge of identifying, researching, analyzing, and executing multiple investments in Korea and around the world. I also performed global investment analysis at Deephaven Capital Management and at Aquamarine Fund. I has presented at several prestigious conferences including the Value Investing Congress (California), The Value Investing Seminar (Italy), the Best Ideas Conference (Online), and ValueX (Zurich).