Of all the Asian markets, the Korean market is probably the most discounted in terms of multiples. Valuation is cheap not only compared to other markets around the world but also compared to its own history.
The market is trading below its book value and at only 10 times forward earnings for 2017. Although the KOSPI index has just hit an all-time high, it is still not expensive as its rise was solely driven by positive earnings revision rather than valuation rerating.
KOSPI Index: Performance (LHS) and Price-to-Book Value ratio (RHS)
PE Ratio: Korea vs Asia-Pacific
Source: CLSA, Quantiwise
Why so discounted?
1. Too much cash on balance sheets
In recent years, the cash flow of Korean companies has substantially exceeded their capital expenditure. This has led to companies accumulating substantial amounts of cash on their balance sheets, driving down their return on equity. Korean companies are among the least indebted in the world. Over 40% of KOSPI companies are in net cash.
KOSPI Index Constituents: Operating Cash Flows vs Capex
Source: CLSA, Quantiwise
KOSPI Index Constituents: Cash and Cash Equivalents
Source: CLSA, Quantiwise
Although this figure is already high in itself, it further underestimates the real cash position of Korean companies as they hold a lot of non-core assets such as stakes in affiliate companies and very often in their own treasury shares.
2. Poisoned pills
Treasury shares represent an effective way of countering potential hostile takeover bids. They also strengthen the position of controlling shareholders as they have no voting rights. In the event of a takeover, the target company can sell its treasury shares to an affiliated company and thus return the voting rights attached to these shares. Obviously, with this kind of mechanism, a Korean group is unlikely to be the target of a competitor's hostile bid, effectively eliminating the potential for takeover premiums.
3. Pension fund collaboration with the Chaebols*
The Korean pension fund (NPS: National Pension System) manages a portfolio of around USD 500 billion, which is 34% of Korean GDP. The NPS holds shares in all the major Korean companies. Since it comes under the government's sphere of influence, it is party to manoeuvres that favour the Chaebols* (… often to the detriment of minority shareholders). Political pressure on the NPS was also one of the reasons leading public opinion to demand the impeachment of former president Park. Its collaborative attitudes towards the Chaebols* are not in the interest of the pension fund beneficiaries. On the contrary, the NPS should be calling for better corporate governance and more effective capital management for the benefit of shareholders, especially in a context of very low interest rates and an ageing population.
4. Payout ratios the lowest in the world
Despite the abundance of cash on Korean companies' balance sheets, payout ratios (dividend payments) have never been so low in historic terms. They are also the lowest in the world at only 20% of profits.
Current Price Earnings Ratio and Dividend Payout Ratio
Source: CLSA, Bloomberg
5. Among the worst corporate governance in Asia
The law on mergers and acquisitions in Korea lacks clarity. It does not impose the mandatory bid rule (MBR) on minority shareholders. This rule, which is applied in most other countries worldwide, requires the acquiring company to pay the same price to all shareholders. In Korea, the law allows the acquiring company to pay a different price (often a much lower one) to the target company's minority shareholders, who thereby suffer at the expense of the leading shareholders.
The credibility of the Korean stock market is also eroded by the extent of leaks of insider information. There are countless cases of share prices surging (or plummeting) for no apparent reason, only to find the reason in an official notification published at a later date. Companies should be required to suspend trading of their shares when they are in possession of important information before it has been publicly revealed.
In addition, Korean holding companies held by founding families charge royalties for the use of their name by their affiliated companies. The problem lies in the fact that there are no laws effectively framing such payments so the holding companies can charge what they want to their subsidiaries with no consideration for the real value of the name or the appropriate amount of these royalties.
These very important issues are blemishes on the credibility of the Korean market and are at the root of its current discount.
How did this come about?
Korea is one of the few countries in the world which has moved from the status of a very poor country to a rich country in just a few decades. In the 70s and 80s, the Korean economy saw its GDP multiply by a factor of 50. At the same time, the sales revenue of corporations like Samsung and Hyundai multiplied by 630 and 950. After such stellar performances, some corporations still have difficulty acknowledging that they want ex-growth and need to start returning to shareholders by raising payout or share cancellation.
Before the Asian crisis in 1997, major Korean companies were heavily indebted as they enjoyed advantageous loans from banks that were themselves controlled by the government. In the wake of the crisis, the government was almost bankrupt with half the banks and Chaebols* defaulting. After the austerity purge imposed by the IMF (International Monetary Fund), mindsets changed and prudent debt-free management was considered more responsible. Companies set about massively deleveraging, resulting in a very conservative balance sheet structure and, correspondingly, a relatively poor return on equity.
Following the Asian crisis, raising capital to finance an acquisition was often difficult. This is why the authorities abolished the MBR. It thus became possible to take control of a company without holding a significant proportion of its capital and, more to the point, without paying its fair value to all shareholders.
Korean companies often use their balance sheet cash to finance acquisitions without regard for the interests of minority shareholders. This is another reason why Korean companies are brimming with cash. It is a source of funding that the directors can use at their convenience. It also explains why they are not inclined to pay bigger dividends. It increases their power to make acquisitions without having to refer to the shareholders!
Formerly, the country used to tax retained earnings in the same way as dividend distributions. After the Asian crisis, this law was abolished in order to shore up the financial strength of companies, which led to an accumulation of reserves on their balance sheets.
We have reached the current situation due to changes in the law mostly resulting from the Asian crisis. These adaptations made sense at the time but are no longer appropriate in today's context. Companies simply respected the laws and used them to their advantage.
Why is this of interest now?
The impeachment of the former president and the arrests of the vice chairman of the Samsung Group and the head of the pension fund (for corruption) suggest that things could change. Furthermore, the recent election of Mr Moon as president of South Korea is encouraging as the reform of the Chaebols* and strengthening the rights of minority shareholders are central to his programme. The new president has just appointed Dr Kim as head of the Korean antitrust body, the FTC (Fair Trade Commission). He is known for his determination to reform the Chaebols. If the new government manages to change these obsolete laws, it could herald an improvement in corporate governance, better treatment of minority shareholders, higher payout ratios and hence a significant reduction in the 'Korea discount'.
In light of past experience, many investors remain sceptical about potential improvements to corporate governance. But the probability of real change is currently running high because Mr Moon's government has the legitimacy to attack the problem. You only have to recall the events which led to the early elections, such as the people's rejection of a governance structure which strongly favours a small group of political and economic elites and was at the root of the Park-Choi scandal and the numerous protests which followed it.
Meanwhile, Samsung Electronics' unexpected decision to cancel all its treasury shares has certainly raised high hopes. Once complete, this cancellation will lead to a 13% increase in EPS (earnings per share). This action, along with the decisions to buy back more shares and increase the dividend, could be a signal that Korean companies will at last start to return more capital to shareholders. If the country's biggest company leads the way, perhaps it is not pie in the sky to imagine other Korean companies following suit.
Plus there is an abundance of cash waiting to be invested in Korea, seemingly over 1,000 trillion won (nearly 1,000 billion dollars). At the same time, the Bank of Korea will probably continue with its accommodative monetary policy.
All these factors should boost the market in the coming years.
Our positioning
In recent months, we have increased Korean stocks in our allocations. We have invested and/or increased our positions in BGF Retail, AmorePacific, Samsung Electronics, Orion, LG Household and Healthcare, Hyundai Mobis and KT&G.
In Korea, as everywhere else, we look for companies with sustainable competitive advantages, strong growth prospects and below-average cyclicity.
Even if profitability ratios are lower than elsewhere, we do our utmost to invest in companies which generate a higher-than-average return on equity (not including idle cash) with positive net cash flow. Good examples are companies like BGF Retail (the leading convenience store chain in Korea), Orion (Asian leader in confectionery market) and KT&G (the leading cigarette and red ginseng manufacturer and distributor in Korea).
* A set of family-controlled companies with complex cross-shareholdings. These conglomerates have close relationships with the government and often receive favourable treatment from it. In the past these businesses have rarely acted in the best interests of their minority shareholders.