For a long time, Korean businesses have shown a weak level of corporate governance and inefficient balance sheets. Companies’ profitability has been weak leading to an important valuation discount. Mr Moon’s election as President of South Korea last year raised hopes for improvements in both corporate governance and the geopolitical situation (see 06/06/2017 article: “What's so interesting about the Korean market?”). Now, after more than a year of his presidency, what are the indications?

Signs of improvement in corporate governance initiated by the two biggest Korean groups

Some progress in corporate governance is evident: Samsung Electronics is continuing to improve the treatment of its shareholders via share buybacks as well as increasing its dividend. The annual dividend has risen from KRW 420/share in 2015 to KRW 850/share in 2017 and is expected to climb to over KRW 1,430/share in 2018 – an increase of 340% in 3 years. At the same time, share buybacks have escalated, from 5,057 billion won in 2015, to 7,971 billion in 2016 and 9,296 billion in 2017, for a total sum of KRW 22,324 billion (over US$20 billion).

In the last two years, the share price has almost doubled, buoyed by robust prices for DRAM chips, of which Samsung is the world's leading supplier. It is also notable that the principal buyer of Samsung shares in recent years has been the company itself via its massive share-buyback programme while investors have been net sellers of the share. Consequently, the share tends to be under-held by the market (see graph) and is still very weakly valued despite the company doubling its profits in two years.

Samsung Electronics net buying breakdown

Source: WISEfn, Mirae Asset Daewoo

Also worth noting is the fact that the company recently increased the number of independent directors on its board. This represents a real advance in terms of corporate governance.

Following Samsung's lead, it was likely that Korea’s second-biggest group, Hyundai, would also embark on reforms. This is a work in progress. The company has already announced that it intends to simplify its complex shareholding structure in response to demands from the government and investors who are calling for a reorganisation to more transparent holding company structures. It is engaged in various actions to unwind the cross-shareholding structures between the group’s entities, which give the Chung family excessive power to the detriment of other shareholders. The activist fund, Elliott, has seen the value in this and taken a billion-dollar stake in several of the group’s companies like Hyundai Motor, Kia and Hyundai Mobis. Through its position as principal investor, Elliott will ramp up pressure on the directors and other stakeholders regarding governance issues and put forward proposals to improve the treatment of shareholders. Elliott is seeking the return of more than 12 trillion won to shareholders, mainly via dividend increases and the cancellation of treasury shares.

However, corporate governance in Korea is not going to be improved overnight. It will take time, but it is not inconceivable that the country will follow the example of Japan which embarked on this process a few years ago (see Steve Glod's 24/04/2015 article: “Investing in Japan – An emerging interest in corporate governance”). Now that the example has been set by the biggest two groups (Samsung and Hyundai), it is likely that other companies will follow suit.

Korea’s corporate governance will get more interesting this year as local institutions will have to fully adopt stewardship code. We already note a 47% increase in proxy vote exercise rate this season and a doubling of dissent rate in the seven largest domestic asset managers, something that could certainly get things moving.

Improving corporate profitability at attractive valuations

The fact is that investors are still rather sceptical about any significant change in corporate governance in Korea, despite the recent rise in profitability ratios. The valuation multiples of Korean companies are still bumping along the bottom at around 9 times estimated profits (see graphs).

Korea forward P/E

Source: CLSA

Korea: ROE

Source: Bloomberg, HSBC

Korean companies currently have huge amounts of cash on their balance sheets. This cash cannot be used and therefore contributes to driving down the companies’ profitability. By increasing share buybacks or cancelling treasury shares, as well as raising dividends, the companies’ balance sheets could be optimised and profitability levels would improve. If ROE increased, the multiples would go up too, narrowing the Korean market discount.

The following graph is a good illustration of how ROE influences valuation multiples in Asia. Note that between 2011 and 2015, the decline in ROE caused valuation multiples to contract. Inversely, an improvement in profitability levels like that seen since 2016 could lead to multiples increasing.

PB following the ROE trend

Source: HSBC, Thomson Reuters Datastream

As mentioned previously, the Korea discount is due to a number of factors:

• Poor corporate governance
• Very low dividend yields
• Inefficiency in terms of profitability
• Shareholder structures characterised by cross-shareholdings giving control to the founding families even though they do not have majority shareholdings.

North Korea opening up?

Another reason for the Korea discount is also the fact that the two Koreas are still virtually at war. An armistice has been signed by China, North Korea’s main ally, and the United Nations (UN). But not by South Korea... Which means that no peace treaty has actually been signed and that the two parts of Korea are still officially at war with each other. For 65 years, the two countries have theoretically lived in fear of the conflict flaring up again.

But over the last few months, the big surprise from the peninsula has undoubtedly been North Korea intensifying its efforts towards opening up. The change of tone at a diplomatic level is certainly very striking. Although it is too early to predict an improvement in the geopolitical situation, the economic benefits that would be generated by the northern neighbour opening up cannot be ignored. Just think of the prospects for the construction and infrastructure sector. If road or rail links became accessible from the south, that would reduce distribution costs and facilitate access to Russia and China. Consumer staples sectors (food, drinks, home cleaning products, etc.) would also benefit and eventually so too would the discretionary consumer sector (TVs, domestic appliances, computers, cars, etc.). Korean food industry experts predict that North Korea could be the new El Dorado for South Korean food and beverage companies and revitalise their growth. Given that the North Koreans share the same language and have the same tastes and preferences as their southern counterparts, consumer staples companies will see significant potential there.

Naturally therefore, any sign of rapprochement between the two countries could also contribute to reducing the risk premium and hence the Korea discount.

Numerous challenges

However, all has not been rosy in Korea since Mr Moon stepped up to power. The recent 16% increase in the minimum wage and the introduction of a 52-hour limit on the working week have had an undesirable effect, negatively impacting the incomes of the poorest households, which could ultimately hit growth in domestic consumption. In the first quarter of 2018, the government was also forced to recognise the biggest increase in income inequality ever seen in a single quarter.

Another consideration is that for North Korea, the sole lever of negotiation is nuclear weapons. It is unrealistic to expect Kim Jong Un to give up permanently his only leverage before any concession from the US, especially as the country has spent decades achieving it. A deal with the United States to lift sanctions in return for complete, verifiable and irreversible dismantling of its nuclear weapons programme would be acutely asymmetrical given the reversal of Iran deal, a stark reminder that an immediate and irreversible denuclearization leaves Kim and his regime vulnerable to a fate similar to Libya or Iran.

Lastly, we note that the recent threats of increasing protectionism worldwide could damage Korea since exports account for half its GDP.

About our management

In the BL-Equities Asia fund, we do not base our investment decisions on macroeconomic or geopolitical criteria. But obviously, we are not insensible to the value of improvements in corporate governance or profitability. We have therefore been encouraged to conduct more detailed research on Korean companies most likely to benefit from these changes. In terms of the potential for better shareholder returns, we have identified Samsung Electronics (see above), car equipment manufacturer Hyundai Mobis, cigarette manufacturer and distributor KT&G, and the leading instant noodles manufacturer Nongshim.

As regards companies already in our portfolio that could benefit from North Korea opening up, we note cosmetics leaders AmorePacific and LG Household & Healthcare as well as food sector businesses like Orion, Nongshim and Binggrae.

Another important consideration is the fact that these companies present sustainable competitive advantages due to their brands, cutting-edge technology or powerful distribution networks. This results in strong cash flow generation and very (even excessively) solid balance sheets.

Outlook

In the current context of generally high valuation multiples for equities, Korean companies still offer a discount and are trading at significantly lower multiples than the average for other companies worldwide. At the same time, their profits and return on equity are clearly improving. This discount could narrow in the future if the current trend to an improvement in corporate governance, greater transparency and better treatment of minority shareholders continues. It is also worth noting that if diplomatic relations with North Korea continue to thaw, this will only hasten an increase in the valuation multiples of Korean companies.