Investors should drown out the noise surrounding neighbouring North Korea and look at the improving fundamentals in the Korean market, according to several fund managers.
There has been much written and said about the increasing tensions between North Korea and the US, with many fearing that South Korea could be caught up in military actions.
However, despite the rhetoric, investors looking for cheap, quality stocks with improving fundamentals should look to take advantage of the negative sentiment towards the Korean market.
In spite of the gloomy headlines, the MSCI Korea market has risen by 21.79 per cent this year, beating the wider MSCI Emerging Markets index by 4.1 percentage points and placing it among the best emerging market countries.
Performance of indices over YTD
Source: FE Analytics
William Lam, manager of the five FE Crown-rated Invesco Perpetual Asian fund, said: “This is the surprise, the Korean equity market is currently trading higher than it was at the end of May – in local currency terms – although percentage gains have recently been reduced to low single digits.
“The market has sold-off on negative headlines, but as before weakness has been short-lived. South Korea has lagged the broader region in recent months, but this may be as much to do with concerns over some of the new government’s populist policies.
“It is also worth remembering that South Korea is still one of the best performing markets in Asia so far this year.
Korea is the largest overweight position in the £1.5bn fund, representing 20.5 per cent of the portfolio, compared with a 14.6 per cent weighting for MSCI Emerging Market index.
One reason for his confidence in the market is that Korean equities remain cheap compared to other markets in the index despite its strong run this year, as the below shows.
Price-to-book of Korean equities vs Asia Pacific and Japan average since 2000
Source: Invesco Perpetual
As, the chart above shows, Korean equities trade at a discount relative to other Asian equities, with Lam describing the gap as “too big”.
“Part of the discount is due to geopolitical risk, which is fair,” he said. “However, most of it is due to Korea’s reputation for poor corporate governance – and low dividend payout ratios.”
However, Gary Greenberg, head of Hermes Emerging Markets and manager of the £2bn, five crown-rated Hermes Global Emerging Markets fund said that this perceptions are beginning to change.
Indeed, he noted that Korea comes out near the top of his top-down analysis thanks to the change in corporate governance that is being undertaken.
“It looks like it has got corporate governance change for the better which should translate into better valuations and Korea is cheap compared to the rest of emerging markets because its governance is worse,” the manager said.
“If that improves over the next three or four years then return on equity should also improve and if the return on equity improves then the market should support a higher multiple.
Jacob Mitchell, manager of the £1.2bn Antipodes Global fund, added that this corporate governance drive has paid dividends to minority shareholders this year.
Traditionally, companies have been run by what is known as the ‘chaebols’ – family-owned or conglomerate structures that have largely been left to run companies how they see fit, he noted.
“There has been an unhealthy closeness between chaebol-owned businesses and the government and that has allowed those family-run companies to do two things that have been detrimental to minority shareholders,” Mitchell said.
While these companies have been “operationally first rate”, these owners have mismanaged balance sheets and expanded into areas that have not been in the best interests of minority shareholders.
“The fact that you are as a minority investing alongside a family is often a good thing but where it hasn’t worked so well is simply the propensity for these companies to hoard cash/capital and not run efficient balance sheets,” the Antipodes manager said.
“The second aspect is occasionally they have also done things in terms of capital allocation decisions that have not been minority shareholder friendly. Diversification decisions that haven’t been focused,” he added.
An example of this is Hyundai Motors, which he said operationally has been “excellent”, but has demonstrated both of the above traits: hoarding cash and then diversifying in a “pretty unhelpful manner”.
However, there is growing optimism that this behaviour could change, with the government becoming more independent and less in tune with these chaebol-owned businesses.
“The types of politicians that are being elected are positioning themselves much more independently of those powerful families and pushing policies that are in some ways holding these families to account,” he said.
This includes calling for more progressive capital management policies and pressuring these families to unwind some of the circularity in their corporate structures which has allowed the family to maximise their control.
In the Antipodes flagship global fund, Mitchell has a 10.1 per cent position in Korean equities – the same weighting it has to the US market.
Australian fund house Antipodes recently launched an Ucits version of the fund last month with £95m in assets, opening up the strategy for retail investors.
“At the stock level Korea is an interest market simply because you have got some very strong companies that are still quite cheap,” he said.
One of its largest holdings is Samsung Electronics, which Mitchell said is a good example of this change in corporate governance.
The headlines surrounding the company have been largely negative, with the chairman on life support and his son and vice chairman embroiled in serious corruption charges.
However, the board, which is beginning to be run more independently, has decided to run a much more aggressive payout policy which it has already put in place.
As such, the company is up 42.29 per cent so far this year, though Mitchell sees further potential for the stock.
Performance of stock over YTD
Source: Google Finance
“A company that we have owned over the last couple of years that has done very well for us is Samsung Electronics. Even that stock after the big run that it has had is not expensive for the quality of company that it is,” he noted.
However, Hermes’ Greenberg is underweight the country despite the top-down fundamentals looking positive.
“Buying a company where governance might improve is a little harder than saying top down that it looks pretty good,” he said.
“So you want to be confident that the governance is going to improve or find a company where it doesn’t really make that much difference – the business is just great but undervalued. That’s where we struggle a little bit.
“We have a few names there and we may have another idea but in Korea it is either thematic and they will pay any price or its very low quality and it is cheap. It is hard to find those in-between. We have a few but if we could find more bottom up we have a bigger weight there.”