Barron's: 12/17/2012
South Korea was that rare developed nation to avoid falling into recession during the global financial crisis, yet such resilience hasn't endeared the world's 11th largest economy to investors. Today, the Korean stock market is among the cheapest on the planet, trading at just nine times 2012 profits—well below 13 times for the Asia Pacific, or multiples of 10.4 for China, 14.1 for Japan, and 14.6 for India.
Blame that steep discount on outdated perceptions. Despite an improving domestic economy, Korea still can't shake its reputation for being a deeply cyclical market hitched to foreigners' appetite for the gadgets and cars it exports. Companies can seem clueless about courting investors, who are further put off by the complex ownership structures of the chaebols, or conglomerate groups. Geographically, South Korea is overshadowed by China to the west and Japan to the east (not to mention that missile-hoarding neighbor to its north). A cumbersome exchange rate, with 1,074 Korean won to each dollar, isn't winning fans.
But things are changing. "What made Korea cyclical was excessive leverage," notes Citigroup Asian strategist Markus Rosgen; net debt to equity, once as high as 300%, meant that interest expenses often wiped out earnings when the global economy slowed. But by late 2011, Korean companies had whittled average leverage down to 44%, and earnings volatility has gone from 180% higher than the regional average to 20% lower. Since 2005, in fact, per-share earnings there have been less volatile year-over-year than, say, Singapore, Malaysia, the Philippines, or Hong Kong. Yet investors haven't given it credit, and valuation multiples haven't expanded much.
Korean companies also can do much more to reward shareholders. Their 14% dividend-payout ratio is among the world's stingiest and could rise to 27% if Korea were to merely catch its regional peers. "Internationalization of the shareholder base will lead to changes in behavior," Rosgen argues, but more important is the country's rapidly aging population. Between 2000 and 2020, the ratio of young to old in Korea, which Rosgen generously defines as those younger than 65 to those older, will shrink from 12.6 to just 5.4. That will become among the worst in Asia, and could persuade companies to pay more dividends to attract and appease investors.
Meanwhile, Korea continues to benefit from Asia's burgeoning middle class. Even before the Korean rapper PSY's Gangnam Style video snagged nearly a billion views to become YouTube's most-watched video, the country's cultural profile was rising. These days, affluent Chinese think nothing of hopping on the two-hour flight connecting Shanghai and Seoul for a weekend of recreational shopping and marathon karaoke. In November, Korean exports grew 3.9% year-over-year, lifted by an 11% bump in exports to China and a 29% jump in exports to Southeast Asia. At 3%, the unemployment rate is among the lowest in Asia, and inflation is tame at about 1.6%. Not surprisingly, investors are expanding their focus from big exporters to domestic consumer plays.
Barclays Capital sees Korean economic growth accelerating to 3% in 2013 from 2.2% this year. The currency could strengthen slightly with rebounding electronics exports and the won's growing safe-harbor status, which helps locals' buying power. Yet expectations for Korea's stock market remain muted, since strategists are reluctant to pencil in multiple expansion before the global economy has stabilized. Chanik Park, Barclays' Seoul-based equity strategist, sees more inbound visitors and thinks index provider MSCI could reclassify Korea to developed-market status. But the firm's 2013 target for the Kospi is just 2200, a mere 11% above recent levels near 1978.
More-optimistic longer-term investors who see better days ahead for Korean stocks might consider exchange-traded funds like iShares MSCI South Korea (ticker: EWY) or the consumer-heavy First Trust South Korea AlphaDEX (FKO). Barclays suggests a "barbell" strategy featuring profitable exporters like LG Display(034220.Korea) and Samsung Electronics (005930.Korea), as well as defensive domestic picks like Hyundai Home Shopping (057050.Korea), Lotte Shopping(023530.Korea), and the casino operator Paradise (034230.Korea).
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