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The Case for South Korea Is Not Just a Matter of Global Growth

Competition has taken a toll, but chaebol stocks with cash and cultural exporters may provide a lift.

If you ask investors about the investment rationale for Korean equities, many cite their acute sensitivity to global economic growth. Some investors warn, however, that this selling point of the Korean market is now in danger of disappearing — but they do not see this as a reason to abandon investment in the country. Crafting an appropriate strategy for Korean equities is certainly no longer as simple as it was, but investors say there are still good returns to be made.

The new situation is summed up by Joohee An, a Hong Kong–based portfolio manager at Mirae Asset Global Investments, the $63 billion Korean asset management firm. “If there’s a big inflow from the U.S. or Europe to Asia, most of it comes through ETFs [exchange-traded funds] these days,” An says. Index investing in Korea, she warns, will deliver a weak return, given the heavy presence of poorly performing companies in the index. For example, the KOSPI stock index is up only 1 percent since the beginning of the year. The alternative, she concludes, is that “we have to be bottom-up stock pickers.”

The traditional rationale was that Korea was suited for global recovery plays because it was top-heavy with capital goods manufacturers and steelmakers, whose earnings grew rapidly when global corporations decided it was time to invest in their own businesses in expectations of rising demand. With the International Monetary Fund predicting global gross domestic product growth of 4 percent next year, an acceleration from 3.4 percent this year, 2014 should have been a big year for the KOSPI.

Eng-Teck Tan, a Singapore-based senior portfolio manager for Asian equities at Japan’s $168 billion Nikko Asset Management, explains the skepticism over whether Korean corporate earnings will respond as they did in previous recoveries. “Historically, when global growth accelerated, Korea benefited,” he says. “This time I think it will be slightly different: Growth in Korea will be mediocre relative to global growth.” He cites the weakness of the yen, following Japanese prime minister Shinzo Abe’s policy of depreciating the currency, and the increasing skill of China and Taiwan in manufacturing industries that Korea used to dominate. “China and Taiwan are focusing much more on niches that are chipping away at the Korean export pie,” he says, pointing to Chinese shipbuilding.

Investors also argue that Korea’s consumer electronics makers, including Samsung, are losing their competitive edge in the important Chinese market, as local manufacturers improve.

One possible strategy is to invest in heavy-goods manufacturers whose struggles to keep up with the competition have pushed down valuations but that have the wherewithal to improve their positions. “We’re finding a lot of value in South Korea, mainly because there are a lot of inefficient balance sheets,” says Louis Lau, director of investments and member of the emerging-markets investment committee of $27 billion Brandes Investment Partners in San Diego. He notes that the chaebol structure of Korean big business — the networks of companies with cross-shareholdings, similar to the keiretsu that prevailed in Japan until the 1990s — paradoxically creates opportunities because of its very inefficiencies. Chaebol companies often hold lots of cash as reserves that can be used to bail out sister companies, rather than returning it to shareholders through higher dividends.

The Korean government is, however, trying to reduce this balance-sheet inefficiency by devising plans for a 10 percent tax on retained earnings, which may, say analysts, create shareholder value by boosting dividends.

Lau cites POSCO, the steelmaker, as a company that can create shareholder value through improved balance-sheet efficiency and the sale of noncore assets. He says these two characteristics explain why four of the top 11 holdings in the $1.5 billion Brandes Emerging Markets Fund I are in Korean companies, with 3.3 percent of the fund’s money in POSCO.

Other investors prefer moving out of hard exports altogether into Korean cultural exports. Mirae’s An notes that Korea’s international cultural imprint has grown in recent years because of soap operas such as Spring Waltz and singers like Psy, whose “Gangnam Style” pop video became the first YouTube clip to receive 1 billion views. These create a huge Asian market for Korean culture. An favors tourism-related stocks such as Hotel Shilla, which operates luxury hotels and duty-free stores selling Korean goods to tourists, and beauty-related companies such Amorepacific Corp., a Korean cosmetics company that has benefited from the glamour associated with Korean products.

An acknowledges that well-managed companies in these softer consumer sectors are not cheap, with forward price-earnings ratios for the coming 12 months of 20 and above. Hotel Shilla has a price-earnings multiple of 42. Her justification: “Emerging-markets investors should look at the long-term brands of companies. The leading companies in these sectors aren’t just Korean.”

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