Don’t invest in Korea – here’s why

If a bank asked police to investigate the head of its holding group for embezzlement and breach of trust, it would be a major shock in most markets.

But in Korea last week, this news knocked just 5% off banking group Shinhan Financial’s shares. And most analysts brushed off concerns over any long-term consequences for the firm.

It’s not clear whether the allegations are true or not. Some suggest they may be part of a management power struggle – as if that somehow makes the situation better.

But regardless of the rights and wrongs, this sort of thing is all too common in the strange world of Korean corporate governance.

And it’s something you need to be aware of before you even consider investing there…

Korea is cheap for a reason

If you’ve been investing in Asia for a while, you’ve probably heard of the “Korean discount”. Korean stocks tend to trade at lower valuations than their peers in other Asian markets.

As you can see below, the Korean discount is persistent and substantial. On both price/book (upper chart) and estimated price/earnings (lower chart), the Kospi index (the white line) is routinely cheaper than the MSCI Asia ex Japan regional benchmark (green line).

Why does this discount exist? Many outsiders put it down to fears over what the unpredictable North Korean regime might do. And this certainly plays a part, although the real threat from North Korea is often misunderstood. War is possible, but unlikely. The real worry is the enormous challenge that peace and eventual reunification would bring. Think of the cost of unifying East and West Germany, and multiply it many times over.

However, far more important than this is the question of corporate governance and the country’s peculiar corporate set-up. Almost all Korea’s major companies are not single firms, but are in fact multiple businesses with extensive cross-shareholdings. Each of these chaebol, as they’re known, is typically controlled by a single founding family.

The scale and reach of the chaebol surprises most outsiders. By far the largest is Samsung, which is controlled by the descendants of its founder, Lee Byung-chull. Westerners probably know it as an electronics firm. But the group is also involved in sectors such as construction, commodities trading, shipbuilding, insurance and retailing, to name but a few.

Samsung’s various subsidiaries account for around 20% of the Kospi index by market capitalisation. And if you invest in Korea through an exchange-traded fund (ETF) which tracks a large-cap benchmark such as the MSCI Korea, your exposure to Samsung is closer to 30%. Within Korea itself, you can even get ETFs that invest solely in the components of a specific chaebol. It’s no exaggeration to say that Samsung is at the heart of both the Korean economy and the market.


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Good business, bad investment

Many of the chaebol became overextended in the 1990s, then got into serious trouble during the Asian crisis in 1997-1998. The most famous internationally was Daewoo, but several others, known mostly in Korea, went under too.

The survivors spent the next few years cleaning up their balance sheets and cutting back. The best have evolved into tough global competitors in recent years. Samsung and LG are now major names in consumer electronics, while Hyundai is seen as one of the world’s most impressive carmakers.

Indeed, you can argue that the chaebol have made a big contribution to Korea’s transformation into an advanced economy over the last few decades.

The problem is that the benefits haven’t really filtered down to shareholders. Corporate governance in Korea remains poor, because the chaebol are basically immune to pressure from outsiders. This is what lies at the heart of the Korean discount.

The most obvious evidence of the chaebols’ contemptuous attitude towards shareholders is their record on paying dividends. Korean stocks might look good value on other measures, but their yields are pitiful. The Kospi trades on a trailing dividend yield of 1.35%. That’s even less than the 1.97% available on Japan’s Topix, a byword for corporate stinginess.

And you only need to look at the national pardoning jamboree that takes place every summer to see how acceptable corporate malfeasance is. To mark the end of World War II – known as National Liberation Day – the president grants a number of pardons.

Each year, business federations submit a list of contenders for absolution. This invariably includes heads of chaebols or other senior businessmen who would elsewhere be facing years behind bars. In Korea, many have their slates quickly wiped clean so that they can continue making ‘a contribution to the economy’.

Standards may be improving – but slowly

These issues always put me off investing in Korea. It can be a good market for a short-term trading view – it’s volatile, with a high-weighting to cyclical stocks.

But as a shareholder, you are supposed to be a part-owner of a business. I don’t like the idea of investing in firms where the management clearly regards minority shareholders as useful idiots.

To be fair, I’ve heard recently from some veteran Korea investors that standards are getting better. Some of the chaebol have cleaned up their structure – LG is usually cited as the one that’s made the biggest steps towards transparency.

Others have at least stopped diverting money into the chairman’s personal vanity projects. The process of handing over power to the next dynasty of the controlling family is sometimes being handled more carefully and professionally.

To me, most of these still seem like incremental improvements. But then, in a market where one early shareholder activist reputedly resorted to walking around shopping centres in a sandwich board asking for other minority investors to join him, any progress is likely to take time.

And there are some signs of a bigger shift occurring. Recently, the National Pension Service (NPS) said that it would cease being a passive investor and push its holdings to improve governance. The NPS is Korea’s biggest investor and it could certainly be a force for good. But for now, I’d prefer to wait for stronger evidence that attitudes are actually changing.

This article is from MoneyWeek Asia, a FREE weekly email of investment ideas and news every Monday from MoneyWeek magazine, covering the world’s fastest-developing and most exciting region. Sign up to MoneyWeek Asia here

11 Responses

  1. 14/09/2010, robert mciver wrote

    I have a Korean ETF which i bought for £1k, 2 weeks ago & it is up 2.8%. Do you think i would be better investing in another Asian market & could you possibly tell me how to gain exposure to the Mongolian market? Thanks

  2. 14/09/2010, Ian Faraday wrote

    The German re-unification almost bankrupted Germany because the rest of Europe sat back and didn’t lift a finger. If Korea would (hopefully) unify it undoubtedly would be propped up by the Americans and Japan. Read “Nothing to Envy” by Barbara Demick and you will get some idea of the ideological problems they are up against but worth it with a 24million market to exploit – be prepared.

  3. 14/09/2010, Cris Sholto Heaton wrote

    Robert, I’m afraid under UK regulations I can’t provide any individual advice on your investments. I can only give general investment commentary in MoneyWeek Asia (within Asia Investor, I can recommend specific stocks but can’t advise readers on their individual allocations)

    My personal view is that Korea is a useful trading market (eg, I said in March that it was interesting short-term due to export strength – it’s up a bit since then but actually not as much as I’d hoped). From a long-term view, it doesn’t appeal to me because of governance, which I think will limit value passed on to shareholders unless standards change.

    But whether you personally should buy or sell a Korea fund I can’t say – it depends on your goals, time horizon, ability to take risk, other investments etc. And obviously my view is one of many and you should take others into account, including perhaps consulting an independent financial adviser.

  4. 14/09/2010, Cris Sholto Heaton wrote

    As far as Mongolia goes, I don’t think there are any ways to invest yet (other than opening an account with a broker over there). There are a couple of foreign-listed companies in the mining sector with assets out there – Ivanhoe and South Gobi – but that’s not the same thing. It’s as much of a frontier market as you can still get – no major fund can invest directly yet because no global custodian bank has a branch yet there and so there’s no way that their assets can be held in safe custody. It’s something I’m keeping an eye on though.

    If any readers know of a way, please correct me on this.

  5. 14/09/2010, Cris Sholto Heaton wrote

    Ian, yes the opportunity that could come out of investing in North Korea after reunification or opening up would be substantial – initially as a low-cost manufacturing centre, which is happening to a limited extent already, quietly with regard to Chinese firms and others as well as the more high profile South Korean-invested special economic zone at Kaesong. The difficulty is separating that theme – I agree that there would be international assistance and investment but there would still be a huge cost to the South.

    (Just to be clear, I’d like to see North Korea free and Korea unified (if unification is ultimately what both sides want) – I’m not saying the appalling status quo should remain because of the financial costs – but the experience of Germany suggests it would have consequences that we can’t ignore from an investment point of view.)

  6. 15/09/2010, Winston wrote

    Interesting.. it’s like watching the discovery channel! : )

  7. 15/09/2010, DST wrote

    From memory, wasn’t there an article posted a couple of weeks ago on MoneyWeek telling us how good a place Korea was to invest?

  8. 15/09/2010, William Martin wrote

    as usual your article provide excellent insights to the scene in asia in a way that even I can understand.

    I don’t always comment on your articles, but I always read them and appreciate them. Please keep ‘em comin’.

  9. 16/09/2010, Cris Sholto Heaton wrote

    DST, yes, you may be thinking of this one from Louis Basenase: http://www.moneyweek.com/investments/stock-markets/seven-reasons-to-buy-into-south-korea-03504.aspx

    That’s a featured article rather than a MoneyWeek house view (and incidentally MoneyWeek Asia is my personal take, which is often different from the magazine as well). I disagree with it. If the Korea story was as good as he argues, I might forgive the bad governance, but the country has lots of issues (high private sector debt, tricky demographics and a difficult long-term competitive outlook). Or if it was genuinely extremely cheap, there could be value there regardless – but I don’t think it is.

    Of course, there are good investments there – it’s been a decent stockpicking market over time. But very few readers have the facilities in place to trade individual Korean stocks, so it make more sense for me to take a top-down view.

    Thanks Winston and William.

  10. 17/09/2010, JB wrote

    For exposure to Mongolia, you might have a look at Origo Partners (OPP.L), an AIM-listed private equity company that invests in China and the surrounding region. It has recently added to its investments in Mongolia, including with the launch of a joint venture with a local firm that will provide financing to companies looking to tap Mongolia’s huge natural resources.

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