Korean shares tend to trade at lower valuations than their peers in other Asian markets. But Korea is cheap for a reason. Cris Sholto Heaton examines the truth behind the 'Korean Discount', and explains why it makes sense to steer clear for now.
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.
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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 shareholdersas 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.
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Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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