South Korean stocks have been trading mostly sideways in recent months, seemingly looking for a trigger, as per the long-term chart of the country’s KOSPI 200 Index (INDEXKRX:KOSPI200) below.

Kospi 200 google chart Korean Stocks

Lately, a pattern of higher bottoms appears to be signaling the emergence of buying interest at market lows.

South Korean president Park Geun-hye is looking to restructure the country’s economy and reduce its reliance on exports, deregulate the financial markets and provide a boost to small and medium industries. She plans to unfetter service-oriented industry and help small business play a greater role in the economy through higher job creation.

Global investors have always appreciated economies that take recourse to such restructuring reforms.

A recent investing idea from Ori Eyal, Managing Partner, Emerging Value Capital Management LLC says South Korean preferred stocks offered a unique opportunity. Quoting at a discount of 50-70% to their common stock counterparts, Korean preferred stocks are a totally different beast compared to those in the US, and in fact are very closely similar to equities. With their cheap pricing, dividend payouts and the prospect of a reduction in the discount in the coming years Korean preferred stocks are a highly attractive investment proposition.

It may be noted that Baupost, run by legendary investor Seth Klarman, has a portfolio that includes a 6% component in South Korean equities.

Are South Korean stocks a buy? How do their valuations stack up in the context of their earnings record over the long term?

Korean stocks and the Shiller CAPE ratio

A research note dated March 17, 2014 issued by Samsung Securities analyst Dongyoung Kim examines the valuation of the Korean stock market using Robert Shiller’s cyclically-adjusted price-earnings ratio (CAPE).

The CAPE ratio analyzes valuation by using inflation-adjusted average trailing earnings over the previous 10 years.

Methodology of the kCape (Korean CAPE)

The Kospi 200 is Korea’s version of the S&P 500 (INDEXSP:.INX) – comprising of the country’s 200 biggest stocks ranked by market capitalization.

kCAPE = Kospi 200 levels / 8-year average of Kospi 200 EPS

[Index and EPS inflation-adjusted; EPS based on last four quarters of reported earnings]

Correlation of kCAPE with returns

“The kCAPE has generally displayed a high negative correlation with long-term returns—ie, investments made when the kCAPE was high generated low 8-year average returns, and vice versa,” observes Dongyoung.

This is reflected in the chart below.

2-kcape-returns Korean Stocks

Current valuation of Korean stocks via kCAPE

The analyst observes that as at March 2014, the kCAPE stands at 13.6x. This is low considering that the 25-year average is 16.9x and the average post-2000 is 17x.

3-historical Korean Stocks

Given the high negative correlation between the returns and kCAPE, it makes sense to buy into this market when the kCAPE is ruling low by historical standards.

“Over the long term, investing in the market at this level would have paid a positive annual return, based on the correlation between kCAPE and returns since 1990—or an even rosier plus-5% based on the post-2000 correlation,” says the note. “In short, we believe the Korean market provides a good entry point for long-term investors at current levels.”