Korean Small-Caps Punch Above Their Weight by Liliana Castillo Dearth and Oliver Lee, AllianceBernstein.

South Korea’s cultural exports are spreading around the globe. While the country’s corporate landscape is dominated by huge conglomerates, we think small-cap companies stand to benefit most from the world’s growing fascination with all things Korean. It might be time for investors to take a closer look.

The Economist magazine recently called Korea “Asia’s foremost trendsetter.” From smartphones to soap operas and from pop music to plastic surgery, consumers across the region—and beyond—can’t seem to get enough “Korean cool.”

So how can global investors join the party? We think the best way to gain exposure to the Korean phenomenon is through local small-cap companies. On recent trips to Seoul, we met with executives from several innovative small firms that produce a variety of in-demand consumer products, and we found that business is booming. In fact, small-cap valuations are at a premium. But profitability has steadily improved (it’s been on the decline at the big Korean conglomerates), and we think there’s plenty of room for further gains.

Overlooked and Underappreciated

Global investors have largely overlooked Korea’s small-caps. Foreigners own less than 6% of Korean small-cap stocks (Display), compared to 31% of large-cap conglomerates, which dominate Korea’s Kospi stock index.

Korean Small-Caps

Much of this can be chalked up to neglect. Small-caps get less attention from analysts—on average, three per stock, compared to 19 for the average large-cap Korean stock. But this neglect affords intrepid investors the chance to add value by capitalizing on growth potential that the broader market has overlooked.

Sitting Pretty with K-Beauty

Many Korean small-caps are behind the products that are gaining popularity and market share around the globe. Korean cosmetics and skincare products, for instance, have become a sought-after commodity—especially in Asia, where they are associated with glamorous Korean actresses and pop stars.

Chinese tourists in particular are huge buyers, snapping up creams and makeup at duty-free shops around Korea. For investors, exposure to the Korean companies provides a way to tap into Chinese millennials’ spending habits. Indeed, Chinese per capita spending on cosmetics has grown six times since 1999, according to Euromonitor International, and looks poised to grow more as the disposal incomes of China’s young female professionals rises.

But we think Korea’s manufacturers are also well-positioned to take a bigger share of the mainland Chinese cosmetics market, which Japanese bank Nomura estimates could be worth $76.2 billion by 2024. That would make it one-and-a-half times larger than the US cosmetics market and almost three times bigger than Japan’s.

Bigger Stake in US Market

Korean cosmetic makers seem to be making strides in the US market as well, largely on the strength of “beauty balms,” also known as BB cream, an innovative, all-in-one skincare and makeup hybrid that combines moisturizer, concealer and sunblock.

In fact, Korean cosmetics are so popular that cosmetics companies around the world are commissioning Korean manufacturers to supply their products to them for sale under their own brand names. This is particularly common in China.

Innovations for Young and Old

Korea today is also home to a booming medical tourism industry, driven mostly by Asian millennials in pursuit of celebrity good looks. That’s helped local pharmaceutical companies to develop new products such as a plant-based, Botox-like drug. These products are already hits in the Korean market, and we believe that many of them could see sales increase exponentially if they gain approval to enter the US, European and other markets.

Companies are also making strides in other medical technologies and products that we expect will appeal to the growing number of aging consumers in markets around the world. Innovations such as using herbal extracts in supplements to treat menopausal symptoms have already helped these products secure sizable shares of the Korean market. Approval to enter markets abroad could unlock global growth.

Finding compelling growth opportunities these days can be a challenge. In Korean small-caps, investors may find a surprising number of companies that are poised to grow—and are punching well above their weight.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Liliana Castillo Dearth (pictured) is Team Leader and Portfolio Manager for the International Discovery Equity Portfolio and Oliver Lee is a Senior Research Analyst, both at AllianceBernstein.