Petra Korean Value Equity Strategy letter for the period ended September 30, 2015.
Dear Petra Investors,
Most of the global market was in disarray during the third quarter. Many investors pulled out of risky assets, especially stocks and currencies of emerging markets. Although Korea was no exception to this trend, it fared much better than other emerging countries as well as its own past. One example showing Korea’s relative stability is its recent currency movement. In our opinion, if similar magnitude of the market sell-off had occurred five years ago, the Korean won would have collapsed. In 2015, our Petra Korean Value Equity Strategy is up more than 6% year to date, while the Kospi is up 5.9% during the same period. Over the longer period, of course, our Petra Korean Value Equity Strategy has significantly outperformed the Korean index by a much bigger margin.
The performance of the Korean stock market has been poor this year but it has been even worse in U.S. dollar terms because of the depreciation of the Korean currency. While it is more difficult to value a currency than a stock, we think both have similar characteristics. Over the long term, a currency of a country with strong fundamentals and financial backup is likely to strengthen. But over the short term, currency movement is affected by various factors which are very difficult to predict. For the time being, the Korean currency is likely to move along with many other emerging market currencies and, therefore, will depreciate whenever global investors move to avoid so-called risky assets. But cheap currency is likely to boost Korean exports and ultimately help the current account balance and the export-oriented economy. As such, for the long term, the Korean currency is likely to strengthen considering Korea’s low government debt level and perennial current account surpluses. So, we are not too concerned about the current depreciation of the Korean won at this time.
The current global macro environment is one of the most uncertain times in our recent memory. For example, the recent market sell-off was triggered by the uncertainties surrounding the timing of the Fed’s expected rate hike. The consensus view is that although the Federal Reserve has delayed raising interest rates, it will eventually increase them because it believes that the recovery of the U.S. economy is on its course and the economy may get overheated without the Fed’s tightening. But many pundits agree that a small misjudgment by the Fed could bring back the economy into recession. On the other hand, some might argue that we are living in an era of global deflation. Prices are falling because the supply coming out of emerging markets far exceeds the demand that developed countries are trying to buoy through a series of massive QEs. Low interest rates in deflationary times might justify high equity valuation but falling revenues and profits do not bode well for the stock market. Whatever the outcome in the end, it seems unfathomable that the unprecedented monetary policy of quantitative easing would end without any side effects.
Another major driver in the global economy is China. China clearly has its own share of the problems. China’s extremely unbalanced economy, which is a direct result of the previous investment-led growth model, means that China will have no choice but to change itself to transition into the consumption-based economy regardless of the Chinese government’s directives. Of course, how smoothly it can transform will depend on how successfully the government can implement the appropriate policies. But if history is any guidance, we are afraid that the smooth transition will not be easy. In one way or another, this inevitable transition and the resulting slowdown will have a negative impact on the global economy, including Korea.
In such uncertain environment, the Korean stock market is likely to remain volatile for a while. Over the long term, however, the Korean economy is likely to be resilient given its strong fundamentals and financial backup. Further, the Korean stock market is likely to remain relatively unscathed because it is not currently overvalued unlike other major markets. In fact, Korea has been one of the cheapest markets in the world for several years. Of course, we are wise enough to know that predicting the macro will never be precise and making investment decisions based on macro factors is very dangerous. As a value investor, we realize that the tried-and-true best investment strategy in delivering a superior long-term investment result is to purchase those companies which can withstand the economic hardship and come out stronger in the end. This is the time when we should be disciplined to buy only competitive and undervalued companies.
Petra Korean Value Equity Strategy - Portfolio Positions Discussion
We have made little changes to our portfolio in this quarter because we continue to have high confidence in our portfolio even though the price of some of the stocks in our portfolio is still below the purchase price.
We have some winners despite the poor performance of the general market. The price of LG Chem Preferred rose significantly this year. We think the stock is still undervalued, considering the ongoing turnaround of the company’s core chemical business and the increasing competitiveness of its electric car battery business. In addition, we like the prospect that the price gap between preferred and common stocks is likely to narrow further in the near future. This is an extra option value for us.
The price of Korea Alcohol Industries, a manufacturer of organic chemical products, also moved up a lot this year. We think that the stock went up as the market began to recognize the value of its publicly-traded subsidiary, ENF Technology, a manufacturer of specialty chemicals for the IT industry. The stock price moved up even further because of the successful turnaround of Korea Alcohol Industries’ core business. This investment is a good example of taking advantage of a holding company discount in Korea.
We have some losers despite our confidence in those stocks. The stock price of Kumho Petrochemical, a major manufacturer of synthetic rubbers, synthetic resins and fine chemicals, went down significantly during this quarter. The stock slid because the much anticipated recovery of its synthetic rubber business has not been fully materialized. But we think the margin is likely to improve from the next quarter as the global demand for rubber is expected to increase. We believe that the market has overreacted to the slower-than-expected recovery in the synthetic rubber business. We also think the stock has upside potential because of its “hidden jewel” in the company’s combined heat and power (CHP) plant, which we conservatively value to be almost equal to the company’s current market cap.
The stock price of Samsung Electronics fell during the quarter because of its lackluster sales of smartphones. However, we think the stock is currently in undervalued territory because the market continues to overemphasize the waning profits of its smartphone business while ignoring the increasing competitiveness and profits of its semiconductor division. We believe that the market will eventually recognize the value of its outstanding semiconductor business. Given the current low valuation, we think the stock has room to rise significantly. Of course, we own Samsung Electronics Preferred because of the extra discount as in the case of LG Chem Preferred.
Jahwa Electronics is a manufacturer of Automatic Focus Actuators (AFAs) which are used in a high definition camera module of a smartphone. Mediocre sales of Samsung’s smartphones negatively affected Jahwa’s sales and stock price. At one point in August, after a precipitous fall in the stock price, the company’s market cap dropped close to the value of its cash holdings. Given the company’s competitiveness in the core technology and Samsung Electronics’ increasing emphasis on camera functions, we think Jahwa is quite undervalued despite its negative short-term outlook.
Hankook Tire is one of our major holdings. Therefore, its impact on our portfolio performance is larger than the percentage drop in the stock price. The stock price has suffered because of poor results in China. But we believe Hankook Tire is a globally-competitive company and its global market share is likely to expand substantially in the long run. We are confident that the recent setback is rather temporary in nature and the company is likely to grow again once its series of new capacity expansions are complete next year. It is probably the cheapest tire stock in the world at 8.2 times its earnings.
Petra Korean Value Equity Strategy - Investment Philosophy
Petra’s goal for investors is to preserve their capital and compound it at a satisfactory return with taking minimum risk for a long period of time. Investors often make the mistake of equating performance with skill. In some instances, a good investment strategy can produce poor performance and a bad investment strategy can produce good performance. Therefore, the real measure of successful investing is whether or not making investment decisions based on the same investment strategy can repeatedly produce satisfactory returns over the long term. We think investing is a matter of probabilities. As such, we would like to emphasize that we have achieved our returns without taking much risk. In other words, if we continue to do what we have been doing in the past, we are confident that we can generate superior returns over a long period of time. Of course, we may experience occasional underperformance from time to time. We always feel lucky to have patient, long-term minded investors as our clients as they have chosen to be in the same boat with Petra for a long journey.
Very truly yours,
Petra Capital Management
Albert H. Yong
Chan H. Lee