Royce Funds: South Korea's Compelling Value Stocks

South Korea’s Influence on Asia is Hard to Ignore

Q&A with Jim Harvey and Dilip Badlani Last updated August 04, 2014

What is it about the South Korean market that you find so compelling?

Dilip Badlani: Korea has always been an interesting market for us. It’s a very deep market for micro-caps—there are approximately 500 companies with market caps between $100 million and $1 billion.

On top of that, a lot of these companies are unlevered—half of these companies have asset-to-equity ratios of 50% or more, which is what we typically look for. The country is easily accessible for us and we have great coverage from the sell side, which helps us to identify companies that meet our investment requirements and high standards.

Jim Harvey: It’s always good when we can screen a market that has this much depth because it typically leads to a robust schedule of meetings with company management teams.

Seoul is one of the least convenient cities to navigate because of its sheer size, so arranging an itinerary there can be tricky. But like many of the other Asian markets we visit, companies are perfectly willing to meet with us. While there are some exceptions, management teams are, for the most part, open to speaking with foreign investors.

Dilip: As a country, what’s impressive to us about Korea is how it’s evolved. In the 1980s it was largely a manufacturing center, and though it is still heavily concentrated in manufacturing, a lot of it has shifted to high tech.

A lot of these Korean companies have become global leaders that supply the likes of Samsung, LG, Hyundai—these iconic brands that everybody knows.

Many of these companies have manufacturing capacity everywhere around the world, and as these larger companies grow these Korean suppliers follow them around and are able to provide them with niche products for their specific needs.

Jim: The Korean government was a big advocate of Korea’s tech influence. Eugene Technology, for instance, basically got its start during the Asian financial crisis when the Korean government was making a push for the big tech players to source more from smaller companies in the country.

Dilip: Korean GDP per capita is amongst the highest in Asia—it’s a trillion-dollar economy, and unlike a lot of other countries it runs a current account surplus. So fiscally the country looks well managed. And most Korean companies, because of the history of the country, are export focused.

South Korea is the seventh-largest exporter in the world, with exports making up roughly half of the country’s GDP.

Korean GDP per capita is amongst the highest in Asia—it’s a trillion-dollar company, and unlike a lot of other countries they run a current account surplus.

Jim: The Korea Composite Stock Price Index (KOSPI) is very sensitive to the global economy: A lot of U.S. strategists look at it as a leading indicator of global growth.

Dilip: There are a decent amount of exports from Korea within Asia, and I think most investors fail to appreciate that.

As demand in these countries has grown, Korea has been able to provide the same quality of product that a lot of Japanese companies used to produce. What Korea has done in the span of 30 years has been pretty impressive.

Can you talk a little bit more about Korea’s influence on other Asian markets?

Dilip: Like many other Asian populations, Korea’s demographics have been a real challenge to the economy. The birth rate has really shrunk—it’s among the lowest birth rates around the world.

Jim: This happened partially because the government promoted smaller families in the 1970s and ‘80s. In addition, South Koreans place a huge emphasis on education.

As is typically the case in any developed country with a focus on education and its costs, people have fewer children.

Dilip: As the economy has matured, the number of children being born has declined significantly, which reduces internal consumption.

As a result, the country is forced to target markets such as India and the Philippines because that’s where demand is growing—it’s an intelligent way to play the overall Asian demand story. But it’s definitely a worry for the country.

You’ve had some success with Korean Health Care companies in International Micro-Cap’s portfolio in the past, specifically pharmaceuticals. Is there any current exposure to the sector?

Jim: We’ve enjoyed success with a few Korean Health Care stocks in the past—we just recently sold our shares of Samjin Pharmaceutical, which made a strong contribution to first-half performance. We also owned Daewoong Pharmaceutical, which was the second-largest contributor to 2012 performance. But as of June 2014 we do not hold any Health Care stocks in the portfolio.

Dilip: Unique to the market, a lot of the healthcare companies from the U.S. and Europe have to partner with a Korean company to sell their drugs in the country—they are not allowed to go in directly.

Right now we’re not seeing anything compelling in our valuation range. Typically, we have looked for and owned services companies within the industry—the marketers and distributors—not the companies producing the drugs.

There are a decent amount of exports from Korea within Asia, and I think most investors fail to appreciate that. As demand in these countries has grown, Korea has been able to provide the same quality of product that a lot of Japanese companies used to produce. What Korea has done in the span of 30 years has been pretty impressive.

Tell us about some of the companies you visited.

Dilip: On this last trip we met with 15-20 companies. Eugene Technology, which Jim mentioned earlier, is a very well-run semiconductor equipment supplier located about an hour outside of Seoul that focuses on semiconductor capital equipment.

Jim: The company had a 10-year sales compound annual growth rate of 48%, so we were able to buy a growth company at a value multiple when we discovered it.

The founder was head of Korean sales for Teradyne and Brooks Automation, two companies that we know very well because they’ve been held for several years in some of our domestic Funds here at Royce.

The company’s main competitive advantage is that its cost structure is lower than that of its global competitors—in particular, Eugene’s R&D spend is lower than other large global players because, as a small company, it has fewer product lines.

Eugene Technology provides unique thin-film deposition equipment. One of its products utilizes low pressure CVD technology.

Management believes the total addressable market for this type of equipment is $1 billion, and they are targeting a 10% market share. The company also manufactures atomic layer deposition equipment, which is a $500 million market. Eugene’s share is only 6% today.

Dilip: This is a business where paying attention to cost is very important. This was our first visit with the company. Just going to its site and seeing how it operates eliminated any doubt we had about management’s focus on profitability.

Jim: It’s basically a nimble, second supplier to the market, usually behind a company like Applied Materials. When we met with management they described a project that took two to three years to develop internally based on a technology called epitaxy.

Today, Applied Materials is the only supplier of that kind of equipment. Eugene’s product was just rolled out and the firm is targeting a 10% market share.

Dilip: Another name we picked up on this trip was textile manufacturer Huvis Corporation. This is a classic value stock trading below book value that pays a dividend.

Textiles is a tough industry, but Huvis is the market leader in a low margin niche. It generates decent returns on invested capital by being the lowest cost player in the industry. And because the industry is so competitive there’s no new capacity coming on board.

Jim: The stock has been down recently. We view it as a low-risk business model that we think, given the valuation, will eventually turn around.

Dilip: Korea also has a big shipbuilding industry—it makes some of the best, biggest ships in the world. So for the LNG (liquefied natural gas) buildup that’s happening globally, a large percentage of the ships are being built in Korea.

We recently bought shares of a company called HanKuk Carbon, which makes the insulation for the ships carrying LNG. It’s one of only two companies that are certified to provide insulation equipment—its competitor is another Korean company.

So it’s pretty remarkable that you have an industry being built around only two companies that can currently supply the insulation equipment. We think HanKuk will be a beneficiary of the global LNG build out, where demand is only likely to increase.

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