Korea’s bellwether Kospi index recently hit an all-time high. Yet Korea is considered to be among the cheapest markets anywhere in the world among OCED countries, and possibly the cheapest in Asia. But all that might be about to change, according to CLSA.
How will the valuation gap close?
The Hong Kong-based investment bank, upbeat about the recent political changes, has set a target of 4000 for the Kospi by 2022, reflecting annual shareholder returns of 15%.
“We've had the first presidential impeachment, the arrest of the country's biggest chaebol heir and the arrest of the head of the NPS (National Pension Service). This could be the beginning of a widespread cleaning up of politics, corporate governance and capital allocation,” Stuart Thompson wrote in a recent newsletter. “And if you are optimistic you could conclude that it is the beginning of the end of the Korea discount!”
“Having seen predictions of the demise of this discount for 15 years or so I mention this again with a great degree of trepidation. But the reality is that each year we get a bit closer to it happening,” he added.
CLSA believes it is not just the election of President Moon Jae-in that has changed things. In fact, the events that led to his appointment “reflect a shift in attitudes with regards to a population increasingly frustrated with the nation's stewardship,” the bank said, alluding to a popular revolt that led to the impeachment of President Park Geun-hye on corruption charges.
Park is accused of extracting donations from family-controlled business conglomerates, called chaebols, such as Samsung, Hyundai and Lotte, and faces prosecution. Alongside, Samsung’s heir apparent, Lee Jae-yong, was arrested on bribery and other charges linked to Park’s foundations.
The regime change also is expected to bring to the fore President Moon’s reformist proposals. He has pledged to reform the corporate governance structure of chaebols and strengthen minority shareholder rights. “The two most important rules under discussion are multi-derivative lawsuits and cumulative votes. But ultimately it is the culture change that is more important,” CLSA observed.
Korea Kospi and capital allocation
CLSA’s expectation of high returns in Korea is based on a number of reasons, among them a low base and low valuations compared to its own history and in comparison with other markets. More than half of listed stocks trade below book, which is one of the highest figures in the world, according to the bank. But above all, its optimism arises from inefficient capital allocation.
“We believe that is where the biggest source of opportunities lies. We recommend that investors buy companies that have a good core business,” the bank said. It cited as examples those with high ROIC and high margin that are also cash-generative but remain undervalued due to poor capital-allocation decisions.
“The key is to essentially find the next Samsung Electronics, a company that has the capacity to carry out more shareholder-friendly measures and become a better capital allocator,” the bank said.
CLSA recommends two set of companies to investors. The first consists of companies that can unlock significant value by raising low payouts and “fixing lazy balance sheets.” These are (in order of their market cap) Hyundai Motor, KT&G, KT, Kangwon Land, Hanssem, KCC, Nongshim, Com2us, GKL and GS Home Shopping.
The second set consists of five companies whose restructuring of business lines will create value for shareholders. These are LG Chem, E-mart, Hyosung, Hanwha Techwin and Hana Tour.
“If we are right then the coming three to five years will see a steady improvement in domestic confidence. This in turn should drive renewed investment, consumption and accelerating domestic equity fund flows (the ultimate benchmark of a nation's confidence in itself and its corporates' profit potential). In aggregate, this will drive a long-overdue market rerating.”
Finally, activism is not easy in Korea, but with the right valuations and climate, Elliott Management type funds could join the crusade.