One Emerging Market To Buy

by James Gruber

Emerging market, really?
Challenges today
2014 economic outlook
Long-term powerhouse
Valuations stack up
Potential risks

Investors can’t bail fast enough on emerging markets at the moment. And rightly so, given the potential for further problems as I highlighted in last week’s post, Emerging Market Banking Crises Are Next. But the indiscriminate sell-off of emerging markets also opens up some potential opportunities. Asia Confidential thinks South Korea stands out as one such opportunity.

South Korea isn’t really an emerging market though. It’s a US$1.1 trillion economy, the 15th largest in the world. With populations above 50 million, the economy ranks 7th globally. Nonetheless, those in charge of indices such as MSCI still classify South Korea as an emerging market. Which should make you question the entire notion of “emerging markets”, as I do.

That aside, South Korea has tremendous long-term prospects. It’s an open economy with a robust democracy. It’s a world-class manufacturer which has every chance of becoming the next Germany. It has a highly educated and hard working labor force. Unlike its former coloniser, Japan, it’s shown the ability to adapt and reinvent itself. And importantly, the prospect of reunification with North Korea in the not-too distant future would prove a tremendous boon for the South and drive an unprecedented investment boom.

The short-term outlook is bright too. Unlike many other emerging markets, South Korea runs a current account surplus and therefore isn’t vulnerable to capital outflows from QE tapering. It also never had the credit boom that other Asian countries experienced. Significantly, it’s highly exposed, via exports, to economic recoveries in the US and Europe (the latter being more dubious than the former).

To top it off, South Korea is the cheapest country in Asia with a 2014 price to earnings ratio (PER) of just 8.8x. There are a number of world-class companies in South Korea trading at just 6x earnings. Bargains in plain sight, you might say.

Emerging market, really?
To get a sense of the long-term opportunity, it’s important to understand a brief bit of history. South Korea tends to get lost in the headlines of much larger neighbours, China and Japan. Only the threat of North Korean conflict or music poking fun at rich people (Gangnam style) occasionally breaks this trend. But the success story of South Korea is on par with its neighbours.

As many of you would know, South Korea was brutally occupied by Japan from 1910-1945. Post-World War Two, it was split into North and South Korea by the US and Soviet Union. The Cold War was the central driver to the Korean War soon after. The 1953 armistice signed at the conclusion of the war split the peninsula along a demilitarised zone. Technically, South and North Korea are still at war. Some 2 million troops patrol the demilitarised zone, making it the most heavily-guarded border in the world.

Fast forward to 1961 and the rise of Park Ching-hee to the leadership. Chung-hee is known for being the most important ruler in South Korea’s history.

When he came to power, South Korea’s GDP per capita was just US$72. Needless to say, a very poor country. Chung-hee drove South Korea into the modern age with often brutal efficiency. He did this through export-led industrialisation and oversaw the creation of the now-famous conglomerates known as chaebol. Along with Hong Kong, Singapore and Taiwan, South Korea became known as one of the four “Asian Tiger” economies.

During the 1970s though, economic growth slowed as the investment-led model ran out of steam. And resentment grew towards Chung-hee’s authoritarian rule. The President was subsequently assassinated in 1979.

South Korea recovered and, along with many other Asian countries, experienced rapid growth in the early-to-mid 1990s. When exploding foreign debts led to the collapse of Asian currencies, South Korea had to go to the IMF for a record US$58 billion bail-out package. This was humiliating to a proud nation.

South Korea handled the Asian crisis in a very different way to other countries, however. People in countries elsewhere moved their money to the Cayman Islands for protection. In contrast, South Koreans banded together, determined to pay off the debts. People queued up for hours to donate jewelry to the cause.

Unlike a number of other Asian countries, South Korea also let companies fail instead of bailing them out. Some 40% of the biggest companies were allowed to go under. This included multinationals such as Daewoo. Staggeringly, the IMF debt was repaid by 2001 and South Korea’s economy was back on track.

South Korea’s adaptability under dire circumstances stands in stark contrast to others. Its once colonial master, Japan, hasn’t shown the same attributes since 1990. And Taiwan, another former Japan colony, has also failed to remake itself post the crisis.

From 1998, the chaebol brought in professional managers to oversee operations, while the founding families retained control over strategic decisions. They moved fast to build plants in China to give them a low-cast labor advantage. They outspent rivals on research and development. And they weren’t afraid to expand abroad and take on the big boys.

Hyundai is a case in point. It first entered the North American car market in 1986. Funnily enough, its cars initially met with some success as Americans mistook them for Honda cars (they had similar logos). Post that, Hyundai’s cars became a bit of a joke, known for poor design and numerous quality issues.

Instead of retreating though, Hyundai doubled down. In 1998, it offered a ten-year warranty, more than twice its competitors. The move was laughed at by many. By it proved a game-changer for the company and the industry.

In 2005, Hyundai opened its first American plant in Alabama. US competitors dismissed the move, given the enormous problems they were having with high-cost union labor forces in Detroit at the time. The difference was that Hyundai didn’t have these same labor issues. And the plant has now become one of the most efficient in the US.

Turn to today and Hyundai is one of the world’s top-5 car companies. Though it’s certainly not the only South Korean company to have proved itself on the world stage.

Challenges today
South Korea does resemble some other emerging markets in one respect: it relies extensively on an export-led economic model. Exports account for 56% of GDP. And chaebols account for 82% of GDP.

It’s obvious that the country needs to become less reliant on exports and look to the next drivers of economic growth. Those drivers are likely to come from the still undeveloped services sector.

South Korea’s leaders realise the urgency of the task. Recently, President Park Guen-hye (daughter of Park Chung-hee) outlined her so-called 474 plan: 4% economic growth, 70% employment rate and average per-capita income of US$40,000.

Simply put, the plan involves the following:

• Shift tax benefits from chaebol manufacturers to start-ups
• Rein in state-owned enterprises
• Provide support to venture capital
• Cut back on regulations in a variety of sectors including health and education to promote competition
• Incentivise employers to hire more young people and women

This isn’t the first time that South Korea has tried to reduce its reliance on exports. In the early 2000s, it granted tax breaks to credit card users in order to spur domestic spending. Predictably, consumers got carried away and delinquencies on credit cards reached 30%. Companies had to be bailed out and economic growth stalled by 2003.

Corporate deleveraging and government restrictions on business borrowing since the 1997 crisis have also encourage bank lending to households. That borrowing has mostly found its way into real estate. Consequently, household debt has grown about 2x GDP since the crisis. And household debt in South Korea is now around 150% of household disposable incomes.

The risks from this debt are limited though. More than 70% of the debt is owed by the top two quintiles by income, which have twice as many assets as debt. Also, South Korea has imposed strict 40% loan-to-value ratios on property purchases. Finally, the central bank has forced some lenders to write off 40% of the value of personal loans, reducing the risks of a consumer debt bust.

However, the challenges of rebalancing the economy and finding new sources of growth remain. Given its track record of adaptability, Asia Confidential is confident that South Korea can reinvent itself again.

2014 economic outlook
So what about the short-term outlook for the economy? Here, the prospects seem reasonable.

Unlike many emerging markets, South Korea consistently runs current account surpluses and therefore isn’t susceptible to capital outflows from QE tapering. It also hasn’t had a credit boom over the past 3-4 years and thus isn’t vulnerable to a hangover on this front.

Prospects for growth look ok too. South Korea’s still large dependence on exports may play in its favour as the country is geared to any recovery in the US and EU. While on paper the US and EU only account for 20% of Korean exports, the number is actually much larger as these are the ultimate destinations for the bulk of Korean exports to emerging markets.

South Korean exports to the US and EU bottomed in 2012 and have steadily improved. Bank of America Merrill Lynch forecasts 8% growth in exports to the US and EU in 2014.

South Korea is highly correlated to US growth. Every 100 basis point change in US GDP growth impacts South Korean GDP growth by 80 basis points.

In addition, deflationary fears in South Korea appear misguided. Inflation is likely to return to the 2% level this year after bottoming at 1.3% last year. Signs of rising inflation can be seen in core inflation, which rose almost 3% quarter-on-quarter, in seasonally-adjusted terms, over the last several months. Any rate hikes though aren’t likely until the end of the year, at the earliest.

Lastly, the housing market is showing signs of life after five years in the doldrums. Transaction volumes and prices improved in the second half of last year. Volumes could reach 80,000 units/month in the first half, the third-highest level since 2008. That said, high household debt should limit the extent of the property recovery.

In sum, the near-term outlook isn’t outstanding. But it’s better than most.

Long-term powerhouse
The long-term prospects for South Korea look brighter, for three reasons:

1. Its already world-class companies are likely to move aggressively up value chains to find new niches to dominate. South Korea is well known for its cars and electronics. It’s also found success in less sexy industries such as shipbuilding too. The top three global shipbuilders are from South Korea. I not only expect continued gains in these type of industries, but new ones too. A highly educated workforce, high investment in R&D and a proven ability to compete and adapt should ensure this.
2. The aim to boost service industries should pay dividends and provide the next leg of growth for South Korea. Skeptics will point to South Korean historical failures on this front. But it’s increasingly clear that South Korea realises the risks of the country being left behind if it doesn’t rebalance the economy.
3. The real potential kicker is North Korea. Yes, North Korea is exceedingly poor but it has a disciplined population of 24 million and immense natural resources. Put this together with South Korea’s capital pool and management capability and you have an irresistible combination. It would likely produce an investment bonanza of unprecedented proportions. South Korea is already preparing for unification by keeping its debt low to absorb the huge costs in rebuilding the North. Note also, the President is pushing for unification, recently saying:

“Unification will allow the Korean economy to take a fresh leap forward and inject great vitality and energy. People would even sing “We dream of unification in our dreams”".

If I’m right about the bright long-term prospects for South Korea, the so-called “Korean discount” should fade. For the uninitiated, markets continue to impose a discount on the valuation of South Korean stocks given the often murky operating structures and financials of the large companies.

This view is somewhat outdated given the substantial improvements in business structures and accounting over the past decade. Further improvements should eventually see the discount disappear, providing further upside to Korean stocks.

Valuations stack up
Price is ultimately what matters with any investment. And on this front, South Korea looks attractive. It’s the cheapest market in Asia, trading at just 8.8x this year’s earnings, a 24% discount to Asia ex-Japan’s 11.6x PER. Consensus forecasts 13% earnings growth in 2014, versus 12% for the Asian region.

If you dig a little more, there are some exceedingly cheap valuations for world-class companies. For instance, Kia Motors is trading at 5.9x 2014 PER. Samsung Electronics is also priced at just 6.9x earnings.

Some of the domestically-focused large caps are also priced at levels not seen in other markets. For instance, KB Financial, a consumer bank, trades at a 40% discount to tangible book value (net asset value, in other words). Yes, return on equity at KB Financial is a low 6% but if this improves from abnormally depressed levels, then the discount to book value should diminish too.

Potential risks
No investment is without risks and these risks need to weighed against the potential rewards. I see three key risks for South Korean stocks:

1. Any recovery stalls in developed markets. The US recovery is painfully slow, but it’s better than elsewhere. Particularly the EU, where deflationary risks remain. If economies in these regions lurch downward again, South Korea would be disproportionately impacted.
2. The yen is also a big risk. Regular readers will know that I foresee a much lower yen in the medium term given the Abe government’s insane money printing policies. Given a lower yen, Japanese exporters are expected to provide much stiffer competition to their South Korean counterparts going forward.
3. The obvious long-term risk is North Korea. A messy and violent reunification with the South would seriously dent future economic prospects.

In my view, the first and second risks are already partially if not fully factored into South Korean valuations. If these things don’t eventuate, or not to the extent envisaged, then the upside for stocks is pretty clear.

AC Speed Read

- South Korea stands out as a buying opportunity amid the indiscriminate emerging markets sell-off.

- The country’s short-term economic prospects are positive given its sound financial position reduces risks from QE tapering. Also, its export-led economy has significant exposure to the US recovery.

- Long-term, South Korea manufacturing prowess could turn it into the next Germany. There’s also the prospect of reunification with North Korea, which would prove an investment boon to the South.

- Valuations are cheap as well, with South Korea trading on just 8.8x 2014 earnings. World-class companies such as Kia are priced at just 6x earnings.

- Potential risks include a slowdown in developed market economies and a lower yen making Japanese exporters more competitive vis-a-vis their South Korean counterparts.

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