I’ve been on a strict diet of cabbage for the last few days – and not because I’ve been caught up in a weight-loss fad. It’s just that I’m in South Korea (Korea), where fermented cabbage known as kimchi is a side dish to almost every meal you order. And to be honest, I’ve grown a little tired of the taste.
Still, despite its fondness for a vegetable that many Westerners would associate with deprivation, this is certainly not a backward country. In fact, Korea might seem like the most high-tech society on the planet, with wifi access available almost everywhere across Seoul. And its transport network puts Britain to shame, with the gleaming airport train station being perhaps the most futuristic-looking terminal I’ve seen anywhere.
But, just like the modern side of Shanghai that I discussed last week, this doesn’t tell the whole story. Despite excellent physical connections, in many ways Korea remains a curiously detached country.
A tough market for outsiders
Korea is a difficult market for non-Koreans to understand. It’s self-contained to a surprising degree. The country earned the nickname of the Hermit Kingdom for its isolationist policy during the 1700s and 1800s and some of the mindset still seems to exist. That’s not to imply that Koreans are personally unwelcoming to foreigners today; far from it. But on a business level, there is a strong anti-foreigner undertone.
You’ll find some of the familiar global names here, such as the inevitable Starbucks coffee shops. But it’s tough going in many other areas. Multinational consumer companies such as Proctor & Gamble and Johnson & Johnson seem to have much less traction in this market than most developed countries.
In banking, only Asia specialist Standard Chartered is a frequent sight on the streets. And the establishment very clearly doesn’t want too much foreign influence. Take the long-running saga of Korea Exchange Bank as an example. After the bank was bankrupted during the Asian crisis, US private equity group Lone Star was allowed to buy a majority stake. In 2008, it tried to sell this to HSBC for a very substantial profit.
But the regulator squashed the deal. Strong rumours circulated that the government had decided that Lone Star would only ever be allowed to exit to a Korean buyer. Few were surprised when a sale was finally announced at the end of last year with the buyer being the homegrown Hana Financial Group.
Meanwhile, tariffs and other barriers help keep foreign goods out, to the benefit of Korean firms. It took almost two years for Apple to get the iPhone approved for sale here – although once it arrived, it proved a huge hit with consumers and forced incumbents Samsung and LG to slash their extremely high local prices.
What drives development?
All the same, Korea matters to emerging market investors, because it’s a member of a very exclusive club. If I asked you to guess how many countries have gone from poverty to fully developed in the post-war era, you might be surprised at the answer: just four.
They are Hong Kong, Singapore, Taiwan (where I’ll be in the next few days) and Korea. That’s it. Germany and Japan underwent similarly rapid growth, but that was redevelopment following war devastation. It’s a pretty shocking rate of return on decades of global development efforts.
The successes have some things in common: notably an early focus on using their one major asset – cheap labour – for relentless export growth. What they did not have is democracy; in fact, Korea and Taiwan had very repressive military regimes for much of their highest growth phase.
But all did have quite clear property ownership, in that title over land and assets was relatively unambiguous. That contrasts with many developing countries, where the question of who owns a specific plot of land is often unanswerable. Peruvian economist Hernando de Soto reckons this is crucial to development. It encourages investment, allows the sale of assets and enables borrowing against them to fund development.
This is a topic I’ll write about in a future issue, since it may help spotlight which of the current crop of fast-growth economies will be able to make the same leap. However, within many Korean circles, much credit gets given to something more specific to the country – and that in the long run I believe is bad for investors’ prospects.
This, of course, is the chaebol – the family-run business groups that are a special feature of its economy. Some of these names are internationally famous – Samsung, LG and Hyundai foremost among them. Others such as SK, Lotte and Hanwha have lower profiles but are enormous players locally.
It can be hard for Westerners to understand quite how sprawling these groups are. If it helps, imagine if Vodafone also ran an airline, BP made cars as well as sold fuel for them, and chipmaker ARM had an insurance subsidiary. Then note that each corporate group has multiple listed subsidiaries, all of which are ultimately controlled by a family-owned holding company though a nest of cross-shareholdings. And finally, you should know that Samsung, the biggest of the lot, accounts for around a fifth of the country’s exports. All told, the chaebol completely dominate both the economy and the stock market.
A strong comeback since the crisis
The chaebol arose through deliberate government policy – favoured businessmen were allowed to establish near-monopolies and fed cheap credit to encourage them to grow and export as much as possible. For a long while, this worked rather well. But it blew up spectacularly during the Asian crisis of the 1997-1998. Many of the chaebol were overleveraged and had diversified increasingly ineffectively; when the flow of credit dried up, many collapsed, including Daewoo, the second-largest.
Many of these loans came from outside Korea, both directly through US dollar loans and indirectly because the banking system had also funded itself on cheap credit. With the financial system imploding, Korea was forced to go the IMF for help.
In a country so proudly independent and recently successful, this was a huge humiliation, far greater than the recent European crises or even Britain’s own bail-out in the 1970s. One of the most striking images from the Asian crisis was the Korean public lining up to donate their jewellery and ornaments to buoy the country’s gold reserves.
Still, Korea recovered strongly – and while many of the chaebol went bust, plenty survived. And despite attracting a lot of criticism for being too unwieldy for the modern world, the best ones have done well of late.
Samsung and LG have successfully built international brands for their consumer electronics businesses. And Hyundai’s car division has shown the kind of focus that now-faltering Toyota used to achieve. Even an avowed hater of automakers like me considered investing in it a year ago. The chart below suggests I should have followed my instincts.
(Share price in won)
I’m unclear what will happen to the Korean economy in the long run. Key sectors such as shipbuilding and electronics will inevitably be drawn more and more towards China. And I’m not convinced the big firms have the mindset that will let them shift up the value chain and stay ahead of rivals in China and elsewhere who will try to outcompete them on price.
Meanwhile, the clout of the chaebol is one of the factors – together with militant labour unions and high levels of bureaucracy – that are often blamed for stifling the growth of smaller, more innovative companies that could perhaps help take Korea in new directions.
But that’s a problem for the future. My standing aversion to the Korean stock market is based on a more immediate issue.
Good for the country, but not for investors
While the North Korean situation gets more headlines, Korea’s other persistent problem is corporate governance. To be fair, some firms have made progress on this: LG has adopted a notably cleaner structure in recent years. But overall the corporate sector remains very troublesome, with businesses being run with little regard for minority shareholders.
And that long-running understanding between business and politics means that the government has little interest in changing this. Senior businessmen who commit serious offences are still generally pardoned after a couple of years, while recent regulatory moves seem to have all been in the wrong direction.
In particular, a proposal to allow chaebol to control substantial stakes in banks strikes me as an exceptionally awful move. The fact that families were not allowed to have an in-house bank to loot was one of the few good points during the Korean part of the Asian crisis (in contrast to, say, Indonesia) – although they still pulled plenty of other tricks such as using their insurance subsidiaries to support their other businesses by buying bonds issued by these.
Stock valuations reflect this. The infamous ‘Korean discount’ is the tendency of Korean firms to trade at lower price/earnings ratios than their peers in other countries. That sounds like they might be a value play. But in this case, low valuations don’t translate to good dividend yields, because there is absolutely no culture of rewarding shareholders for providing capital.
As an example, take Samsung Electronics. It trades on a p/e of 8.7 – but yields just 1.08%. LG Electronics trades on a p/e of 13.8 and yields 0.2%. Compare with the Taiwanese tech sector, and you can see the difference. There, Acer trades on a p/e of 10.5 and yields 5.1%. HTC shares have done very well and now trade on a p/e of 23 – but still yield 2.2%. Semiconductor foundry TSMC trades on a p/e of 11.3 and yields 4.2%.
Of course, if this were likely to change, Korea would look like a very interesting value play at current prices. And I suppose it could happen. But anyone thinking along those lines should be aware that the country is littered with the graves of Western activist investors who thought they could pressure management to alter their ways.
The best-looking sector
So are there any interesting niches in Korea? Well, one that’s long seemed interesting to me is cosmetics. An analyst once told me that the average Korean woman applies four different face creams every day. And when you see the profusion of beauty shops in Seoul, you can believe it.
Heavyweights include LG Household & Healthcare (KS:051900), a spin-off from the LG group that’s spent several years putting together acquisitions to become very well placed in the consumer staples area. It seems well run under a competent management, but on a p/e of 24 times consensus estimates for FY2011 and a yield of 0.7%, it’s not cheap compared with the market.
Perhaps more interesting is rival Amorepacific (KS:090430), a cosmetics specialist that may be able to build a good business in China over the long run. But again it’s not a bargain on a p/e of 21 times and a yield of 0.6%.
At the value end of the market, one manager suggested taking a look at Able C&C (KS:078520), whose Missha stores I saw everywhere on this trip, including in metro stations (see somewhat murky photo below). It trades on an estimated p/e of seven, although it is around 30 times smaller than LGH&H and Amorepacific with a market cap of just US$200m.
Unfortunately, none of these firms has an international listing and Korea is an awkward market to trade. (If you want to do it at reasonable-ish rates, it’s probably best to go through an Asian broker such as Singapore’s OCBC Securities or Hong Kong’s Boom Securities, rather than a UK one.) I don’t hold any of these shares at present, but might consider looking into Amorepacific in particular on a major sell-off.
But for most foreign investors, I think the main interest of Korea is that the index is high in cyclical companies and export-heavy. That makes it useful for trading shorter-term trends in the global economy, perhaps through an ETF such as the iShares MSCI Korea (LN:IKOR). However, I’ve never seen the appeal of Korea as a long-run investment. And my mind hasn’t changed in this trip.