It’s not a good time to be an investor in emerging markets.
The threat of the end of quantitative easing (QE) in the US has sparked a rush out of the sector, as investors’ appetite for risk collapses. The slowdown in China isn’t helping.
However, the fact is that many ‘emerging’ markets are in better condition than the average developed country. If you’re a long-term investor, and you can stomach some volatility, there are already a few decent bargains to be had.
One Asian country in particular looks a good bet – South Korea…
South Korea – not your average emerging market
South Korea is part of the MSCI Emerging World Index. In other words, it’s classed as an emerging market. However, in reality, it’s little different to most developed countries.
The country has inflation-adjusted GDP of $32,272 per person, according to the International Monetary Fund. That makes it richer than Spain, Italy or New Zealand.
It also has a far more open economy than many developed nations. According to the Heritage Foundation’s Index of Economic Freedom, it has a score of 70.3. This makes it ‘freer’ than Belgium and France.
Most importantly, it has very low levels of government debt. Indeed, total state debt only amounts to 35% of GDP. And the government is planning to raise more funds by selling off liquid state assets, such as its stake in the shipbuilding industry.
This prudence means the government is in a position to be able to boost spending to help compensate for any slowdown in China. That’s an option that many other Asian countries don’t have.
Of course, national debt is about a lot more than just a country’s outstanding bonds. There is also the question of hidden liabilities, such as pensions. There are also potential liabilities – one classic example being the banking sector. If a country agrees to stand behind its banking sector in a crisis, then it’s a mistake to ignore banks’ balance sheets if you want to get a true picture of its financial strength.
But South Korea scores well on both of these points. Unlike most countries, its state pension system is backed by investments, rather than just funded out of immediate contributions (as is the case in most UK public sector schemes).
Seoul also has taken steps to strengthen the banking system and slash the kind of hidden liabilities that are still weighing on Europe. For example, two years ago, it took the bold step of shutting down a number of dodgy savings banks.
In the short run it meant that the state deposit insurance fund had to pay out to nearly 90,000 savers. However, large savers were made to take substantial losses. This tough action was aimed at making sure that both savers and bankers got the message that the state was not going to write a blank cheque to bail out their mistakes.
As well as closing down problem banks before they grow into even bigger problems, South Korea has tried to reduce the amounts that banks borrow and lend in dollars. Again, this is aimed at making the banking system more stable, by reducing its dependence on foreign money, and its vulnerability to exchange rate risk.
The currency wars won’t derail South Korea
Another factor that will help South Korea is the strong performance of its export sector, especially in exporting to the US. This has come under pressure recently from Japan’s campaign to weaken the yen. But it would be a mistake to write off Korean exporters simply because of a bit of competition from Japan. South Korea has more going for it than a weak currency.
While a free trade deal with the US was signed in 2007, it only came into force last year. This removed tariffs on most Korean goods, with the remaining restrictions due to be phased out over ten years. This is important because Korean firms had previously encountered resistance in key industries.
At the same time, South Korean firms have done well from changing consumer tastes. For instance, the electronics firm Samsung has seen demand for its smartphones surge – it’s one of the main reasons that Apple has had such a tough year.
And going back to the currency front, the Korean won has recently started falling again against the dollar. Overall, exports to the US have already grown by 20% since last year.
As well as boosting demand, strong links with the US will also make Korea less dependent on China and Japan. This will reduce the impact of both the falling yen and the slowdown in China.
South Korea’s problem neighbour
So South Korea has plenty of things going for it. Yet it is as cheap, or even cheaper, than most Asian markets. The price-to-book ratio measures what you could get (in theory) if you bought a stock or index, then sold all the underlying assets of the company or companies involved. If p/b is below one, then you are effectively saying that the company is worth more dead than alive.
South Korea trades on a p/b of 1.03. In other words, its shares are valued at just 3% more than you could technically get by liquidating the lot. This makes it better value than Hong Kong (27% above book), Japan (43% above), and Malaysia (a whopping 129%).
South Korea does, of course, suffer from the presence of its anti-social neighbour to the north. Investors are terrified of the potential for Korean ‘reunification’, or a war in the region. So there’s always going to be an element of political risk discount in the price. But even so, the scale of the discount to its peers seems unreasonably large.
So how do you invest? You could use an exchange-traded fund, but it’s worth remembering that the Kospi benchmark index is very heavily dominated by Samsung. The truth is, you’d almost be as well to just buy Samsung shares as to track the Kospi.
A more interesting, albeit risky, option is the Weiss Korean Opportunity Fund (AIM: WKOF). This AIM-listed fund invests in the preference shares of Korean companies. Preference shares (or ‘prefs’) are halfway between bonds and regular shares. Like bonds, they receive a fixed payment (in the form of a dividend) and enjoy a claim on the company’s assets in the case of a bankruptcy.
However, since they are riskier than regular bonds (they come below conventional bonds in the pecking order if a company goes bust), they tend to behave more like stocks. This means that, over the long-term, while they are more volatile than bonds, they also tend to have higher returns. And right now, Ian Barrass of the Henderson Value Trust thinks that Korean prefs are significantly undervalued compared to ordinary shares, and so could have a lot more room to rise from here.
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