Why North Korea-South Korea deal would boost investor outlook
South Korean equities continue to look cheap compared to Asian peers and fund managers are bullish, but how would reunification affect their investment case?
Friday marked the first time a North Korean leader had set foot across the Military Demarcation Line and into South Korea since the Korean War in 1953. The historic meeting between Kim Jong-un and Moon Jae-in culminated in an agreement from both sides to work to de-nuclearise the Korean Peninsula.
But what of the investment case for South Korea? The country’s stock market accounts for 15 per cent of the MSCI Emerging Markets Index and 17.5 per cent of the MSCI Asia Pacific ex Japan Index. Its largest constituent, Samsung Electronics is the second largest firm in both indices.
The Morningstar Korea Index is one of the best-performing year-to-date, up 2.34 per cent. The KOSPI Index is currently 38 per cent up from its early 2016 low.
The economy continues to improve. It’s now the third-largest in South East Asia and in the three months to September 2017 its economy grew by 1.5 per cent, its best rate of growth since the second quarter of 2010.
Clearly any thawing of tensions between the two sides would be welcome. But that’s unlikely to alter the investment case for the country, according to fund managers. What is driving increased confidence in South Korea is changes to corporate governance practises.
Korean stocks fail to deliver dividends
South Korea has long traded on cheap valuation multiples compared to its neighbours, partly as a result of political tensions but more pertinently because of historically poor governance at many chaebols – Korea’s big, family run business empires.
The Korean market has the lowest payout ratio of any major stock market in the world – at around 24 per cent - despite its companies being highly cash rich. "A lack of effective oversight has allowed company managers to simply hold cash back from shareholders," says James Syme, manager of UK-based JOHCM Global Emerging Markets Opportunities Fund.
But that’s changing. The current Liberal government has introduced a stewardship code, meaning reforms similar to those occurring in Japan are improving the environment for shareholders. Chaebols, or Korean large industrial conglomerates, are coming under increasing pressure to up their dividend payout ratios.
These reforms worked in Japan, boosting valuations on those firms that bought into the code, says Ben Surtees, manager of the UK-based Jupiter Asian Fund. "Like in Japan, I’m confident the code will also force many Korean companies to relinquish their poor governance practises, which should help improve valuations," he adds.
Syme says these reforms are needed, as the ageing population in Korea means income is needed more than ever, resulting in the lack of dividends becoming a growing issue in Korean politics.
However, he doesn’t dismiss the potential benefits reunification could have on the long-term economic outlook. Drawing on the example of East and West Germany coming together, he notes that it could be negative in the short term.
However, North Korea has many attractive traits for South Korean firms to draw on, including a large pool of cheap labour that is keen to work. It could also open up trade routes from Seoul to Beijing and through to Moscow and the Middle East.
Surtees concludes: "The short-term consequences would be an extremely bitter pill to swallow for South Koreans and investors alike. But in much the same way that Germany now dominates Europe, Korea could occupy a similar position in Asia in the future."
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David Brenchley is a reporter for Morningstar UK.
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