Is it now safe to buy South Korean stocks?

Finally, the day came when Donald Trump and Kim Jong-un met in Singapore. It seems to have gone pretty well, resulting in an agreement to work towards removing nuclear weapons from the Korean peninsula, and a commitment from Trump to suspend all US military exercises in South Korea. South Korean stocks look pretty cheap. Is it safe to buy them again?

A lot of politicians and the media have been carping about the summit between the US and North Korean leaders. They say Kim is a nasty dictator that shouldn’t receive such privileges as getting to sit down with a US president. But what would they prefer, a nasty dictator with nuclear weapons or a nasty dictator without nuclear weapons? Anyone with even an inch of brain would say the latter.

Of course, this is just a first step that agreed some general intentions. There’s much detail to work out and, as my Dad might say, “there’s many a slip ‘twixt cup and lip”.

But, at the very least, there’s now a real possibility that the US and North Korea can put the past behind them and have a less mutually-threatening relationship. It’s good news for North Korea’s neighbours as well – South Korea, China and Russia – which have also been working to calm things down.

Perhaps bizarrely, South Korean stocks actually fell on the day of the summit meeting. The iShares MSCI South Korea ETF (NYSE:EWY) was down 1.1% on Tuesday. Go figure.

As long-time readers will know, I recommended South Korean stocks back in June 2015. But, two years later the tensions between the US and North Korea were escalating severely. So I recommended pulling out in July 2017 and taking a 24% profit (see here).

Under a year later, there’s been a dramatic turnaround in relations. Doomsday has been averted. Is it now safe to buy South Korean stocks again?

The latest developments are certainly positive, but I’d like to see some concrete actions before sounding the “all clear” sirens. In the meantime, here’s an update on where the market stands.

The MSCI Korea Index still looks on the cheap side. At the end of May, it had a price-to-earnings (P/E) ratio of 9.9, price-to-book (P/B) ratio of 1.1 and dividend yield of 1.9%. That dividend yield is about the same as the S&P 500 index. But the P/E is just 40% of the US index and the P/B is 32%.

However, that’s still a relatively modest dividend yield. Even more than in other markets like the US, investors in South Korean stocks are likely to make most of their profits from capital gains over time, as company profits grow and/or the valuation multiples expand upwards from their relatively low levels.

The EWY ETF tracks a modified index called the MSCI Korea 25/50 Index. This limits any individual stock to less than 25% of the index. It also puts a limit of 50% the sum of all stocks that are each more than 5% of the index. The idea of the 25/50 indices is to improve diversification in concentrated markets.

This is relevant in South Korea, since Samsung Electronics makes up 28% of the unmodified index. Currently, EWY has 21% exposure to Samsung Electronics. I’m not certain why that’s so far below 25%, but it may be that the rule has been applied across other companies within the overall Samsung web of companies (known as a chaebol in South Korea).

I counted eight other stocks among EWY’s holdings that started with the name Samsung. But, including Samsung Electronics, these holdings added up to 28%. So it’s not entirely clear what’s going on here, other than to say Samsung Electronics alone is down from 28% to 21%. Overall, EWY’s valuation ratios are similar to the unmodified country index.

South Korea is highly advanced in terms of industry and technology. For example, I remember in the late ‘90s when it was at the head of the race to adopt the internet, leaving the US and Europe for dust.

Is South Korea a developed market or an emerging one? Views are split on this, at least between leading index providers. FTSE classified the country as developed way back in 2009, but MSCI still counts it as emerging.

Personally, I think South Korea should be thought of as a developed market. GDP per capita, at current exchange rates, was US$30,000 last year. That’s a fifth less than Japan but 6% ahead of Spain.

On a purchasing power parity (PPP) basis, which adjusts for local price levels, GDP per capita was US$39,000 last year, just ahead of New Zealand and only around 10% behind the UK, France and Japan. (For more details about the country, see the earlier article.)

With the improving relations between North Korea and other relevant parties – mainly meaning South Korea, the US and China – should you buy South Korean stocks?

Given the relative cheapness of the market, it’s certainly tempting. Perhaps it’s worth dipping in a toe already. But I’d recommend waiting for more concrete progress before making it a substantial position.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.