This country is “at war”, but you should invest

What do all of these things have in common? Samsung, LG, Daewoo, Hyundai, and Kia. All are major global brand names that come from South Korea, a small country of 49 million people that appears to dangle precariously between Japan and China. Officially it’s still at war with its communist Northern neighbour, although there’s been a ceasefire for 62 years. Nowadays South Korea is rich. But its stock market is currently a bargain.

Sixty five years ago this week, on 25th June 1950, the Korean War started. Hostilities lasted three years before a ceasefire was agreed. Soldiers from both sides still eye each other suspiciously across the “demilitarised zone” (DMZ) that separates the two Koreas.

Since the ceasefire, things have turned out very differently for the people on each side of the DMZ. Those stuck living under the communist yoke live in abject poverty. Meanwhile their capitalist southern neighbours have forged an industrial and technology powerhouse.

South Korea – more formally known as the Republic of Korea – has achieved remarkable things. Back in the ‘50s and ‘60s it was a low income country, on a par with other poor countries in Asia or Africa. But its tough and hard working people have made their home into a great Asian success story.

Nowadays it produces GDP per capita of US$35,400, at purchasing power parity (taking account of the cost of living). That’s just between the level of the UK (US$37,700) and Italy (US$34,500). Meanwhile it’s estimated that communist North Koreans still struggle by with GDP per capita of just US$1,800 a year.

If ever there is any question of the benefits of capitalism over communism, and its ability to lift people out of poverty, then the drastic difference in wealth and living standards between South and North Korea provides a clear and unequivocal answer.

According to the International Data Corporation (IDC), Samsung Electronics had the leading share of global smartphone sales in the first quarter of this year. It accounted for 25% against second placed Apple Inc’s 18%, and well ahead of third place Lenovo, with just 6%.

For its part, Hyundai-Kia is ranked fifth for global volumes of vehicle production, behind Toyota, General Motors, Volkswagen, and Nissan-Renault.

Clearly both Samsung and Hyundai have built impressive global businesses despite their relatively small home market. And their products are great quality as well. I’ll give you examples from personal experience.

A couple of years ago I bought an un-Korean Apple iPhone – at what I consider vast expense – just because it’s compatible with the Apple computer that I use. (Apple computers are also expensive, but since I use mine so much, and it works so well, I have no complaints.)

But I soon discovered that the iPhone had some annoying problems. It has trouble connecting to weak wifi signals where the equivalent Samsung phone has no problem.

I’ve sat with people in the same beach side restaurants and watched them happily read emails and browse the internet over wifi, using Samsung phones made in the same year as my iPhone. Meanwhile I couldn’t get a connection.

The iPhone also takes terrible photos and videos in low light, such as at my kids’ school shows. The Samsung’s pictures are excellent by comparison. These things are just my personal experiences, and later Apple phones may be better. I don’t know. But the point is that Samsung makes great stuff.

I’ve also owned a Korean car in the past. It was a big Hyundai for lugging around the family and all their kit, and going on holidays. The build quality was great, especially given that it cost around 40% less than equivalent European models. Needless to say I think the Koreans make some great stuff for the global middle classes.

Given the quality of Korean products, it should be no surprise then that the country is an export powerhouse. Last year South Korean exports totalled US$628 billion, making it the 6th largest exporting country in the world, despite its modest size. That’s only 12% behind 5th placed Japan, a country with over two and a half times as many people. It’s also 9% more than 7th placed France.

The country is a technology powerhouse too. I can remember in the late ‘90s and early 2000s that South Korea was way ahead of Europe and the US in how fast it adopted broadband internet.

According to an old research paper I dug up from 2003, 17% of South Koreans had access to broadband in December 2001. That compared with just 4% in the USA.

Nowadays the US and Europe have caught up to the Koreans in terms of connections, with pretty much everyone having internet access who wants it. But South Korea still comes first in the world in terms of the speed of its internet.

According to internet research firm Akamai, internet connections in South Korea are 40% faster than Japan and 55% faster than the USA. Also there are 170 fixed and mobile phone lines per 100 population. This is a highly connected country.

A few more factoids on the economy, so you get the picture. The government runs a small budget surplus, and public debt was just 34% of GDP at the end of 2014, according to the International Monetary Fund (IMF). Due to the large export earnings the country also had a current account surplus of $628 billion in 2014, or 5.5% of GDP.

Unemployment is a low 3.9% and inflation is just 0.5% against a target range of 2.5% to 3.5%. The OECD projects economic growth of 3% this year and 3.5% in 2016.

South Korea is clearly a highly advanced industrial and technological society. It also has a pretty big stock market. At the end of May the market capitalisation was US$1.4 trillion, according to the World Federation of Exchanges.

That’s equivalent to 94% of GDP, which is higher than the Netherlands. The point being that the Dutch invented stock trading way back in 1602 when they started buying and selling shares in the Dutch East India Company. The Korean stock market has only been around since 1956, but is large and liquid.

How to invest in South Korea

Now let’s get to the nub of the matter. Korean stocks. There’s some debate about how investors should view the South Korean stock market.

Index provider FTSE upgraded it to “developed market” status in 2009. Competing index provider MSCI still classifies South Korea as an “emerging market”, which implies a poorer country with less developed financial markets.

For my money – given its advanced industry, technological leadership and income levels – there’s no doubt that South Korea should be seen as a developed country.

If you invest in South Korea then you should include it in your allocation to developed markets and not emerging ones. It’s well ahead of middle income countries in Asia such as Thailand, China, or Indonesia – let alone poor ones like the Philippines and Vietnam.

Now here’s the really good news. South Korean stocks are cheap. At the end of May the MSCI Korea index had a price-to-book (P/B) ratio of 1. That means it’s trading at liquidation value, assuming all assets and liabilities in company accounts were reported at market values. But these are productive and profitable companies, and so they should easily trade at a premium to book value.

Based on last year’s earnings the P/E ratio is a reasonable 12.3, which falls to a modest 9.6 using projected 2015 earnings (MSCI figures). However, dividend yield is quite low, at only 1.4%. Investments in this market will be mainly for capital gains, and not for dividend income. South Korean companies continue to invest for growth.

The past track record has been strong. US$100 invested 15 years ago had grown to US$389 by the end of May this year (see chart below). That’s including dividends and before tax. It works out as 9.5% a year gross return, taking account of compounding (with profits on reinvested dividend income).

Total profits from the MSCI USA index were only 38% as much over the same time period (111% instead of 289%). Plus the US stock market is now extremely expensive, whereas South Korea is cheap.

From this starting point I’m confident that Korean stocks will continue to be much better investments than US stocks over the next 10 to 15 years. (See here, here and here for why US stocks are expensive.)

Over the shorter term the South Korean market is trading at the same level as it was in early 2011, measured in US dollars. Of course prices have gyrated up and down, but the overall result has been a sideways market for four and half years. In the meantime Korean companies have continued to grow.

That’s why there’s now a well priced opportunity to buy South Korean stocks. The underlying value of companies has grown but market prices haven’t reflected that growth. The next chart shows the MSCI Korea index over the past five years.

The easiest way to invest in the South Korean stock market is via the iShares MSCI South Korea Capped ETF (NYSE:EWY), which tracks the MSCI Korea index. It’s a huge fund with US$4.1 billion invested and annual fees are a reasonable 0.62%.

This isn’t a get-rich-quick scheme. It’s a reasonably priced long term stock investment in an advanced country that’s geographically close to large and fast growing neighbours (31% of exports go to China).

Based on some number crunching I expect Korean stocks to return around 10% a year over the next decade, measured in US dollars. I recommend you buy some today as part of your core stock portfolio.

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.