Is it time to invest in South Korea again?

As tensions reached boiling point on the Korean peninsula, in mid-2017, I recommended exiting positions in South Korean stocks. With the sudden outbreak, or potential outbreak, of better relations between North Korea and the other countries that matter – being China, South Korea and the US – it’s time to take a closer look again. Especially because South Korean stocks are cheaper than ever.

Long time readers will know that I recommended South Korean stocks back in June 2015 (see here). That was by way of the iShares MSCI South Korea ETF (NYSE:EWY). In summary, my reasoning was that South Korea is an advanced country with low debts, the economy is strong, and the stock index was fairly cheap (at the time it had a price-to-earnings ratio of 13.6).

However, in July 2017 I decided that the risks had become too high to stay invested. So I recommended that EWY should be sold (see here) for a 24.3% profit, in US dollars (21% from capital gains and 3.3% from dividends, net of fees). It was a good outcome over two years.

The decision to recommend selling was a difficult one. Despite the gains, the market was even cheaper by then (P/E 12.3). In fact, after that recommendation to sell, and despite the risks, the market actually gained some more (due to rising earnings).

But, in the light of information at the time, I still believe it was the right decision. Trading with hindsight is easy. But all current decisions must balance both potential future profits and take account of pending risks.

Regular readers will know that I like crisis investing, which involves scooping up cheap assets when fear is at a peak. Economic and financial meltdowns often provide excellent buying opportunities. Those brave enough to take the plunge can make huge profits in the following years, as things settle down.

But there comes a point when the risks of a permanent loss become too great, even if assets already look cheap. Just ask anyone that owned Russian stocks ahead of the 1917 revolution and subsequent switch to communism…or held Chinese stocks just before the communists won the civil war in 1949. Both took 100% losses as assets were confiscated.

Financial crises are one thing, and they get solved in time. But political revolutions or wars can lead to confiscations or widespread destruction of productive assets.

It’s best to get out before that happens, rather than run the risk that it might all blow over. No one wants to be the apocryphal frog in the pan of heating water, feeling increasingly warm but failing to jump out before it boils.

In the middle of last year, North Korea was busy testing nuclear bombs and its latest ballistic missiles. “Supreme Leader” Kim Jong-un used state media, his own personal version of Twitter, to call US President Donald Trump a “mentally-deranged dotard”. Trump called Kim a “maniac”, “madman” and “little rocket man”. Both bragged about the sizes of their nuclear buttons.

The point was that relations between the US and North Korea were incredibly tense, and the two leaders were exchanging very personal insults. In my judgement, that meant emotions could rule the day, setting the two countries on a course for armed conflict, whether nuclear or otherwise.

At the time, I wrote this:

“…it looks like things could really kick off in Korea this time, unlike the periodic sabre-rattling that we’re used to. There’s no sign of either side backing down. It wouldn’t take much for heated rhetoric to turn into a hot war.

In my book, that means the risks of owning South Korean stocks are currently too high. They’d be cheap in a stable environment, but not in one with the clear potential for an imminent catastrophe. Of course it could all blow over, and the market could keep heading up. But surely there are safer places to invest in the world right now?”

But now, suddenly, things have changed dramatically and relations appear to be on the mend – and not just between North Korea and the US.

First of all, Trump announced in early March a plan to meet Kim. The exact date and location aren’t yet fixed, but it’s expected to happen later this month. Assuming it goes ahead, this will be the first ever meeting between the two countries’ heads of state.

Then, in late March, Kim took a train ride to China and met Chinese President Xi Jinping. Relations between North Korea and China were previously poor, but this was a clear sign of improvement. It’s likely that Xi also had a hand in what happened next.

Just last Friday, on 27th April, Kim Jong-un went to visit South Korean President Moon Jae-in…in South Korea. This is a big deal, as Kim is the first North Korean leader to cross the demilitarized zone (DMZ) that has separated the two countries since 1953.

That year was when an armistice was agreed in the Korean war, although no formal peace treaty has ever been signed. Technically the two countries are still at war. Symbolically, at Kim’s invitation, Moon briefly stepped into the DMZ from the South Korean side.

Then they had a summit meeting and made a joint declaration that they’ll work together towards a denuclearized Korean peninsula and a formal peace treaty (in four-way talks including the US and China). Also, they will cease propaganda broadcasts across the DMZ, work on modernising rail and road links across the border, and have joint participation in international sporting events.

This clearly marks a major improvement in relations between the two Koreas. Next, we’ll have to see how things go between Trump and Kim. A sticking point for all of this could be what happens in future to US military bases in South Korea. However, as of now, relations between North Korea and the three other countries that really matter – South Korea, China and the US – seem to be improving significantly.


The opportunity in South Korean stocks

This means South Korean stocks have got my interest again. That’s especially because they’re even cheaper now than they were when I recommended them back in June 2015. The MSCI Korea index has a P/E ratio of just 10.4 these days.

Here’s are some high-level facts about South Korea:

  • Population of 51 million
  • GDP is similar to the UK and Italy (at purchasing power parity, or PPP – a measure of volume of production)
  • GDP per capita is similar to Japan and New Zealand (PPP)
  • 6th largest exporting country in the world (between Japan and France)
  • Highly technologically advanced, and one of the first widespread adopters of the internet (e.g in December 2001 broadband access was available to 17% of South Koreans, but only 4% of Americans)
  • Government debt is a relatively low 38% of GDP. Unemployment rate is 4%, consumer price inflation in year to May 1.6%.
  • Market capitalization (value at current prices) of stock market was $1.8 trillion at the end of March, or 120% of GDP.

Views are split amongst providers of stock indices whether South Korea is a developed or emerging market. FTSE classified the country as a developed market way back in 2009, but MSCI still classifies it as an emerging market. In my view, in terms of how you think about it for your asset allocations, it should be thought of as developed.

The easiest way to invest in South Korea is still via the iShares MSCI South Korea ETF (NYSE:EWY). There are other Korean ETFs, but they’re tiny (for more on the risks of investing in tiny ETFs see here). EWY has invested assets of $4.3 billion (US dollars). It’s invested in 113 different stocks and charges annual fees of 0.62%.

EWY tracks something known as the MSCI Korea 25/50 index. The “25/50” moniker means stocks from a single issuer can’t exceed 25% of the total, and the sum of all stocks with more than 5% weighting can’t exceed 50%. Together, these reduce concentration in any individual stock.

This matters in South Korea, since the standard MSCI Korea index has a 31% weighting to one single company, Samsung Electronics Co. Ltd. (Korea:005930). Its main businesses are producing semiconductors (chips of its own design or of third parties), smartphones and consumer electronics (e.g. TVs).

Within EWY the weighting to Samsung Electronics is currently just under 24%. The fund P/E is 10.4, based on last year’s earnings.The dividend yield of the index is around 1.9%, so about 1.3% should be the expectation for investors in EWY, net of fees.

Samsung Electronics has a current P/E of 9 (and perhaps as low as 5.3 on a forward basis, given the huge growth of first quarter results). Stripping it out leaves the rest of the index with a P/E of 10.8.

With a bit of number crunching, I estimate that investors should expect long-term returns, from this level, of around 11% a year, give or take. That assumes no increase (or decrease) in the valuation multiples, and with most of the profit coming from capital gains.

Note that compound capital gains in the stock price of Samsung Electronics, measured in US dollars, averaged 15% a year over the past decade, with dividends on top. The common stock trades in Korea or London (as a global depository receipt, or GDR).

This makes direct access difficult for many investors. That’s either because their brokers don’t offer access to those exchanges, or because they’re American. SEC regulations ban US citizens from investing in GDRs.

This makes EWY a convenient way to get exposure to cheap stock of Samsung Electronics, but along with a basket of other South Korean stocks. However, since the index is trading so cheaply overall, this looks like an attractive prospect.

My recommendation is to wait and see what comes out of the forthcoming meeting between Trump and Kim. If relations keep improving, it could be time to invest in South Korea again.

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.