Is it time to cut the Korean discount? As investors in Asia know, Korean firms have long traded on lower valuations than their peers in other regional markets. Today, the MSCI Korea index trades on a price/earnings ratio of just under 10 times forecast earnings. The MSCI Asia ex Japan regional benchmark trades on 12 times, while the MSCI Taiwan – which like Korea is a market heavy on cyclical export industries – is on 15 times.
Given the global success of firms such as Samsung Electronics and Hyundai Motor – plus many other less-famous exporters who have taken advantage of the weak won and strong yen to steal market share from Japanese rivals – this gap seems increasingly hard to explain. So why does it persist?
One explanation for the existence of the Korean discount is simply the existence of North Korea, with investors demanding an extra risk premium as compensation for the threat posed by that unpredictable regime. But while it sounds plausible at first, this is at odds with the very limited shadow that North Korea seems to cast over the South on a day-to-day basis in every other aspect of business.
The more likely explanation is Korea’s long history of poor corporate governance, especially at the sprawling family-run business groups – known as chaebol – that dominate the economy and exert enormous political influence. The record here is often shocking for an advanced economy such as Korea: Senior business figures convicted of corruption and other criminal offences have routinely been pardoned because of their purported importance to the economy.
That said, while governance remains weak, some analysts and investors make the case that at least it’s improving. Some firms have adopted more shareholder-friendly structures, notably LG Group. And the question of curbing the power of the chaebol is a major political issue, albeit driven more by qualms about the way they squeeze small independent firms, thus creating a climate in which innovative start-up business struggle to survive.
These small signs of progress could explain why Korean discount may slowly be closing. The MSCI Korea currently trades on a price/book ratio of 1.38, above its average since 1995 of 1.18. Conversely, the MSCI Asia ex Japan is slightly below its average of 1.75, at 1.71. The difference between the two is at its lowest since 2003-2004 and it appears that the gap may still be narrowing. (Looking at the value of the market relative to book value – the net value of corporate assets – instead of relative to earnings helps avoid the question of whether profits in this export-dependent market are close to a cyclical peak.)
Given the business progress made by Korean firms lately, it’s understandable that investors would be happy to pay a higher price for them if they were clearly changing some of their less attractive traits. But within the last few weeks, we’ve seen a reminder of how far there still is to go. In January, Chey Tae-won, chariman of SK Group, was indicted on charges of embezzlement. Shortly afterwards, SK Telecom closed a deal to become the largest shareholder in chipmaker Hynix – and this week Chey was voted in as co-chief executive of SK’s new affliate.
Arguably, the good news for governance advocates is that there was significant shareholder dissatisfaction with Chey joining the Hynix board while fighting criminal charges. The bad news was the response of the state-run National Pension Service, the country’s biggest investor, which has said several times that it will take a more activist approach and attempt to improve management at the companies in which it invests.
NPS is the biggest shareholder in Hynix after SK. How did it decide to express its displeasure with an issue where a bit of activism would seem well-placed? It concluded the best thing to do was remain neutral – a decision that led two of its committee members to resign.
That kind of inaction by a heavweight investor has to be seen as disappointing. Of course, high-profile criticism of this affair could ultimately help spur changes at NPS, at other investors and at the chaebol. But progress so far suggests that improvements in Korean corporate governance are likely to be slow - and this suggests that the discount deserves to remain for now.