Corporate Reform Could End the 'Korea Discount' on Stocks

 | Jun 06, 2017 | 11:00 AM EDT
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With a new president in place, South Korean stocks have continued to set record highs this year. That makes the market one of Asia's standout performers, along with Hong Kong and the Philippines.

Korean equities are in a sweet spot. Earnings are improving and, more importantly, prospects are looking good for corporate governance reforms. The benchmark Kospi index is up 16.9% so far in 2017, and just off its highest point in history. But, having broken out of a six-year range, it doesn't look like the bull run is at an end.

Are we about to see the end of the "Korea discount," the penalty imposed by investors on Korean companies thanks to their poor corporate governance of the past? There are two ways of playing that theme, based on smart investment in companies with large amounts either of treasury shares or preferred stock, as I'll explain later.

Samsung Electronics (SSNLF) has made the first move in what investors in Korean stocks hope will be substantial reforms among the country's massive chaebol conglomerates. The stakes couldn't be higher. With their arms in every industry, the top five chaebol alone account for some 60% of economic output.

Why the need for corporate reform? Chaebol were all too often run for the benefit of the members of the founding family first and foremost, with spinoffs offering them sweetheart deals and consolidations somehow always concentrating power in their hands. Customers and employees came next, with shareholders a distant priority.

It is somewhat at odds that Samsung has led the way, since its acting leader, Jay Y. Lee, is now charged in the influence-peddling scandal that brought down impeached former president Park Geun-hye. Shining a legal light on the shady world of business-government ties has essentially put Korean corporate culture on trial.

Still, the Samsung board is taking shareholder-friendly steps.

At the end of April the company made the surprising move of opting to cancel all its treasury shares, worth more than 40 trillion won ($36 billion). The hope is that other Korean companies will follow the lead of a chaebol that accounts for 15% of the nation's whole economy. 

Treasury shares result when a company buys back shares but holds them, rather than cancelling them. They have no voting rights and pay no dividends, but have at times been sold or plain given to allies, to consolidate power or penalize minority shareholders. Their cancellation simply reduces the number of shares issued.

Société Générale has compiled a roster of 35 companies with significant amounts of treasury shares. Besides Samsung Electronics, SK Telecom (SKM) is the main U.S.-listed company with double-digit figures, equivalent to 12.6% of its common shares.

Metals-and-mining steel giant Posco (PKX) is also U.S.-listed and has 8.2% of the total common-share float as treasury shares. Hyundai Motor (HYMTF)  has the equivalent of 6% of common stock and 5.5% of preferred shares in the company vault as treasury shares. 

Since they need to appeal to doubting foreign as well as domestic investors, it wouldn't be beyond the realm of possibility to see them all cancel their treasury shares.

For those who can access Korean markets directly, search-engine provider Naver KS:035420, the country's top cigarette maker, KT&G (formerly Korea Tobacco & Ginseng) KS:0333780, insurers Samsung Fire & Marine KS:000810 and Samsung Life Insurance KS:0322830, and trading conglomerate Samsung C&T KS:028260 - the original Samsung Corp. - all have market capitalizations of more than $7 billion and significant amounts of treasury shares.

Another way to play the potential end to the "Korea discount" is to buy the preferred shares of the chaebol, since they trade at significant discounts to their ordinary shares. It's logical, CLSA equity strategist Chris Wood says, that the preferred shares would be a chief target of any share buyback plans that the conglomerates initiate.

Samsung Electronics, again, has already led the way in that regard. It has been buying back its preferred stock, trading at a discount of 22% to common shares, over the last two years. 

Korea-wide, the discount of the value of preferred shares to the common-stock price is vast, typically at least 33%, and for 10 or so companies more than 50%.

Hyundai Motor (again), cosmetics company Amorepacific (AMRPF) , LG Chemical KS:051910 and LG Household & Health Care KS:051900 all have more than 1.2 trillion won ($1.1 billion) in preferred shares outstanding. LG Electronics KS:066570 is next in line.

The ranks of those with a preferred-share discount of more than half over common shares run through a few names that may be familiar to international investors, although they are listed domestically.

They include LG Electronics (again), Hanwha KS:000880, holding parent company Amorepacific Group KS:002790, CJ Corp. KS:001040 and its foodstuffs subsidiary CJ CheilJedang KS:097950, Daelim Industrial KS:000210, and Samsung SDI KS:006400, all with at least $110 million in preferred shares.

Lotte Chilsung Beverage KS:005300, Kumho Petrochemical KS:011780 and SK Chemicals KS:006120 all fall below that $110 million threshold but have equally large discounts.

Korea remains a closed culture and economy. I've had people answering the phone at Fortune 500 companies simply hang up on me before because I didn't speak Korean. Compare that to the first point of contact in Japan, where a sweet receptionist always, and I mean always, answers "One moment, please," and presumably rushes off to find someone who can speak English. 

Those without access to the Korean markets and domestic listings might want to look at the iShares MSCI South Korea Capped ETF (EWY) , by far the biggest U.S.-listed but Korea-focused exchange-traded fund.

It also has a cousin that avoid the oscillations of the won, the iShares Currency Hedged MSCI South Korea ETF (HEWY) . The hedged version (up 21% in 2017) has given up some of the 29% gain seen in the ETF tracking in local currency. 

The Deutsche X-trackers MSCI South Korea Hedged Equity ETF (DBKO) is also dollar-hedged against the Korean currency. It has lagged other Korea ETFs slightly this year, with a 19% gain. 

The AdvisorShares KIM Korea Equity ETF (KOR) , managed by Korea Investment Management, seeks growth-oriented mid- and large-cap stocks and has posted a 23% gain.

Upping the ante for those with an incredibly bullish view on Korea is the Direxion Daily South Korea Bull 3X Shares ETF (KORU) , which offers triple leverage. Given the strong run in Korean equities so far this year, the ETF has doubled in 2017. But such products often diverge dramatically from any underlying benchmarks at times of rapid market movements, and are best used as day-trading devices.

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