Monday, March 19, 2012
The ``Korea Discount'' is defined by Forbes Magazine as ``the amount by which investors undervalue Korean stocks.'' This discount rate can be seen in how Korean stocks have consistently maintained low price-earnings ratios, and are predicted to maintain this low ratio in the future as well. Korea is perceived to have certain long-term investment risks that need to be addressed.
This risk can be characterized as risk of both foreign and domestic capital flight. Foreign investors currently own roughly 40 percent of the shares on South Korea's stock exchanges, and this investment is perceived as somewhat volatile and at higher risk.
Domestic investment is also at risk of capital flight as South Koreans are no longer inhibited from investing abroad (since the financial liberalization of its market in 1998).
So what are these perceived risks that have caused capital flight and consequently enabled Korean stocks to be valued at a discount?
1. One predominant cause for potential capital flight remains South Korea's geographic proximity to and political rivalry with the unstable North Korean regime.
For example, when North Korea tested a nuclear weapon and launched a short-range missile on May 25, 2009, the KOSPI stock index tumbled as much as 6.3 percent.
Similarly, on Oct. 9, 2006, when North Korea conducted its first nuclear explosion, the index fell 2.4 percent. In both cases, however, the KOSPI quickly recovered, recovering much of its losses the following day (Bloomberg 2009).
2. Another cause of concern for investors is Korea's significant debt load. Household debt in South Korea surpassed 700 trillion won in September for the first time ever, which may have a snowball effect when interest rates rise.
Similarly, chaebol conglomerates are experiencing financial instability _ the LG Economic Research Institute (LGERI), recently reported that 12 out of the 41 largest conglomerates failed to earn sufficient returns to cover interest payments during the first three quarters of the year.
And out of the 12 underperformers, seven recorded deficits. Government debt as a share of GDP has also significantly increased.
3. Another reason for the Korean discount is an overbearing labor union force. Lim Ji-won, an economist at JPMorgan Chase, said, ``Labor union issues are a persistent discount factor for South Korea.''
In 2007, according to International Labor Organization data, South Korea had six times more strikes than in Japan, whose population is more than double the size.
Recently, on Nov. 25, 16,000 railway workers went on strike, paralyzing 96 percent of Korail's cargo train service, with only 11 out of 300 daily cargo trains running normally.
With unions that are so powerful now as to be able to disrupt the entire country's transportation sector, investors are thinking twice before investing in such a high risk market.
4. A perception of an unfair playing field in the market is another concern for investors in Korea. Last year, Transparency International ranked Korea as 39th on the Corruption Perceptions Index (CPI), tied with Oman.
In contrast, Japan ranked 17th, Australia 8th.
Slush fund scandals and allegations of bribery abound in the media nowadays, and can be found across a broad spectrum of Korean society, from education to business to politics.
In addition, foreign investors sometimes feel particularly left out of a fair playing field, as was the case when Lone Star, a Dallas-based private equity fund that holds a controlling stake in the Korea Exchange Bank (KEB), was denied permission to sell its investment.
The perception of an unlevel playing field in the market, whether from corruption or protectionism, is a major reason for the discounted value of Korean assets.
5. Finally, the Korea discount is also the result of underrated assets due to uncompetitive marketing in certain industries. For example, Korea's science and technology sector, which ranks fourth, has a global image that ranks ninth.
Improving the image of Korea Inc. could help create a more accurate understanding of the Korean market, but in the meantime this is another reason for assets in Korea to be valued at a discounted price.
The Korea Discount is the reward for assuming a greater degree of risk in this emerging market. Those who are not risk adverse and are willing to accept a risk premium can take advantage of this discount rate and reap handsome rewards.
But before entering the market, it is essential to understand the risk variables of geopolitical proximity with North Korea, Korean debt and credit concerns, the impact of Korea's labor unions, potential transparency issues and the need to further develop a positive image of Korea Inc.