Value stock or value trap? The Korean discount

South Korea’s stock market, despite being home to Asia’s fourth largest economy, is often considered undervalued by analysts, leading to what is sometimes referred to as the “Korea discount.”

Data from the Korea Exchange showed that the Kospi benchmark index as a whole has a price-to-book ratio of 0.92, and its price-to-earnings ratio stood at 18.93. A price-to-book ratio measures whether a company’s share price is undervalued, with a number below 1 indicating the stock may be below fair value.

The “Korea discount” refers to a tendency for South Korean securities to be assigned lower valuations or bear an inflated risk premium by investors, explained Vikas Pershad, portfolio manager for Asian equities.

For investors who subscribe to the idea that prices will gravitate toward fair value, an undervalued market could be a great investing opportunity.

But it may be more complex than that.

If stocks continue to be undervalued, what appears to be a value buy for investors could quickly turn into a so-called value trap — where investors buy what appears to be a relatively cheap stock, only for the stock price to continue falling or remain stagnant.

So, why is there the “Korea discount”?

There are a number of reasons for this, according to Jiang Zhang, head of equities at investment firm First Plus Asset Management. They include geopolitical risks involving North Korea, corporate governance, limited foreign investor participation and most notably, the company’s management or corporate structure, he told CNBC.

In South Korea, most market heavyweights are corporations called “chaebols,” large family-owned global conglomerates that are usually controlled by the founder’s family. These may consist of a group of companies or several groups of companies.

Notable chaebols include market heavyweights such as Samsung Electronics, LG, SK and Hyundai.

Chaebols make up a huge part of the South Korean economy. One such example is Samsung and its affiliated companies, which contributed 22.4% to South Korea’s GDP in 2022.

However, these very same companies are part of the reason behind the Korea discount phenomena.

Chaebols “often have complex corporate structures which have resulted in poorer governance, transparency, and shareholder rights,” said Jeremy Tan, CEO of Tiger Fund Management, the fund management arm of online brokerage Tiger Brokers.

Zhang pointed out that under the family-owned structure of chaebols, investors hold little sway over the company’s strategic direction.

He highlighted that family owners, by virtue of having a dominant stake in the company, may pursue businesses that are unrelated to the core business or are loss-making, which will destroy shareholder value.

Some investors may take the position that a lack of capital gains is acceptable for their portfolio because they plan to hold stocks for dividend payouts.

However, IHS Markit highlighted in June last year that in South Korea, the ex-dividend date comes before the companies’ dividend announcement dates.

As such, shareholders of South Korea stocks face a unique set of risks and opportunities as they are expected to hold their share through the ex-dividend date without knowing how much dividend will be distributed.

The ex-dividend date refers to the date that an investor needs to own a stock in order to receive the dividend. This is unlike companies in most other advanced markets, which announce their dividend payout and ex-dividend date before the ex-dividend date passes.

Zhang also said South Korean companies historically “do not have a habit of returning money to the shareholder because they view the money to be theirs, rather than that of the shareholder.” Those that do have an average dividend payout ratio of about 15% to 20%, he added.

In comparison, Chinese and Japanese companies have a payout ratio of 30% to 40%, while those in Southeast Asia have a ratio of 40% to 50%, according to Zhang.

With such challenges, should investors be putting their money into South Korea stocks — or should they stay away?

Most analysts say South Korean equities are attractive for long-term investors, as long as the country continues its proposed reforms. South Korea’s Financial Services Commission claimed this year that it had made “notable progress” in capital market reforms.

Efforts include improving foreign investors’ access to capital markets, improving dividend distribution practices and including English language disclosures.

Hebe Chen, market analyst at IG International is of the view that the South Korean market “unquestionably merits more attention from global investors.”

If the proposed reform increases accessibility to global investors and resolves corporate issues, it will draw more attention to South Korean equities, Chen said, adding it will “hopefully consign the ‘Korea discount’ to history.”

However, she advocates that before any meaningful changes take effect, investors should exercise more patience for the time being.

South Korea’s inclusion to the MSCI World Index could be another factor. The country is currently part of of the MSCI Emerging Markets index, but has expressed interest in being recognized as a developed market, which could lead to being included in the MSCI World Index.

Efforts by Korean authorities to promote investment are good signals, said Ryota Abe, economist from Sumitomo Mitsui Banking Corporation’s global markets and treasury department.

“If authorities continue to improve the investment environment further, the chances for the South Korean stock index to be included in the [MSCI World Index] will grow,” he said.

However, improvements will take a long time, he pointed out, adding that should it materialize, more inflows will be expected, which will be “optimal” for the South Korean market.

Nonetheless, not all sectors are equal.

While South Korean companies are prominent in sectors like semiconductors, automotive and finance, there are also other bright spots.

There are promising long term opportunities in sectors such as defense, battery supply chain and infrastructure, M&G Investments’ Pershad said.

He pointed out that “the strengthening partnerships between South Korea and West Asian countries, particularly Saudi Arabia, are creating additional investment opportunities.”

Zhang, from First Plus, said investors should look for small- and mid-cap companies that are subject to less family influence, are better positioned for change in corporate governance, and open to a more friendly shareholder return policy.

On the other hand, large cap companies that are have extensive family influence may not be willing to change the existing status quo.

Zhang suggested looking at small- and mid-cap companies that have “global exposure, a proven business model, consistent revenue and earnings growth.”

When the global economy shifts into recovery mode, he said, these companies can easily capitalize on the broader opportunities. Such companies also have a higher likelihood of delivering generous payouts, he added.

“Investors will be ultimately rewarded with both attractive dividend returns and stock price appreciation.”