South Korea is the tenth largest economy by gross domestic product and has a per capita income of USD 31,360 (2020), qualifying it as an advanced economy. Korea was given the title of the ‘Miracle on the Han River’ for its spectacular rise from an agrarian economy in the 50s to an industrial power house in the latter half of the 20th century.
Despite its notable economic achievements, the Korean equity and currency markets are hindered by governance challenges and investment hurdles. These have kept Korea in the emerging market (EM) bucket by equity index provider MSCI since 1992. Weak corporate governance in large conglomerates, restricted access to the currency market and onerous onboarding hurdles for foreign investors among other factors, have prevented Korea’s upgrade to developed market (DM) status.
Why is corporate governance a big issue in Korea?
Korea’s benchmark Composite Stock Price Index (KOSPI) is dominated by family-run conglomerates called Chaebols (wealth clique in Korean) such as Samsung, LG, SK Hynix and Lotte among others. Chaebols constitute over 50% of the KOSPI’s market cap and the top 10 own over 27% of all business assets in the country. Chaebol families were praised for their role in industrializing Korea during the 60s and 70s and turning the nation into a manufacturing powerhouse from an agrarian economy. Today, Korea’s economy is the 10th largest in size, in a large part thanks to Chaebols.
Notwithstanding their massive contribution to the economy, Chaebols are notorious for their opaque corporate governance policies to retain power with founding family members. These conglomerates have often used circular shareholding structures, made decisions to favour family members and generally disregarded minority shareholder returns. To provide context — the gap in the dividend payout ratio of MSCI World (comprising developed market stocks) and MSCI Korea stood at 21.72 ppt in 2000, 28.01 in 2010 and 29.85 in 2020. The persistent weakness in dividend payout — as Chaebol managements prefer to hoard cash rather than invest — drive Korean stocks’ valuation discount to peer indices as well.
Activist hedge funds are trying to force policy changes
An activist hedge fund invests in companies and plays an active role in changing policies and / or management to unlock business improvement and value. Several activist funds have endeavoured to implement governance reforms in Korean corporates. Local fund KCGI attempted to remove Korean Air / Hanjin Group CEO and establish an independent board of directors to improve decision-making. Samsung’s Lee family is notorious for retaining power with family members. In 2015, activist hedge fund Elliott Management failed to prevent the merger of Samsung C&T and Cheil Industries as the Korean government intervened and backed the Chaebol. This was despite Samsung heir Lee Jae-yong’s blatant attempt to consolidate power in the corporation. These examples highlight the difficulties faced by minority shareholders to unlock value from the biggest Korean firms.
Korean stocks have stagnated over the past decade
Aside from corporate governance challenges, Korean stock prices are held back by the cyclical nature of businesses. For instance, the KOSPI is dominated by cyclical stocks such as semiconductors (Samsung, SK Hynix), shipbuilding (Hyundai), construction (Hyundai Engineering and Construction) and steel (Hyundai Steel, POSCO) that are sensitive to the economic cycle. Korea is an important producer of memory chips that go into manufacturing electronics. The memory chip sector is highly cyclical and correlated to global economic cycle and firm inventory. The KOSPI is often vulnerable to shifting sentiments of the memory chip sector. This generates earnings volatility for corporates and prevents steady flow of capital from foreign investors.
An upgrade to developed market status to the rescue?
If Korea were to achieve an upgrade from emerging to developed market (DM), its stocks would be added to the MSCI World indices which have greater capital invested in them. Against the USD 960 billion tracking MSCI EM, MSCI World Indices benefit from approximately USD 3.6 trillion in assets under management. Research houses estimate USD 20–50 billion capital inflow into Korean stocks upon inclusion into MSCI World indices. These flows may finally help the KOSPI reach the aspired 4000 level and exit the prolonged period of stagnation.
Public officials may be keen for reforms
Korea elected conservative People Power Party’s Yoon Seok-youl as its next president on 9 March. As a former high-profile prosecutor general, Yoon took corrective action against large corporations, suggesting the potential for corporate governance improvements under his leadership.
Democratic Party (DP)’s candidate Lee Jae-myung called for reforms to facilitate Korea’s upgrade to DM during his election rally. In response to MSCI’s wish list, the Korean finance minister spoke about implementing currency reforms this year. It is too early to tell, but these developments paint an optimistic picture for Korean stocks.
Conclusion
Given the stagnation in Korean stock prices and the very low expectation of an upgrade to DM (following numerous failed attempts), the realization of an upgrade and entry into MSCI World indices could be very positive for Korean stocks. From an investor’s perspective, any seriousness from policymakers and Chaebols for corporate reforms is positive. In recent years, Korea’s Fair Trade Commission (FTC) banned new circular shareholdings in 2013, facilitating a reduction in business owners holding key board posts. Companies with independent audit committees rose and the KOSPI’s dividend payout ratio has been inching higher. This momentum needs to continue to see any evident impact on share prices.
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