The Korean equity market is cheap. It’s always been cheap. Many things are cheap for a reason though and a key feature of the Korean market is the lack of shareholder focus and precious little alignment of interests between company management teams and minority shareholders. But to quote Robert Zimmerman “the times they are a changing” and we are beginning to see greater shareholder alignment.
We have often spoken to investors about the Korean market where, for mainly historical reasons, large, sprawling conglomerates dominate the index. These companies are typically controlled by a family and are known as ‘chaebols’. After WW2 these chaebols were instructed (supported and helped too) by the government to grow and to grow rapidly in order to generate employment and drive the country’s economic development. They have successfully done this. From an economic perspective Korea is now widely considered as ‘developed’. These chaebols are no longer required to grow for growth’s sake. Many are listed entities and as such have an obligation to run themselves in the best interests of all shareholders.
Changing people’s behaviour takes time, especially when it is so entrenched. The behaviour of the controlling families has not changed in line with the development of the Korean (and indeed global) economy. The organisational charts of many chaebols resemble bowls of spaghetti, such are the number of subsidiaries within one group. A famous car company owns a baseball team, a football team and a country spa – naturally! These cross holdings make understanding who actually controls what, difficult and where capital is deployed across a group, almost impossible.
Pressure from shareholders and indeed the Korean regulators is now forcing the chaebols to adapt and become more shareholder friendly.
Dividends are a simple signal of shareholder alignment. Korea has always had the lowest payout ratio of any market such is the attitude towards returning cash to investors (see chart below).
Yet this has changed over the past few years. Many chaebols horde cash – they have a mindset of building war chests to finance acquisitions and grow after all. Recognising this, from January 2015 the Korean government introduced a tax on a company’s retained earnings – in essence, encouraging companies to reduce their cash pile and distribute some of it back to investors who, thanks to another regulatory change, are benefitting from a reduction in dividend income tax. In 2015, the amount of dividends paid out by Korean companies rose 28% from the previous year. Payout ratios remain low, but it would appear we may be heading in the right direction.
So what else could make the ‘cheap for a reason’ tag redundant? Other instances of better shareholder alignment can be seen by Samsung Electronics, part of Korea’s most famous chaebol, doing a share buyback programme last year – and crucially rather than buying those shares back and then putting them into a treasury share account, they have cancelled those shares. As part of its shareholder return initiative the tech firm also plans to return between 30-50% of its annual free cashflow to shareholders for the next three years.
Another more recent development is also hugely encouraging. Given the sprawling nature of these businesses, intra-group transactions have been used as a means to move capital around the business – with transactions often taking place at what can only be described as dubious valuations. The government has, at long last, shown its intent to enforce some relatively new regulations focused on in-house business transactions by slapping a large fine on a well-known company. In this instance, one part of a group selected the services of a printing company who are part of the group and signed them up at a significantly higher price than they had paid their previous external printing supplier. This tightening up of regulations mean chaebol families can no longer grow their own wealth by controlling and manipulating in-house group deals. They now have to increase their wealth via dividend income, meaning the subsidiaries in the group will begin to increase their dividend payouts.
We see parallels between these changes in the way that Korean firms are run and the corporate governance reforms that Prime Minister Shinzo Abe has introduced in Japan. The Japanese stockmarket rallied on the ‘Abenomics’ programme and we believe a greater focus on shareholders could have a similar effect in Korea.
Today Korea is cheap for a reason. Tomorrow it might just be cheap.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.