To Buy or Not to Buy Korea

10/16/2007 12:00 am EST

Focus: GLOBAL

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carlton Delfeld, editor of Chartwell Advisor Global ETF Report, says Korea has been one of the top-performing markets and he runs down the pluses and minuses of the ETF.

The iShares MSCI South Korea (NYSE: EWY) exchange traded fund, which tracks the benchmark Kospi index, is the third-best performing mainstream ETF so far this year.

Up [nearly 30% in 2007], EWY has been bested only by China and Thailand. But while recent gains have been largely fueled by Korean investors, foreign investors have been selling. Asia's third largest economy is becoming an increasingly volatile place to do business: rules are changed retrospectively, tax treaties [are] ignored, and the legal framework can be ignored when nationalism directed at foreign enterprises catches fire.

[Also], Korea cannot compete with the growth levels of emerging markets such as China and India, plus its companies have the lowest dividend payout ratios in the region.

Together, Samsung Electronics, POSCO, and Kookmin Bank account for 30% of the South Korean ETF (EWY) and the stock market’s market capitalization. Samsung alone accounts for 15%, but the company is not a terrific play on the South Korean economy. Rather it is a global play on [the company’s] three key markets and the expected payoff from its extraordinary commitment to R&D.

The key question is whether the market is still attractive from a valuation perspective. It seems still cheap—Korea trades at a 24% discount to the region on a price-to-book-value basis.

[But according] to data from Thomson Datastream and Reuters, Korea's market is actually trading now just a bit over 13x earnings. This is a higher valuation than Singapore, the UK, Netherlands, and Sweden.

All this may help to explain why international investors have offloaded Korean stocks for the past three years. But the trend has accelerated recently, with foreigners shedding a net $10.8 billion of equities last month alone. They now own only 33% of the Korean stock market, a level last seen in 2000, when the shock waves of the Asian financial crisis were being felt.

[Yet] return on equity is on a par with the region, and Citigroup points out that Korean companies' average debt/equity ratio has dropped from 300% to 500% before the crisis to just 22.5% now. Legislation [has recently been passed] to open up South Korea's financial markets, and it is also likely that a more business-friendly president will be sworn in next year, bringing much needed reforms.

The challenge is the low-cost manufacturing platform with huge economies of scale just next door—China. Samsung already has 29 plants and 50,000 workers in China. Since China is already starting to manufacture stuff like machine tools that the South Koreans were busily exporting during the last few years, South Korean planners believe it must quickly transform itself into a finance, communications, and transportation hub—akin to the role of Singapore or Switzerland
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The question then becomes, does it have the right companies [and] the right skills, and what is its competitive advantage? On balance, South Korea has a place in your portfolio. (The ETF closed Monday around $70.50—Editor.)

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