U.S. investors seeking to diversify risk have a big problem.
The U.S. stock market is rather expensive, while Europe is mired in slow growth and problems with its common currency. Japan has public debt equal to 250% of the country’s GDP and a massive budget deficit. Meanwhile, China has a banking system that is deep trouble.
Yet there is one country that appears relatively untroubled, and should form a central part of any risk diversification program.
That country is South Korea. The country is a major beneficiary of lower oil prices. Already rich, it has a growth rate well above the U.S. or European countries. It has one of the smallest state sectors of any country in the OECD.
South Korea has its difficulties, most notably with its unruly neighbor to the north. But the country’s political risks are largely uncorrelated with those in the rest of the world. As a result, investing in South Korea diversifies a portfolio by adding exposure outside of the U.S. and Europe.
South Korea has government spending of 33 percent of GDP. Among the OECD’s 35 member states, only Chile spends less. Even more impressive, it consistently runs a modest budget surplus, so that even with relatively high defense spending its public debt is only 37% of GDP.
With a generally free-market orientation, South Korea has thus avoided the extreme monetary and fiscal policies pursued by most of the world in recent years. Historically, the country has been quite protectionist, with relatively high tariffs. However the conclusion of the U.S.-South Korea Free Trade Agreement in 2012 has opened its domestic economy to international competition, sweeping away some uneconomic sectors.
South Korea is a democracy, where the center-right party, currently called Saenuri, has won the last two presidential elections. The big business “chaebol” are however quite unpopular, and the government has imposed a number of restrictions on mergers and industry consolidation. In general, we should look to invest in independent companies rather than chaebol members, whose cross-shareholdings and other inter-relationships are murky and can result in bad governance.
The Economist’s team of forecasters estimates that South Korea will grow at 3.8% in 2015. That’s on par with the growth rate in 2014, and the forecast may be low. South Korea produces less than 10% of the oil and gas it uses and is one of the most energy-import-dependent world economies. This is of course a big benefit currently, given the recent decline of oil prices. Moreover, many of its industries such as shipbuilding and steel making are highly energy intensive. South Korea is also highly competitive, with a balance of payments surplus of 5.8% of GDP in 2014.
South Korea’s stock market is competitively valued, but there is a limited range of companies with ADRs trading in the U.S. The stock market is trading at less than 12 times earnings. That’s a big discount to valuations for the U.S. market. In the last year, the South Korean index is up less than 2%. Given South Korea’s excellent prospects, that makes it an excellent buy.
If you want a direct indexed exposure to South Korea, the iShares MSCI South Korea Capped (NYSE: EWY) ETF is the biggest player. It’s substantial with $4 billion in assets, an expense ratio of 0.62% and a yield of 1.2%. Its “capped” nature means it avoids investing too much in the very largest conglomerates, notably Samsung, which would otherwise make it unbalanced.
If you prefer some stock picking expertise (including domestic South Korean companies you can’t buy directly from the U.S.) you might look at the Matthews Korea Fund (MAKOX). This is an open-end mutual fund which has been investing in Korea since 1995 with an excellent track record. The fund is small, with $184 million in assets. It’s expense ratio of 1.1% is acceptable for an active fund, and has beaten the KOSPI share index over every period since its inception.
For direct investment in South Korean shares, I suggest you look at two stocks that should be major beneficiaries of the decline in energy costs.
The first is Korea Electric Power (NYSE:KEP), the country’s regulated electric utility. The company reported losses in 2011 and 2012 because of high energy costs. It swung to a small profit in 2013 and is expected to record a much larger profit in 2014. The stock is currently trading at 10 times trailing earnings. In 2014 it paid a small dividend, and Korean analysts expect a much larger dividend to be declared this year. The yield could rise to 3.4% in 2015 and 5% in 2016. The stock is currently trading at 54% of book value, and has the advantage that its operating capacity utilization is steadily improving, driven by the 4% annual increase in South Korean power usage.
The second is Posco (NYSE:PKX), one of the world’s largest and most efficient steel companies. Last year its revenues increased by 7%, after three years of declines. Moodies estimates that sales will increase by another 10% in 2015. Profitability should gain more because of lower energy costs; the shares are trading on 10 times expected 2015 earnings. Based on dividends declared in 2014, the shares yield 3.2%, but a dividend increase can probably be anticipated. It’s worth noting that Warren Buffett owns a 5% stake in the company.
South Korea is fertile ground for value investors. Adding exposure to this country is a smart move for investors who want to own stocks outside of the U.S. and Europe. Whether you buy an ETF, mutual fund, or individual stock, now is a good time to buy South Korea.
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