In recent times, South Korea has found itself at the center of international news due to a tumultuous atmosphere involving martial law, political uncertainties, and fluctuations within its markets. However, it's vital to understand that the issues afflicting the South Korean stock market go far beyond the immediate disturbances triggered by the recent emergency decrees. Even before these events unfolded, the performance of Korea's equity markets had been underwhelming, revealing deep-seated problems that are likely to remain even after political stability returns.
The phenomenon often referred to as the "Korean Discount" encapsulates this troubling reality. Despite showcasing strong cash flows and robust earnings, a significant number of publicly-traded companies in South Korea have consistently seen their stock prices languish below book value. The last 10 to 15 years have seen Korea elevate itself to the status of a developed economy, experiencing steady GDP growth; yet, its stock market performance has paled in comparison to other global markets.
The KOSPI, South Korea’s primary stock market index, is home to numerous major corporations, including industry giants such as Samsung Electronics, LG Energy Solution, and SK Hynix. As of mid-December 2023, the overall price-to-book ratio (P/B) for KOSPI stood at a staggering 0.88. This marks an annualized return of merely 2.2% over the past decade, while more than half of the listed companies are trading below their net asset values. In stark contrast, the Nikkei 225 index in Japan is valued at 2.2 times its book value, and the S&P 500 index in the United States boasts an impressive 5.25 times.
The prolonged state of undervaluation in the South Korean market contributes to a phenomenon known as the value trap, wherein stocks display low valuations and solid profits, yet their prices fail to experience significant increases. This scenario generates a dangerous cycle, whereby waning investor confidence perpetually undermines the market's potential for recovery.
Earlier this year in February, the South Korean government announced plans to emulate Japan’s successful “valuation enhancement” initiative aimed at improving capital efficiency within Korean firms while fostering better communication with investors. Initially, this announcement provided a temporary boost to the market. However, unlike Japan's well-received plans, Korea's efforts have, unfortunately, been disappointing. Figures indicate that since the Tokyo Stock Exchange (TSE) released its “valuation enhancement” guidelines in May 2023, the Nikkei 225 index surged by 40%, while the South Korean market saw a brief surge followed by a significant downturn at the start of 2024.
What, then, is at the heart of these challenges facing the South Korean market?
The root causes of the “Korean Discount” can be traced back primarily to low returns on equity and inadequate company governance structures. The lackluster return on equity reflects an inflation of corporate balance sheets, which in turn discourages firms from distributing cash to shareholders in the form of dividends.
A considerable portion of the problem lies with South Korea's family-run conglomerates—known as chaebols—which often feature a cross-shareholding structure that hinders effective corporate governance. This structure tends to empower founding families to exert disproportionate control over companies at the expense of minority shareholders' interests.
Regrettably, the government's “valuation enhancement” initiative appears insufficiently rigorous to address these systemic issues. It merely encourages companies to disclose their capital efficiency plans—essentially their mid to long-term objectives and strategies to achieve them. Though the government has designed several tax incentives to support this initiative, these measures have yet to be ratified by Parliament.
Crucially, unlike Japan's approach, which includes mechanisms for “naming and shaming” companies that fail to comply, South Korea's equivalent lacks any such accountability measures. Since January of this year, the Tokyo Stock Exchange has maintained a list of companies that have disclosed their commitments to capital efficiency, indirectly pressuring those firms that have yet to do the same. This kind of peer pressure seems to be encouraging more Japanese companies to adhere to regulations.
Another obstacle lies within South Korea's tax laws. Investors have long believed that the country's substantial inheritance tax—approximately 50%—creates a disincentive for chaebols to inflate company valuations. Early in 2024, the recently impeached Yoon Suk-yeol administration announced a tax reduction plan, but in the current fraught political atmosphere, its implementation seems highly uncertain.
Moreover, the domestic tax regime imposes taxes of around 15% on dividends paid to South Korean residents, which appears to further inhibit dividend distributions.
What's next for the landscape of South Korean investments?
Despite these mounting challenges, there seems to be a glimmer of optimism among investors in South Korea. Recent stock repurchase announcements, notably Samsung's declaration of a buyback exceeding $7 billion, have ignited hopes that Korean firms may begin to shift towards benefiting shareholders more effectively.
Suddenly, there's a growing movement for shareholder rights within South Korea. Notably, after investors voiced strong objections, the founding family of Korea Zinc—one of the world's largest zinc refiners—recently abandoned a controversial new stock issuance plan that sought to fend off a takeover bid from its co-founder.
Nevertheless, genuine reform in South Korea may require time to bear fruit, especially considering the current volatile political environment. It is safe to assert that the "Korean Discount" is not likely to vanish in the near future.