The world, or at least the media, is on edge with Kim Jong Un's latest tirade and threats of launching a nuclear strike on the United States. The North Korean leader warned last week that, "the moment of explosion is approaching soon," and promised to conduct a diversified nuclear strike in retaliation for any further aggression against his country. While there are several reasons for heightened concern, the threat of an ultimate conflict is negligible, and history shows that investors may want to position in ADR shares of companies based in South Korea that could rebound after a key date.
A Tough Month for the KOSPI Index
Shares in the broad market iShares MSCI South Korea (EWY) are off 6.7% since March 14th against a relatively smaller 2.0% decline in the Vanguard Total World Stock ETF (VT). Some of the country's companies have been hit harder with LG Display (LPL) falling 9.2% and POSCO (PKX) down 9.5% over the same period.
While the threats and bravado are nothing new from the small Asian country, there does seem to be an element of heightened risk this time around. The fear is not from any new strength in weaponry or ability, but just from the fact that Kim Jong Un is relatively untested at approaching the line without sending the world to war.
His father, Kim Jong-il became president on the death of Kim il-sung in January 1995, but took three years to consolidate his power. It was not until 1997 that he officially took his father's post as General Secretary of the Workers' Party of Korea. After President George W. Bush labeled North Korea as part of the axis of evil in 2002, the country swore to, "mercilessly wipe out the aggressors." While this and smaller incidences occurred regularly, it wasn't until 2006 that Kim Jong-il really started rattling the sabres with the country's first nuclear test. Tensions escalated further in 2009 when the country claimed a successful test of a nuclear weapon as strong as that used in Hiroshima.
The younger Kim was named supreme leader after his father's death in December 2011. Tensions were still high after North Korea launched an artillery attack on a South Korean island in 2010, killing 46 people, but the leader has been slow to start any new confrontations until just recently.
Reason for Regional Alarm but Little Else
There is little evidence that the country has developed the guidance systems needed for its long-range Taepodong-2 missile with a range of about 4,000 miles. Even this distance just barely puts parts of Alaska in range. Were it to have a functioning guidance system, the International Institute for Strategic Studies believes that it is still several years away from developing a functional nuclear device for its warheads. The alarm is warranted across South Korea and Japan, well within striking range, but most still believe there is little risk of an actual conflict.
More likely is that the President is just trying to provide a show of power to his people in a lead-up to the birthday celebration of his grandfather on April 15th. Kim il-sung was the leader of the Democratic People's Republic of Korea from its establishment in 1948 until his death in 1994. He invaded South Korea in 1950 and is proclaimed as the Eternal President of the Republic. His birthday is a major celebration in the country and the rhetoric out of Pyongyang could escalate until the date. As has been the playbook in the past, I suspect we will see a missile test launch on or before the date. Afterwards, news agencies will report a successful show of power and that enemies of the country have backed down in fear. Tensions will de-escalate quickly with plans for a summit.
A History Lesson in Stock Gains
Investors may want to learn from history and build a position in shares of Korean companies leading up to the 15th on an eventual de-escalation. The chart below shows the drop in select companies and the country fund on November 23, 2010 when tensions soared over the artillery bombing of the South Korean island. Two weeks later, shares had rebounded sharply with some names exceeding their prices set before the escalation.
As the country fund, the iShares MSCI South Korea ETF is the most diversified and is the least risky of the group. The fund trades for 10.0 times trailing earnings of the companies in the index and pays a 0.59% yield. I have been a big fan of LG products and believe the stock is a good long-term pick. The 46.4 times trailing multiple is worrisome, but the shares could still rebound when tensions ease. The company will be launching the new OLED TV technology later this year and could see a strong uptick in investor sentiment on the news. The company has an extremely thin operating margin of 3.1% but could see improvement on the launch of new technology.
SK Telecom (SKM) has done relatively well through the ordeal, only falling 1.8% in the past three weeks. The shares are seemingly cheap at just 1.1 times trailing earnings, but expectations for 2013 earnings brings the forward multiple up to 8.2 times. The company recently partnered with Broadcom (BRCM) to launch the first 5G WiFi hotspot router. With video and data consumption from mobile on the rise, the company should be on track to meet or beat revenue for this year.
Steel producer POSCO has fallen 9.5% recently on tensions and fears that it will limit growth. The shares trade relatively cheaply at 9.6 times trailing earnings and pay a 1.0% yield. The company's operating margin of 5.7% is not that great relative to peers, but cash per share is high at $19.26 per share. The company has come under fire for its supply of steel to Iran, but recently management said that it has scaled down its business with the sanctioned country.
With pace of development in North Korean nuclear capabilities, an eventual conflict may be inevitable. Just as dangerous as a nuclear-capable North Korea would be its ability to sell the devices and technology to countries like Iran. Despite the danger, I believe there is a negligible threat this time around, and both short-term and long-term investors should position in companies that could bounce when tensions ease.