Emerging Markets: Investment In South Korea, A Market With Characteristics Similar To Developed Markets

| About: iShares MSCI (EWY)

Summary

South Korea is one of the countries in the world with high economic growth, which is expected to continue.

Last year, iShares MSCI South Korea Index Fund ETF (EWY) outperformed emerging and developed markets.

Investment in South Korea can be attractive for investors who want to have higher exposure to Information Technology.

The major investment risks are the stability of its currency, increased competition from China and weak corporate governance.

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South Korea is one of the largest economies in the world, and it has been one of the fastest growing economies for the last 50 years.

Is South Korea an Emerging or Developed Market?

Historically, investors classify a country as "Emerging" or "Developed" based on metrics such as GDP or GNP per capita and individual judgments. While South Korean GDP per capita is lower than other developed markets, it is significantly higher than other emerging markets.

Source: World Bank

Reasons to classify South Korea as a developed country:

  1. The size of the economy: South Korea is the 11th largest economy measured by GDP.
  2. Trade: South Korea is the 7th largest exporter.
  3. Market size: South Korea is the 10th largest stock market in the world.

For years, investors have argued whether South Korea is a developed or emerging market. Based on the individual judgment of investors, South Korea is classified as an emerging market in one index and as a developed market in the other one.

As an example, in 2009 FTSE Russell reclassified South Korea to developed market from emerging market because of the high economic position.

Nevertheless, MSCI decided not to change the classification this year due to the following reasons:

  1. The lack of convertibility of the national currency. Investors are forced to use the Korean won and local counterparties only during business hours. The lack of a 24-hour foreign currency exchange system compromises the trading and liquidity of the developed market index-tracking strategies. Additionally, non-residents are not permitted to buy won-denominated hedge funds, including forward currency contracts.
  2. Restrictions imposed by the local exchange. South Korea prohibits in-kind transfers of securities.

In August 2016, the government reformed the country's foreign investor identification registration rule for the first time in 24 years and extended the operation hours of the stock and exchange markets by 30 minutes.

With further reforms that will address concerns, MSCI will likely reclassify South Korea as a developed market, and investors will agree on single classification.

For the past 10 years, iShares MSCI South Korea Index Fund ETF (EWY) performed in line with the iShares Emerging Markets Index ETF (EEM), the largest diversified equity emerging markets fund. The fund, however, underperformed S&P by 3.63%.

(click to enlarge) Click to enlargeSource: Bloomberg Terminal

Last year saw the outstanding performance of the emerging markets and iShares MSCI South Korea Index Fund ETF significantly outperformed SPDR S&P 500 ETF (NYSEARCA:SPY) by 6.87%.

Click to enlargeSource: Bloomberg Terminal

The central question is: "Will the fund perform as well as last year or will SPDR S&P 500 ETF a better investment opportunity for an American investor?"

The starting point of my analysis will be a brief country analysis and economic forecast.

(click to enlarge) Click to enlargeSource: Bloomberg Terminal

  • There is the low political risk in South Korea. It is, however, concerned with North Korea and its latest nuclear weapon testing.

Click to enlargeSource: Bloomberg Terminal

  • Corruption may be an obstacle, but both businesses and the government are actively fighting against it. For the last 12 years, corruption significantly decreased based on the Freedom from Corruption index. Corruption is a common characteristic of the emerging markets.

Click to enlargeSource: Bloomberg Terminal

  • Even though South Korea is the fastest growing country in the world, its GDP growth is predicted to be higher than most of the developed markets. GDP growth depends solely on the exports, which contribute 45.9% to the GDP. Rapid GDP growth is a common characteristic of the emerging markets.

Click to enlargeSource: Bloomberg Terminal

  • Inflation is forecast to be lower than most of the developed markets. From 2013-2015, the central bank missed target inflation and lowered estimates to 2.5-3.5% for the next two years. Low inflation is a common characteristic of the developed markets.

Click to enlargeSource: Bloomberg Terminal

  • South Korea has a low unemployment rate, which is not expected to rise in the next biennium. Low rates of inflation and unemployment support the stable growth of the economy.

Click to enlargeSource: Bloomberg Terminal

  • Because interest rates in South Korea are higher than developed markets, the country attracts foreign direct investments. High interest rate is a common characteristic of the emerging markets.

Click to enlargeSource: Bloomberg Terminal

  • Based on low inflation and unemployment rates, its currency is forecast to be stable. This is crucial for the export-oriented economy and shareholders - when a currency appreciates, revenues are negatively affected as goods become more expensive for foreigners; but when the currency depreciates, shareholder wealth is negatively affected. The stable exchange rate is a common characteristic of the developed markets.

Click to enlargeSource: Bloomberg Terminal

  • South Korea is rated Aa2/AA/AA- with the stable outlook by three rating agencies. Investment grades are common characteristics of the developed markets.

I will compare iShares MSCI South Korea Index Fund ETF and SPDR S&P 500 ETF based on the fundamentals.

Click to enlargeSource: Bloomberg Terminal

  1. iShares MSCI South Korea Index Fund ETF is cheaper and undervalued relative to the SPDR S&P 500 ETF based on the P/E, P/FCF, P/B, P/S ratios.
  2. Meanwhile, the above-mentioned ratios for the iShares MSCI South Korea Index Fund ETF, ROE and ROA are higher than for the SPY. Thus, investors receive a higher rate of return for $1 of assets and equity when they invest in the SPDR S&P 500 ETF.
  3. While the earnings yield is higher for the iShares MSCI South Korea Index Fund ETF relatively to the SPY, the dividend yield is lower. This is one of the major factors that drives significant sell-off of the South Korean equity.
  4. The beta for most of the funds is the same, meaning that both funds have the same degree of risk.
  5. Both ETFs have a high exposure to the business cycles. The USA and South Korea are currently in an expansion business cycle.
  6. iShares MSCI South Korea Index Fund ETF weighted significantly higher in Technology, consumer cyclical sectors compared to SPDR S&P 500 ETF. Those sectors outperform during the expansion business cycle.
  7. SPDR S&P 500 ETF weighted significantly higher in the consumer non-cyclical, basic materials, communications and energy sectors. Those sectors outperformed during peak/recession business cycle.

What drives the performance of the iShares MSCI South Korea Index Fund ETF?

Click to enlargeSource: Bloomberg Terminal

The performance of the iShares MSCI South Korea Index Fund ETF is driven mainly by the information technology, which is significantly weighted.

Click to enlargeSource: Bloomberg Terminal

Samsung Electronics (OTC:SSNLF) and SK Hynix Inc. (OTC:HXSCF) significantly contributed to the high performance of the technology sector. Nevertheless, Samsung SDS, a manufacturer of lithium batteries, performed poorly due to product defects in the Samsung Galaxy 7 and the company's decision to stop manufacturing the phone. Despite these issues, most analysts believe that Samsung is still a strong buy and will outperform.

Consumer discretionary, the second largest industry of the fund, is significantly underperforming.

Click to enlargeSource: Bloomberg Terminal

India has overtaken South Korea to become the fifth largest producer of automobiles. As such, sales from South Korea declined. The concern is not only lower sales revenues but also the possibility that labor union strikes will occur to protest the outsourcing of Hyundai and Kia Motors, which performed poorly. Most analysts, however, believe that Hyundai and Kia Motors are a strong buy and will outperform in the future.

The poor performance of LG Electronics (OTC:LGEAF) is due to the decline in sales of its mobile phones as well as due to currency fluctuations. Nevertheless, a majority of analysts recommend buying shares in this company.

What should be the primary considerations for investors interested in the iShares MSCI South Korea Index Fund ETF?

  1. South Korea is growing rapidly and the economy is expected to be stable for the next few years.
  2. South Korea is highly regarded in the information technology sector, which is forecast to outperform by analysts.
  3. Most of the companies are sold in South Korea and not available on the NYSE or Nasdaq.
  4. Even though, the consumer discretionary sector has underperformed, analysts believe that companies in the ETF will outperform in the future.
  5. South Korea can be reclassified by MSCI from an emerging market into a developed market. This will bring even more attention from investors who invest only in developed markets.

The major risks of investing in EWY are enumerated below

  • Geopolitical risks. After North Korea's recent nuclear weapons tests, there was a significant sell-off of the Korean equity. Nevertheless, this is an excellent opportunity to buy cheap shares based on the negative news about North Korea.

Click to enlarge Source: Bloomberg Terminal

  • South Korea's semiconductor industry is facing increased competition from China, which offers lower production costs and is currently trying to become the world leader in this sector.
  • South Korea's heavy reliance on exports. The profitability of exports depends on demand from the global market. After a recent review, WTO decreased the expected rate to 1.7-3.1% from 3.6% in April.
  • South Korea's largest trading partner was China and USA for 2015. For the past two years, China has experienced the lowest rates of growth since the 1990s. The IMF has recently lowered its estimates for the growth rates of the Chinese and American economies. The narrowing trade surplus with China can potentially lead to exchange rate fluctuations, which will increase the volatility of the profitability of the Korean companies and return on equity.
  • The depreciation of the Chinese yuan can have a deflationary impact on South Korea. Japan and China are South Korea's largest competitors. If their currencies depreciate, their goods will be cheaper. As a consequence, South Korean companies will be less profitable.
  • Markets expect that in December, there will be an interest rate hike, which will appreciate the value of the US dollar. This will result in the depreciation of the national currency which, in turn, result in lower profits for South Korean companies and even lower returns for shareholders. Increased interest rates will also likely lead to the sell-off of global emerging markets similar to what happened in 2014 when the interest rate was last raised.
  • Poor corporate governance. The word "chaebol" is a combination of two Korean words "clan" and "wealth." South Korean corporate culture is driven by founding families who carry out orders without question. This has the effect of poor governance. The problem with the Samsung Galaxy S7 and the expected $17bn worth of losses was due to poor governance. The chaebol model is also a reason for reduced competitiveness of South Korean companies. Because managing families do not act in the best interests of their shareholders, they are not able to benefit from mergers and acquisitions opportunities. Finally, the chaebol structure limits shareholder activism.

The Bottom Line

  • South Korea is one of the fastest growing economies in the world, and the trend will continue in the future.
  • South Korea shares characteristics of the emerging and developed markets. It can be classified both ways based on the individual judgments of the investors.
  • While FTSE Russell classified South Korea as a developed market, MSCI is expected to reclassify to developed market from emerging based on the results of the government reforms.
  • The economy has a well-developed information technology sector and R&D.
  • South Korea can be attractive for investors who want to have higher exposure in information technology or for diversification purposes.
  • Despite the positive growth and active development of the information technology, investment in South Korea has a risk associated with the stability of its currency, competition from China and weak corporate governance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.