georgeclerk
The iShares MSCI South Korea ETF (NYSEARCA:EWY) remains a very attractive value play in the ongoing semiconductor upcycle and one of the best ways to gain exposure to chip giants Samsung Electronics (OTCPK:SSNLF) and SK Hynix (OTCPK:HXSCF), the world’s two biggest memory chip makers. Both Samsung Electronics and SK Hynix are listed on the Korea Exchange and do not offer ADRs trading on the US exchanges as they are only accessible through the Pink Sheets OTC market, or indirectly through ETFs. EWY is the biggest Korea-focused ETF with $5.4bn AUM, dwarfing the $189mn managed by the Franklin FTSE South Korea ETF (FLKR) and the closed-end Korea Fund (KF) with $135mn AUM.
EWY has a relatively higher 23% weight of Samsung Electronics in the index, which makes it highly-exposed to what happens with Korea’s biggest and most popular stock. SK Hynix has the second-highest weight in the ETF with 9% weight, followed by carmakers Hyundai (OTCPK:HYMTF) and Kia Motors (KIMTF) with 3.13% and 2.74% weights, respectively, and Korea’s largest bank KB Financial Group (KB) with 2.98% weight.
SK Hynix’s and Samsung’s results in Q2 buoyed by strong memory chip sales
It should be noted that both SK Hynix and Samsung are seeing better-than-expected earnings in Q2 as sales have been buoyed by robust demand for semiconductors. According to preliminary earning guidance given by Samsung on July 5, its operating profit rose by 57.3% y/y to 10.4tn won in Q2, while sales rose by 27.3% y/y to 74tn won. At the same time, SK Hynix saw its operating profit increase by 89% y/y to 5.4tn won, while sales rose by 125% y/y to record-high 16.4tn won. SK Hynix expressed confidence in its earnings report that “demand for AI server memory will continue to rise in the second half, and sales of high-performance memory products will increase as new PC and mobile products supporting On-Device AI will be released on the market.” At the same time, Samsung plans to release full earnings on Jul 31, but actual earnings seldom deviate significantly from the preliminary guidance.
The HBM market has seen massive uptick in demand in H1 due to the surge of investments into AI servers which demand high-performance memory chips. It should be noted that SK Hynix remains the darling of the AI memory chip sector and is currently estimated to hold over 90% market share in the HBM3 market, according to TrendForce. In addition, it is the main supplier of HBM3E chips used in the high-end Nvidia (NVDA) products. However, Samsung has been unable to fully take advantage of the AI boom given that its HBM3 and HBM3E memory chips have so far failed Nvidia’s verification tests.
However, some positive developments occurred in July which raise the odds that Samsung will regain its lost market share to SK Hynix in HBM market. First of all, Samsung’s next-gen HBM3E memory became rumoured to be on path to receive validation by Nvidia in Q3, according to a report from TrendForce which cited industry sources. In addition, another report floated by Reuters suggested that Nvidia will start using Samsung’s HBM3 memory, but only in low-powered chips aimed at the Chinese market. The latter report also said that the high-performance HBM3E chips are still not cleared for use. That said, Samsung has denied so far all reports about its HBM3 validation status from Nvidia and has repeatedly said that it is still working with Nvidia to pass quality assessment tests.
At any rate, competition between the two Korean memory makers is projected to heat up in Q3 as both of them aim to supply next-gen HBM3E 12-layer chips to Nvidia. In my view, it is imprudent to bet against Samsung in the HBM race as it is still the largest memory chipmaker by volume with significant expertise in the sector, while it is also sitting on more than $70bn of cash on hands as of Q1 2024. That said, Samsung is definitely experiencing a chip crisis and the next few months will be crucial for the firm’s semiconductor business. That said, I think the market currently prices that Samsung will continue to lag behind SK Hynix, which opens the door for Samsung’s stock to gain from potential positive developments for the firm in the HBM market in Q3.
Korean stocks remain cheaper than peers amid persistent structural issues, lack of developed market status
The Korean stocks ETF EWY remains significantly cheaper than iShares MSCI Taiwan ETF (EWT) and the iShares MSCI Japan ETF (EWJ) as South Korea continues to grapple with the so-called Korean discount that reflects multiple structural issues. For example, the EWY trades at 13.43 times earnings (as of July 24) compared to 22.84 for the Taiwan-focused EWT and 16.66 for the Japan-focused EWJ. In terms of the P/B ratio, EWY trades at 1.1 times book value compared to 2.39 for EWT and 1.6 for EWJ. At the same time, it should be also noted EWY exhibits the highest volatility between the three with a 3-year standard deviation of returns of 27.81%.
iShares MSCI 
In my view, the divergence with Japan is particularly striking given that EWT has a much lower weight in the information technology segment at 14.7% compared to EWY which has 36.6% in the IT sector. That said, MSCI continues to classify Japan as developed country, while Taiwan and South Korea are classified as emerging markets. Korea failed to gain classification as developed market in MSCI’s review of market accessibility last month largely due to an ongoing ban on all short-selling which was introduced in Nov 2023. However, MSCI still noted that Korean government has implemented a variety of measures aimed at improving accessibility for investors.
Korea still has a chance to score a win in terms of market recognition if it is included in the FTSE World Government Bond Index (WGBI) in the next review that is scheduled to be conducted in September. South Korea is already on the watch list for inclusion in the WGBI index as the government has implemented reforms such as extending FX trading hours and enhancing foreign participation in the onshore FX market. Potential inclusion in the index could generate significant foreign investor’s inflows worth USD 58bn to the local debt market, according to an estimate from the finance ministry, which would serve as a major tailwind for the Korean won. Naturally, inclusion in the WGBI index should also boost Korea’s stock market returns by way of strengthening the Korean won.
Corporate Value-up programme shows government’s commitment to curb Korean discount
When the government unveiled its Corporate Value-up programme in February it was initially met with skepticism given that it didn’t include any mandatory measures as it will run only on voluntary basis similar to measures that have already been tested in Japan. Criticism against the programme revolved around the fact that it will do very little to tackle the issue of persistently strong controlling shareholders which preserve a hold on a number of large family-owned conglomerates (chaebols), including Samsung, SK, Hyundai and LG.
Controlling shareholders oftentimes have conflicting interests with minority shareholders as their main focus remains on preserving family control over businesses. At the same time, South Korea has one of the highest inheritance taxes in the world at 60% for large stakes in conglomerates, which means that controlling shareholders have little interest to expand shareholder value given that it would lead to higher tax bill when the controlling stake gets inherited.
Nonetheless, the government has shown a clear commitment to deal with the so-called Korean discount issue by placing the onus on measures that will enhance shareholders returns. For instance, the government recently proposed a law to lower the highest inheritance tax rate to 40% from 50% and to scrap a proposal to introduce a capital gains tax on large shareholders from start-2025 which could trigger a sell-off by large investors in the second half of the year. The government has also made it its top priority to improve market accessibility for foreign investors and gain developed market status for both its equity and debt markets.
Overall, I remain fairly optimistic that the Korean government will manage to boost shareholder returns through the Corporate Value-up programme and other measures. The main reason is the increasing political influence of retail investors which rose to 14mn in 2023, or almost one-third of the population, from roughly 6mn in 2019. The government will certainly want to keep retail investors happy in the run-up to the 2027 presidential elections which will be key a contest between the two main political parties in Korea.
Long-term challenges remain such as demographic crisis, standoff with North Korea, US-China trade war
In addition to the corporate governance issues, South Korea also faces other structural issues such as the unprecedented demographic collapse and the security threat coming from North Korea. South Korea’s fertility rate fell to the lowest in the world at 0.72 in 2023 due to a variety of factors such as high housing costs, stringent parental leave regulations and excessive competition at the workplace. The government has proposed to through money at the problem by offering lucrative incentives to couples to have kids, but the issue is likely more complex than that. South Korea can still partially solve the issue by allowing more foreign workers, though.
Meanwhile, the security situation on the Korean peninsula also doesn’t bode well for equity prices given that as North Korea has toughened its military posture recently. North Korea has become increasingly provocative rhetoric against South Korea, illustrated by the fact that Kim Jong-un named South Korea his “main enemy” in Jan 2024. In addition, North Korea recently signed a mutual assistance pact with Russia which brings further complexity to the security situation. Overall, the chances that South Korea has to deal with at least limited contingency related to North Korea remain pretty high in the mid-to-long-term.
Separately, the prospects for renewed US-China trade war could also impact stock prices significantly given that Korea does a lot of trade with China and the US. The potential new US administration may decide to toughen sanctions against China that will impact chipmakers such as SK Hynix or Samsung. In addition, US may also reduce subsidies for chipmakers and carmakers investing in the US which will impact both chipmakers, as well as the Hyundai-Kia group.
Conclusion
Despite the numerous issues facing the Korean stock market, I remain fairly confident that EWY is a good value bet to hold over the next 2-3 years, or at least until the start of the next semiconductor downcycle. The main selling point is the low P/E multiple of just 13.4 and the fact that the two main holdings of the fund, Samsung and SK Hynix have benefitted greatly from the ongoing upsurge in AI investment.
That said, the two companies also remain exposed to a potential re-pricing of AI stocks due to concerns about low return on investment for AI products. Nonetheless, I think that EWY offers significantly less downside to potential AI repricing than a lot of US stocks due to its very cheap valuation. At the same time, it offers excellent entry point for investors that still want to capture some AI gains, but are discouraged by the high valuations of mainstream AI stocks.
Meanwhile, I also think that EWY may get a boost from some events in the short-term such as the potential verification of Samsung’s latest HBM3E chips by Nvidia, or the inclusion of Korean bonds in the WGBI bond index which would prop up the Korean won. On the other hand, I would be looking to sell EWY if there are signs that the US-China trade war would intensify significantly under the new US administration.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
