During a volatile January, the fund outperformed the MSCI Emerging Markets index by 0.5%. Emerging Market equities surrendered all of December’s hard-won gains, led on the downside once again by Chinese markets. During the month, the largest relative contribution came from our positions in Korea, followed by China and Greece. This was partly offset by weak returns from Latin America as well as our underweight in India which held up relatively well.
We have continued reducing exposure to energy producers but have added to Korea as well as taking advantage of weakness in China to further narrow our underweight to that market.
We have regularly spoken and written about the conundrum that is the South Korean market. Its companies are world-beating, with strong brands and high profit margins compared to the rest of the world. The same companies however report some of the lowest returns on equity and consequently the market trades at one of the lowest price/ book multiples in the world.
The reason for this Korean discount is simple – companies have traditionally been terrible stewards of shareholders capital. They tend to keep highly inefficient balance sheets and the controlling families often treat them like a personal piggy bank, making unrelated investments and conducting related party transactions. Often this results in byzantine cross-shareholdings and surprising uses of treasury shares. Investors including ourselves are forced to use high discount rates to account for this governance risk and uncertainty.
Occasionally Korea goes through an investment fad – in recent years this was related to EV and battery technology, with many stocks rallying to crazy valuations and then falling back to earth. The latest mania that has gripped the market since the start of the year however is very different. The so-called ‘Korea Value-Up’ theme is driven by an expectation that the government will force Korean corporates to finally apply capital discipline and lead to a re-rating of businesses trading at steep discounts to book value. This idea is not entirely outlandish – the National Pension Service owns around 10% of the market. With a rapidly aging population it is soon moving to negative cashflows and ultimately will face a deficit. By encouraging companies to improve shareholder returns and narrow Korea’s valuation gap, the government can at least delay this crunch.
Although there is an upcoming election, there seems to be political momentum and an expectation that some measures will be announced in coming weeks. Among others, reforms to the punitive inheritance tax could remove a disincentive to make companies highly valued by the market. We have long owned companies that we considered to have great businesses and potential for significant capital returns but that may have been slow to reform. Even if reforms are not radical the increase in scrutiny and discussion may prod them in the right direction.
