The ‘Korea discount’ is widening despite the Moon administration’s campaign to reform family-controlled conglomerates. In the following Q&A, we look at how political risks are creeping into financial markets.
6 minute read
South Korea’s label as an emerging market may strike many as anachronistic. Its transformation following the 1950-1953 Korean War is often held up as one of the fastest economic growth stories in modern history, earning it the label of ‘The Miracle on the Han River’. From an agrarian economy ranked below Bolivia, the nation has become the 12th largest economy in the world1 with a larger annual gross domestic product (GDP) than some developed markets, including Spain, the Netherlands and Switzerland.
The economic advancement, however, has not necessarily translated into overall stock market performance. South Korea’s companies tend to be undervalued versus peers, a phenomenon known as the ‘Korea discount’. One of the ongoing reasons for the discount is the poor corporate governance track record of the chaebols, a group of family-controlled conglomerates that played a critical role in lifting South Korea’s economy after the war and in subsequent decades. But their overarching financial power and government influence also severely limits minority shareholder rights, strangles competition and has frequently led to mismanagement.
In 2016, former president Park Geun-hye was impeached and later sentenced to 25 years in jail for colluding to take millions in bribery and extortion from businesses, including Samsung. The company’s heir, Lee Jae-yong, was sentenced to five years in connection to the same case but freed after an appeals court suspended his sentence. He is facing a retrial.
As with corporate scandals in other nations such as Malaysia, Mexico and Brazil, Park’s replacement Moon Jae-in campaigned on a promise of cleaning up corruption. Yet more than two years after taking office in May 2017, material reforms to curb the power of chaebols are notably sparse. The gap between Korea’s price-to-book ratio compared to other Asia emerging market stocks has widened (see Figure 1). Increasingly, politics is influencing the pace and scale of much-needed corporate governance reforms at a time when South Korea can hardly afford to be complacent about its economy, which is slowing.
Figure 1: Price-to-book ratio, MSCI Korea vs. MSCI Asia ex-Japan
In the latest instalment of our Q&A series on ESG in emerging markets, emerging market equities portfolio manager Will Malcolm and ESG analyst Stanley Kwong discuss how equity investors in South Korea should assess ESG risks and opportunities.
Why are chaebols so crucial to the South Korea economy?
Malcolm: Historically, chaebols have played an important part in building Korea’s economy. Benefitting from national economic policies launched since the 1960s to transform South Korea into a tech and industrial powerhouse, chaebols now account for about 60 per cent of the Korea Composite Stock Price Index (KOSPI) as of 30 September 2019, according to JPMorgan data.
Along the way, however, events such as the Asian financial crisis and domestic corporate scandals, including the 2016 corruption case against Lee and Park, exposed severe weaknesses in Korea’s corporate structure. The need to refocus these giant conglomerates is well-known, but the capacity to change them has been limited because of the web of control structurally built into the system.
These key corporations hold incredible sway, financially and politically
Chaebols such as Samsung, for example, have become too big to fail. Accounting for as much as 20 per cent of the country’s GDP,2 it could boost the entire Korean economy if investors become more positive; but equally, the opposite holds true. These key corporations hold incredible sway, financially and politically. In Korea, the whole economic ecosystem is intertwined with politics, making chaebol reforms much more challenging.
Why is change more critical now when calls for reform have been going on for years?
Malcolm: These are the flagship companies for the country, and all indications suggest they will struggle to compete in this more challenging global environment by continuing under the old regimes. From a macro perspective, there are headwinds to economic growth. First, the US-China trade war has punished South Korean stocks disproportionately. Second, tensions between Japan and South Korea are putting more pressure on the economy. Third, the competition for capital in emerging markets is rising; China’s efforts to attract foreign investment, for example, could further reduce South Korea’s appeal if the necessary corporate reforms don’t materialise.
Chaebols are increasingly a source of public unrest
Pressure is also building from within. Once venerated, chaebols are increasingly a source of public unrest. The simmering anger culminated in what became known as the Candlelight Struggle in 2016-17, when hundreds of thousands protested against the Park administration over corporate corruption. Investor activism is escalating in South Korea, now registering the second highest share of activism campaigns in Asia behind Japan.
Are there any signs of reform?
Kwong: It is clear the government wants to reform chaebols and improve corporate governance. However, the Moon administration has been held back over the past few years by domestic political dynamics. For instance, the country is battling a persistent problem in unemployment, where it ranks 28th among 36 OECD countries.3 While a recent minimum wage hike contributed to the problem, higher unemployment – particularly among the youth population – is also partly due to a larger population of elderly people living in poverty and needing to stay in low-paying jobs for longer to make ends meet.4
The country is battling a persistent problem in unemployment
The government remains dependent on chaebols, which are the largest employers in the country. Any efforts to curb their power could therefore have unintended consequences for the labour market.
Nevertheless, the government deserves some credit for improvements to corporate governance practices, although it is early days. The government introduced a voluntary stewardship code subsequently supported by the state-run National Pension Service (NPS), one of the world’s largest pension funds. NPS owns a material stake in over 80 companies in the KOSPI and it has to be hoped that such a large institutional investor could influence corporate behaviour for the better.
The new stewardship code has also had an impact in other ways. For instance, all 200 companies listed on the KOSPI submitted corporate governance reports in 2018. Companies are unwinding their cross-shareholding structures and dividend payout ratios are increasing. Despite these improvements, investor access to company boards to discuss ESG issues remains a challenge. Among many of the major chaebols, the next generation of company leaders is coming through the ranks. With a change in leadership, investors may have more opportunities to engage.
What might concern investors about the government’s attempts to restructure chaebols?
Kwong: Even though the top-line message is to improve governance, the concern is that far too many proposals are either stuck or moving very slowly through the National Assembly process. The Moon administration is also proposing policy changes that have the potential to undermine its efforts to reduce cross-shareholding among chaebols. For example, the government wants to introduce a dual-class system, which allows certain share classes for founders and other executives to hold more voting power than ordinary shareholders. South Korea does not allow this currently, although Hong Kong and Singapore introduced it last year to attract listings like Alibaba. The South Korean administration is looking to introduce it for small and medium-sized enterprises. However, a big worry is, once it becomes available to SMEs, what’s to stop big companies like Samsung also issuing dual-class shares?
What other incentives do companies have to improve governance practices?
Malcolm: Companies often require a catalyst for change, and recent events have provided that. Their behaviours and understanding of corporate governance are improving dramatically; for example, more are engaging with shareholders to discuss these issues. They are much more aware of how business leaders should operate and what international investors expect. There is also a recognition that improved corporate governance has the potential to add value. If shares go up, the families with effective control over these companies become wealthier. This should be a reasonable argument to precipitate change.
Improved corporate governance has the potential to add value
There is the added advantage of having these shifts in corporate attitudes coincide with regulation and shareholder pressure. The government certainly has a lot of power to implement reforms, but they can’t do it alone; they need institutional shareholders to play their part.
Is investor engagement having any impact?
Kwong: Institutions have a collective responsibility to try and encourage change, but at the same time acknowledge this won’t happen overnight. At the moment, there is a degree of cynicism in the market that often culminates in shareholders dumping Korean stocks in reaction to disappointing governance events, rather than using them as reasons to engage. Without a stake in the stock, shareholders lose their ability to influence.
That said, instances of foreign voting and engagement are increasing, though not always with all minority shareholders on the same side. One of the more high-profile cases this year involved a proxy fight led by Elliott Management over dividends and board reforms at Hyundai Motor Group. One of the reasons Hyundai pushed back was because Elliott called for US$6 billion in one-time dividends to be paid out with cash from the balance sheet.
The auto industry is facing major challenges in the form of the evolution of autonomous and electric vehicles
We supported Hyundai, not Elliott. We see our role as being a long-term steward of the company, and we were concerned that taking such a large dividend from Hyundai would jeopardise its ability to compete; the auto industry is facing major challenges in the form of the evolution of autonomous and electric vehicles. So although institutional investors are engaging more, they don’t always approach it with the same agendas.
What issues are at the forefront of investors’ engagement efforts?
Malcolm: Companies’ attitudes towards dividends are gathering a lot of interest. In South Korea, the corporate sector is sitting on record levels of cash but, on average, the dividend payout ratios tend to be below their Asian peer group. It is edging up but remained at about 20 per cent on average in 2018, below the 25 per cent average for Asia ex-Japan and about 30 per cent for Japan. When you've got the capacity but not willingness to pay a higher dividend, there is definitely room for improvement in returning cash to shareholders. We are working with other institutions to obtain clarification and asking companies to declare their formal approaches to dividend payout policies.
Where can investors find ESG opportunities in this environment?
Malcolm: The narrowing of the discount in South Korean stocks – if it manifests – will be a slow burn. In effect, companies need to change their spots, either willingly or being dragged through it by way of engagement or regulations. Still, it is not obvious that valuations at an index level are on an upward structural trend, even though progress being made.
Rather than systematically overweighing the index, investors may be better off targeting companies making the right improvements in their corporate governance structures – Hyundai and Samsung are moving in the right direction. There are also positive changes stemming from the engagement efforts of institutional investors. This, combined with more momentum behind the reform efforts from a regulatory and legislative perspective, means there is an argument for some South Korean stocks to have a higher rating.
- World Development Indicators database, World Bank, 19 September 2019
- William Pesek, ‘Ill-timed scandal for the Republic of Samsung’, Nikkei Asian Review, 19 November 2018
- Kim Yon-se, ‘Korea ranked 28th among 36 OECD members in employment’, The Korea Herald, 10 September 2019
- Bryan Harris, ‘South Korea’s elderly overtake young in the workforce’, FT, 12 March 2018