While the Kospi Index did not move much in 2016, we witnessed the exceptional outperformance by large cap stocks. This is exactly the opposite situation from the past several years in Korea when small caps had significantly outperformed large caps. The MSCI Korea Small Cap Index fell 13.8% (in Korean won term) in 2016. As we mentioned in our last quarterly letter, many small caps stocks might have been negatively affected when many Korean institutional investors (led by National Pension Service) made a policy shift towards passive investing strategy during 2016.
On a global level, the year 2016 has been full of unexpected outcomes. It started with Brexit and culminated in Donald Trump’s winning the U.S. presidential election. Some pundits say these outcomes are just the results of populism and downplay the significance. But if we dig deeper into the root cause of today’s rampant populism, we can easily understand why. Many people favored populist agenda because they are disenchanted with the current economic situation. In fact, the economic recovery since the global financial crisis in 2008 benefited only a few rich people and sidestepped those who are in the middle and lower classes. In light of this situation, populists are touting economic policies which might bring short-term positive impacts on these groups, but are likely to have long-term negative consequences. Even in the U.S., where the economy seems to be in the course of recovery, many American people continue to be dissatisfied with the pace of the economic recovery and ended up electing a populist candidate. The newly elected U.S. president is trying to reverse the previous policies and instead promote potentially damaging ideologies, including protectionism and nationalism. In other developed economies such as the Eurozone and Japan, despite having adopted similar monetary and fiscal measures to those of the U.S., the economies do not seem to show any sign of recovery and the situation looks even bleaker.
If we look around other regions in the world, the economic outlook is no different and many uncertainties persist. For example, a possible trade war between China and the U.S. could make the global economy even more capricious and unpredictable. Given the already vulnerable state of the Chinese economy, the trade war might bring about another global crisis. Also, Trump’s efforts to reduce trade deficit are at odds with a strong U.S. dollar. This seemingly contradictory situation could trigger a global currency war and/or high inflation in the U.S. The situations in other emerging countries are in no better shape. A strong U.S. dollar could lead to a capital exodus out of these regions, and this in turn could dampen any hope of economic recovery. It seems that we can hardly find any positive news anywhere in the world.
Despite the year full of many uncertainties and surprises, most stock markets performed well in 2016. However, Korea was an exception again as the broad market in Korea did not move much at all. In fact, the Korean equity market has gone nowhere over the past six years. The Kospi Index level at the end of 2016 is almost the same as the level at the start of 2011. This dismal performance of the Korean equity market contrasts sharply with the strong performance of other developed markets. The Korean market has actually performed in line with other emerging markets. Sure, Korea is still categorized as an emerging market by MSCI. But considering Korea’s more diverse and fiscally sound economy compared with that of other emerging economies, this lackluster performance seems unjustified. In the wake of the Fed’s rate hike and Trump’s winning the U.S. election, the U.S. dollar gained momentum and strengthened against most other currencies. Korean won, of course, depreciated against the U.S. dollar, but has been much more stable compared to many other currencies. We think this may signal the resiliency of the current Korean economy.
After many years of stock market doldrums in Korea, the Korean market has become cheaper and more undervalued, at least comparatively. Many international value investors are looking to come back to Korea for this reason. In terms of valuation, Korean market is one of the cheapest markets in the world with a P/E of about 10. Developed markets, including the U.S. market, currently trade on average at a P/E of about 20. Even emerging markets trade at a P/E of about 14. Although few things are predictable in investing, no bull market has ever started when the market was expensive. History tells us that over the long term, cheap markets will get more expensive and expensive markets will get cheaper. This may explain recent inflows of foreign capital into the Korean equity market.
Of course, the Korean market has its fair share of problems. One of them is a perennial issue of poor corporate governance, which is clearly a discount factor. But as we have emphasized previously, the corporate governance in Korea has been improving, albeit at a slower pace than many investors had hoped. Ironically, the current political crisis in Korea might work as a catalyst to pave the way to real, broad reform. The next administration is likely to push for laws to strengthen corporate governance and enforce better governance at companies. In fact, it’s about time for the Korean government to impose stricter rules on chaebols and the national outcry can be used as ammunition for push. In our opinion, it is always better to invest in a market with some room to improve, rather than a market with little room to improve.
While the Korean stock market has moved sideways over the past six years, some sectors or styles always rose while others declined in a given year. During this process, volatilities of different sectors or styles have been balanced out. For example, in 2016, large caps significantly outperformed the market and recouped the underperformance of previous several years, while the broader market remained flat during the same period. Although the sector or style rotation is quite a common phenomenon in the stock market, the recent Korean market has shown more pronounced movements. We think this is due to the increasing number of momentum investors in Korea. Momentum investors buy rising stocks and sell declining stocks. That is why once one sector begins to rise, it continues to move up for a much longer period than most investors can reasonably expect, and vice versa.
In effect, momentum investing reinforces the market’s inefficiencies with its herd mentality, while value investing helps the market to become more efficient by identifying mispricing opportunities in the market. Therefore, value investing cannot exist without the presence of momentum investing. For this reason, oftentimes, the more investors practice momentum investing, the more opportunities become available for value investors. But the increasing volatility does not always benefit value investors. Because momentum investors also sell declining stocks regardless of the fundamentals, the price of undervalued stocks may go down further for a prolonged period of time. Therefore, if you end up buying undervalued stocks too early, it may take longer for the price to catch up with intrinsic value.
In fact, this is exactly what has happened recently in Korea because of the increasing number of short sellers who mostly practice momentum investing. For example, many Korean companies in the consumer discretionary sector have been in vogue in the past several years because of their success and/or growth potential in China thanks to the growing popularity of Korean brands in the region. However, the stock price of many of these companies, mostly small to midcap companies, began to slide materially in 2016 because of the Chinese government’s deliberate, retaliatory actions against Korea’s earlier decision to deploy the Terminal High Altitude Area Defense (THAAD) anti-missile system (sponsored by the U.S.) in Korea. Although the impact of these “anti-Korea” actions is real, the market has probably overreacted and, in most cases, stock price declines were rather excessive.
In Korea, only a small number of investors adopt a value-oriented investment approach and apply a robust research process, which gives rise to significant market inefficiencies. As a result, if you are willing to bestow a rigorous bottom-up fundamental research process, you are likely to find numerous opportunities to buy undervalued stocks featuring a huge margin of safety, which are rarely available in the more efficient market. In that sense, we consider ourselves lucky to be operating in Korea where we can find more compelling value stocks. It is no coincidence that Warren Buffett once mentioned Korea when he was asked where he would start if he were to set up his original partnership today.
We will not stray from our rigid value investing discipline. We manage our portfolio with the intention of achieving good absolute returns regardless of how the market performs. We implement this investment philosophy with a bottom-up value investment strategy whereby we buy only those stocks that are competitive but substantially undervalued.
This post has been excerpted from a letter of Petra Capital Management.
Albert Yong and Chan Lee of Petra Capital Management are instructors at Asian Investing Summit 2017.
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