Ori Eyal is a featured instructor at Best Ideas 2017.
Ed. note: Please read the important disclaimers toward the end of this post.
“Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified… The strategy was to buy the securities of twenty companies … $100 million was quickly put to work.”
— Warren Buffett – 2005 talk to students at Harvard
“When Warren said he’d put 100% of his fund in Korea, maybe he wouldn’t quite do that, but pretty much [he would].”
— Charlie Munger – 2006 Berkshire Hathaway Annual Meeting
We recommend investing in a carefully selected basket of 15 Korean preference shares which trade, on average, at a 50% price discount to their respective common stocks. Korean preference shares are a form of equity security and are materially equivalent to Korean common stocks. They are legally entitled to a higher dividend and have a legal claim on company assets, earnings, and cash flows.
Investors enjoy three separate levers of return:
- Korean stock market return
- Higher dividend yield from preference shares
- Return from narrowing of the price discount between preference and common shares
Preference shares lack of voting rights justifies a small price discount of 10% – 20%, but cannot justify the huge price discounts at which they trade. Multiple catalysts are causing this price discount to gradually narrow. These include mean reversion, rising dividend yields, improved corporate governance, normalization of the Korean stock market and reduction of market inefficiencies and bargain hunting value investors.
Since we started investing in 2013, we have almost doubled our money while the Preference shares price discount narrowed from about 70% to about 50%. Over the next few years this, still huge, price discount could further narrow from 50% to a more reasonable 30% discount. Adding 7% annual Korean market appreciation (our estimate) and a 2% dividend yield could result in upside of 90% over the next 4 years (over 17% annualized IRR).
Importantly, the risk of permanent capital loss in this basket approach is minimized since we invest in a diversified basket of 15 cheap, profitable, dividend paying preference shares. Therefore, we view this investment opportunity as compelling from a risk-reward standpoint.
In addition to employing this strategy in Emerging Value Fund, we are also offering this strategy to investors via separately managed accounts.
Korean Preference Shares:
Over 100 of the publicly listed companies in South Korea have both common and preference shares. The Preference shares in Korea are very different than preferred stocks in the US and most other countries. They are legally required to pay a higher dividend than the common stocks, have a claim on company assets, cash flows and profits, and are treated fairly whenever corporate events take place.
At Emerging Value Capital we track all the Korean preference shares and have done extensive research on most of them. We have been profitably investing in Korea for over a decade and view the current opportunity to invest in Korean preference shares as compelling.
Why Invest in a Basket:
While most of our investments are in individual companies, we do occasionally prefer to purchase a basket of related securities. This happens when we are confident that a certain sector or class of securities will, in aggregate, perform very well, but we are less certain about each individual member of the group. We think that Korean preference shares perfectly fit this definition. While not every company in our basket will be a star, we expect that, on average, our basket will perform very over the next few years. An added benefit of the basket approach is that we are able to adjust our basket of preference shares as prices (and relative discounts) shift.
Portfolio Strategy (Selecting Preference Shares for our Basket):
We track over 100 preference shares in Korea and have invested in a basket of 15 carefully selected preference shares.
When selecting Korean preference shares for our basket, we look for 8 key criteria:
- 50% – 60% price discount between the preference share and common stock.
- Sustainable dividend yield.
- Reasonable trading liquidity (average daily trading volume).
- Good business with competitive advantages.
- A history of profitability and positive free cash flows.
- Strong balance sheet.
- Trustworthy and capable management team.
- Extremely cheap price relative to the intrinsic value of the business.
While clearly not all preference shares in Korea meet these criteria, we have found 15 preference shares that meet our high standards for investment.
Preference Shares in Our Basket:
The following table lists eight out of the fifteen Korean preference shares in our basket.
In addition to simple mean reversion, we believe that there are four catalysts that will close the high price discount between Korean common stocks and Korean preference shares over the next few years:
- Improved corporate governance and minority shareholder rights.
- Rising Dividend Yields.
- Normalization of the Korean stock market and reduction of market inefficiencies.
- Bargain hunting value investors.
- 40% from price discount narrowing (going from 50% discount to 30% discount).
- 30% from common stock price appreciation (7% per year for 4 years).
- 8% from dividends (2% X 4 years).
- Total Return = (140% X 130% ) + 8% –1.0 = 90% (over 17% annualized IRR).
Importantly, the risk of permanent capital loss is minimized since we invest in a diversified portfolio of 15 cheap, dividend paying, preference shares. As such we view this opportunity as compelling from a risk-reward standpoint.
Disclaimer: This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum. Past results are no guarantee of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk including the loss of principal. An investment in Emerging Value Fund or in Korean preference shares may be deemed speculative and is not intended as a complete investment program. It is designed only for sophisticated persons who are able to bear the risk of the substantial impairment or loss of their investment. The Fund is designed for investors who do not require regular current income and who can accept a certain degree of risk in their investments. Prospective investors should carefully consider the risk factors specified in the Funds Offering Memorandum before making a decision to invest in the Fund.
Meet Ori Eyal, Portfolio Manager of Emerging Value Capital Management.