South Korean stock values dampened by corporate governance issues

South Korean companies demonstrate enormous potential and yet many of them trade at a significant discount to their Asian and global peers.

Jesper Madsen, a portfolio manager at Matthews International Capital Management in San Francisco, said that consequently South Korean can be a frustrating place for foreign investors.

“My last visit to Korea reminded me of why equities of Korean companies are often not priced in line with the value they create,” he said.

“There have been many attempts to rationalize the discount, with explanations ranging from threats posed by an unpredictable North Korea to the cyclicality of many Korean businesses.”

However, Madsen believes the issue of corporate governance may be the biggest factor.

“The crux of the problem as I see it comes down to the basic question of who the true owner of the business is, and furthermore, which stakeholder gets to decide how capital is allocated within the company,” he posed.

The issue, he states, is encapsulated in the dividend yield of the Korean market.

“At just 1 percent, the dividend yield of Korea’s market is among the lowest in the region despite the fact that Korean companies in the MSCI Korea Index are trading at about 10-times their estimated 2010 earnings [versus 15-times earnings for the broader MSCI All Country Asia Pacific Index]” he indicated.

Or, to put it another way, Korean companies are good at generating earnings, but they fail at paying a fair share of these earnings to minority shareholders.

“This is not just of relevance to investors seeking income, but to all investors in Korea,” Madsen said.

“Korean equities have tended to be priced at a persistent discount begging the question of whether this is indeed a discount or perhaps just fair value for a set of companies that will need to improve their corporate governance to be valued fully.”

Madsen notes that to understand the reluctance of some companies to pay minority shareholders a fair dividend, it is helpful to look at Korea's history and the structure of the capital markets.

“Small- and mid-sized companies have historically been (and continue to be) overly reliant on banks for financing -- a precarious position during times of crisis when banks recall loans or become unwilling to roll over short-term finance used for working capital purposes,” he indicated.

“Smaller companies therefore hoard retained earnings for precautionary reasons. While it is prudent to ensure access to capital to withstand short-term economic and financial volatility, many companies take this to an extreme.”

Larger Korean companies, he explains, were traditionally structured as conglomerates known as a “chaebol,” which would often be an intricate network of companies held together by cross-ownership and a dominant family and main shareholder. In this structure, capital was kept within the group to finance the various group businesses.

“In this scenario the cash flow of companies was often diverted to other business within the group of companies, rather than paid out to minority shareholders,” Madsen said.

“Since the Asian crisis, Korean lawmakers have attempted to close some of the most direct means of intra-chaebol capital transfers, and regulations now support ‘holding companies’ that better align the interest of minority shareholders with company insiders and dominant shareholders.”

However, he adds, while regulation has been greatly improved, the general mindset has not yet shifted.
“In many cases this has left the management of larger companies with a tendency to retain earnings for no seemingly valid reason, at times engaging in investments that may be detrimental to shareholder value,” Madsen stated.

Madsen concedes that Korea boasts great companies in Korea, some of which are changing their ways.

“As investors we look at the improvement occurring at the margin and remain hopeful that Korean companies are moving in the right direction as they embrace better capital management and corporate governance practices,” he stated.

“If and when this occurs, Korean companies may finally be priced in accordance with the value they create.”