South Korean equities don’t get much respect from investors. It’s one of the reasons why we believe Korea trades cheaply relative to both developed and emerging markets, second only to Greece and Russia on a price-to-book basis. It is possible that many investors have given up on the possibility that chaebols – the family-controlled conglomerates that dominate South Korean industry and finance – might finally begin to utilise their capital in a more shareholder-friendly fashion. We believe to rebuild its credibility, South Korea should consider taking a page out of its neighbour Japan’s playbook.
Figure 1. South Korea’s valuation discount to developed and emerging markets
Source: CLSA 2016.
South Korea’s chaebols have a history of stockpiling cash to drive future growth in capital-intensive industries. On the other hand, the government and national pension funds like the National Pension Service (NPS) need cash circulating in the economy rather than accumulating on corporate balance sheets. Even now, as South Korea’s Financial Services Commission (FSC) lobbies for inclusion into the developing market indices, the prevailing attitude among corporates continues to be one of growth-over-returns1. The Bank of Korea has gotten involved as well, unexpectedly cutting rates by 25bps on June 8th. The cut – with potentially more to come in the second half of the year – may help prioritize the search for yield among Korean equities for domestic funds like NPS.
To combat this reluctance to distribute cash to shareholders, the government introduced the “Corporate Accumulated Earnings Tax” in late-2014. This measure is designed to penalize companies who don’t distribute or reinvest at least 60% of net profits. The reaction, though, was disappointing to say the least. One of the largest South Korean chaebols responded by announcing an over-priced land purchase as an alternative to raising dividends or paying extra tax. Some South Korean chaebols, it appeared, would rather find ways of undermining the new reforms than return the cash.
The opacity of the chaebols’ management practices might have persuaded financiers at home and abroad that South Korean shareholder returns are not going to improve dramatically any time soon. Our composite of international broker estimates indicates a small pickup for South Korea’s dividend payout ratio, while a consensus of South Korean brokers collected by Wisefn believes the payout ratio to actually decline through 2018. These assumptions, though, are worth interrogating more thoroughly.
Investors may consider South Korea’s cash return story working on two levels, both of which may imply higher shareholder returns. On the one, optimistic, hand, government policies and shareholder pressure may act to revive chaebol distribution policies. Even if this does not occur, the chaebols will eventually face family succession issues and may have to increase payout ratios in order to meet sizable inheritance tax liabilities.
Figure 2. South Korea vs emerging market dividend payout ratio forecasts, 2015-2017
Source: Wisefn, Bloomberg, Citigroup, Deutsche Bank, Credit Suisse, CLSA, JP Morgan, UBS, Goldman Sachs, Morgan Stanley and BofA Merrill Lynch, 2016.
South Korea shares many of the problems that plagued Japan in the early days of Abenomic reform. Firstly, with USD430 billion of assets and nearly 10% ownership in the KOSPI, the NPS has underperformed the domestic equities index since 20132. In the wake of the unexpected rate cut the Korean 10-year government yield has now fallen below equity yields for the first time since the start of the millennium. Japan’s Government Pension Investment Fund (GPIF) faced the same yield-suppression issue which compelled it to become more proactive about shareholder distributions and corporate governance.
Figure 3. South Korea 10-year sovereign yields vs. KOSPI equity yields
Source: Bloomberg, JP Morgan, 2016.
Secondly, ratios like cashflow return on investment (CFROI) and return on equity (ROE) have deteriorated over the last decade to a point where many South Korean companies struggle to earn their cost of capital (something we saw in Japan during their darkest days). Weaker returns reflect a combination of declining asset efficiency, weighed down by excess cash on the balance sheet, and contracting margins. But South Korea’s trends don’t fit cleanly in an export-oriented or an emerging market narrative. South Korea’s margins have declined while margins for export-heavy countries like Germany and now Japan have expanded. Slower global trade and overcapacity have hurt emerging markets broadly, but South Korea’s asset intensity ratios have been harder hit.
Figure 4. South Korea’s CFROI and the drag of excess cash
Source: Credit Suisse HOLT, 2016.
Thirdly, the problem of circular ownership within chaebols – have a look at Samsung’s labyrinthine corporate structure below to get an idea of the complexities involved – may create conflicts of interest between controlling families and minority shareholders similar to Japan’s crossholdings problem.
Figure 5. Samsung’s ownership structure
Source: Samsung, Credit Suisse, 2016.
Finally, high-profile corporate governance issues have plagued both countries. Some South Korean conglomerates are even run by chairmen or senior executives who have criminal records. Stewardship and corporate governance codes offer ways of institutionalizing norms and disentangling vested interests.
As South Korean chaebols finally – by choice or otherwise – set about reforming their distribution policies, we feel they would be wise to heed Japan’s example, particularly the emphasis on capital efficiency ratios like ROE over shareholder returns. There’s much to criticize about Abenomics, but we believe Japan deserves credit for improving ROE back to cycle-high, in the process linking awareness of cost of capital to the notion of corporate governance. Yen depreciation provided a tailwind, but operational improvements and shrinking the equity base via share buybacks drove as much as 70% of Japan’s ROE gains, according to Mizuho Securities.
We have written in the past why formal commitment to ROE targets matters in Japan, and its strong historical correlation to, relative outperformance versus the TOPIX over more than ten years3. We found that, over time, markets rewarded companies with valuation premiums for this signalling.
Even the more progressive South Korean companies, though, are choosing to anchor themselves to shareholder returns targets rather than ROE. This approach only partially addresses the symptoms of capital inefficiencies, and it ignores the South Korean bias towards growth at the sacrifice of returns. Investors are forced to ask just how sustainable these progressive dividend policies are if South Korean companies don’t reform their underlying businesses?
In fact, we found only two South Korean companies – both banks and unfettered by controlling family interests – that issue formal returns targets. By contrast, we identified 87 Japanese companies at the start of Abenomics, a figure now close to 250, according to Life Insurance Association of Japan survey data4.
We believe there’s a strong case to make for ROE in South Korea, which bottomed out at 8.2%(cite source and date) – barely above the cost of capital – just as the government announced the new tax policy. Analysts frequently argue that ROE is inappropriate for South Korea’s economy which is cyclically-geared to technology and heavy industries like shipbuilding, automotives and chemicals. We disagree. There are many examples of Japanese companies that guide through the cycle, hitting ROE targets on an earnings basis when the business cycle is recovering or strong, and managing the equity base through share buybacks and cancellations when the cycle is contracting.
Figure 6. South Korea, EM, US, Japan and Europe ROEs
Source: Credit Suisse HOLT, 2016.
We believe that the transition from an emerging market growth bias to a returns bias will take time for South Korea. Japan has taken considerable measures to cultivate the ROE norm alongside institutionalizing stewardship and governance codes. The launch of the Nikkei 400, a ROE-focused index, raised awareness as well as provoked changes in distribution policies from companies who were excluded. Japanese ministries went so far as to develop campaigns to educate managements on how to decompose ROE in terms of return on sales, asset efficiency and financial leverage, in an effort to move away from a short-termism style of business planning5.
The good news is that South Korea has already begun the process with South Korea’s former finance minister, Choi Kyoung-hwan, kickstarting a slate of “Choinomic” reforms. Choi didn’t survive the 2015 elections, but parts of his legacy survive. The FSC introduced a draft stewardship code in 2015, and is considering a corporate governance code for companies. Still, more needs to be done, particularly in reframing the notion of capital efficiency in the way that Professor Kunio Ito accomplished in Japan. It could be that figures like Jay Y. Lee, heir to Samsung Group, begin to symbolize the transition to a more pragmatic, shareholder-oriented approach.
There are also encouraging signs of dividend payout ratios going up. Government state-owned enterprises (SOEs) were the first to increase their payout ratios, but there’s growing evidence of change within chaebols. Many are simplifying their group structure and allowing underlying units, to begin signalling higher distribution policies over the next several years.
This process needs refining. Some units have announced share buybacks to appease investors, instead of addressing recurring returns. Others have guided to dividend payout targets based on free cashflow rather than net profits, giving them an enormous hedge around capital spending. Nonetheless, we believe it’s rational to expect some kind of trickle-down effect if the chaebols adopt progressive shareholder return policies across their affiliates.
We think that South Korea sits at a unique confluence of factors – a proactive NPS, tax policy changes, chaebol succession issues, falling bond yields and corporate governance – capable of rerating it relative to emerging and developed markets. But we believe a rerating requires a more pro-active South Korea to emerge: one that emphasizes better capital allocation and more transparent forms of corporate governance over the growth bias. It is clear that both the NPS and FSC seem to recognize this opportunity. Now, it’s time that South Korea’s corporations and, particularly, the families that control its chaebols, to align themselves as well.
1. Sun-young, Lee. “Korea aims for MSCI Upgrade.” Korea Herald. 27 January 2016. http://www.koreaherald.com/view.php?ud=20160127001247
2. National Pension Service. “Investment Portfolio: Performance – Relative Returns.” 1 March 2016. http://fund.nps.or.kr/jsppage/fund/mcs_e/mcs_e_03_03.jsp
3. Mitchell, Jason. “Unhedged Commentary: Japan’s Commitment Issues.” Institutional Investor. 17 July 2014. http://www.institutionalinvestorsalpha.com/Article/3363025/Blogs/Unhedged-Commentary-Japans-Commitment-Issues.html
4. The Life Insurance Association of Japan. “Survey Results on Approaches toward Enhancing Equity Values.” 23 March 2016. http://www.seiho.or.jp/info/news/2015/pdf/20160323_3.pdf
5. Ministry of Economy, Trade and Industry. “ITO Review of Competitiveness and Incentives for Sustainable Growth.”25 April 2014. http://www.meti.go.jp/english/press/2014/0425_02.html