This can help tackle the so-called ‘Korean Discount’, where equities in South Korea trade at markedly lower valuations than that of their peers in other markets. Robeco has extensively engaged with companies, regulators and trade bodies to try to improve the situation to unlock more value for shareholders.
Ongoing governance problems include inefficient balance sheets, inconsistent capital return policies, and a lack of effective boards that are strong enough to challenge management at the notorious ‘chaebol’, Korean conglomerates that are essentially run as an exclusive club.
“The current government was elected for its reform manifesto, particularly regarding the chaebol, and although it has made some changes, the reform agenda has stalled because the ruling party haven’t got a majority in parliament,” says Lim, Robeco’s active ownership specialist for the region.
He says the latest report by the Asian Corporate Governance Association (ACGA) acknowledges that although regulatory enforcement and supervision is improving, there has been no improvement in the weaknesses in minority shareholder rights.
“Very little has changed regarding the commercial code as that requires statute changes,” says Lim, who recently attended an ACGA series of meetings with investee companies in Seoul. “On the other hand, soft law represented by voluntary codes such as the Stewardship Code has gained traction.”
“So, although the trend for investors is positive, any new corporate governance legislation is less likely, as the government’s term is coming to an end. It means both domestic and foreign investors need to be more interventionist if they wish their portfolio companies’ valuation to improve.”
The first issue that needs addressing is board effectiveness, particularly in developing the role of the chief financial officer (CFO), Lim says. “The CFO role is well-established in other developed markets, but is uncommon in Korea and Japan,” he says. “Companies do have a senior person who is head of finance and accounting, but their role is primarily for financial reporting rather than developing a financial strategy which creates economic value.”
“So, one part of our job is to push for that CFO role to have more prominence, and then to engage with the board members – particularly the independent directors. There is a distinct lack of financial expertise at boards in my view, and this inevitably results in unproductive investments or inefficient balance sheets, all of which contribute to the Korean Discount.”
The second problem is capital management, an issue in which shareholders could face limitations, as Korean law discourages investors from interfering in companies ‘operational management’.
“Even well-managed companies often invest in businesses that seem unlikely to generate an adequate return,” Lim says. “About 70% of companies in Asia including Japan do not generate a return that covers their cost of capital over five years. This means they are destroying shareholder value. That’s not just a financial issue, it is a governance issue, and a societal issue, not least because local savers are deprived of returns on their investments.”
“Using just one metric, for dividends paid in 2018, the pay-out ratio of Korean companies was a miserly 23% when compared with the emerging markets’ average of 38%, and kicked into the long grass by the Australians’ huge 79% – a remarkable discrepancy.”1
One positive development has been the introduction of the Korean Stewardship Code in 2017, which now has 89 investor signatories. Like similar codes elsewhere, it remains entirely voluntary, with no legal teeth. In contrast, Japan’s stewardship drive is backed by powerful bodies such as the Ministry of Economy, Trade and Industry.
“The Korean Commercial Code is civil law legal system derived from Japan, and a significant characteristic is an inflexibility in adopting principles-based approaches on abstract issues like fiduciary duty, or a board’s duty is towards its shareholders; these matters are not yet well-developed in Korea,” Lim says.
Does all this mean that the Korean discount is unlikely to narrow soon? “In financials, for example, the discount is as wide as it was five years ago, despite improving disclosure and corporate governance that is ahead of most other industries,” says Lim. “Price-to-book ratios for Korean banks are around 0.5, so investors ascribe a 50% discount to book value. In contrast, banks in Singapore and Australia are trading at a 20% and 50% premium to book value, respectively.”2
“We’re not bearish on Korea, but a big discrepancy exists with other markets in the region, where companies trade at a premium because investors trust the management to deliver positive returns on capital and create economic value.”
However, there have also been positive developments. For example, company financial statements will need to be audited in time to allow investors to approve them. There are also new provisions to allow significant financial investors more freedom to engage companies on a wider range of topics – this was previously limited to dividends only. This should enable large domestic investors to become activist with their portfolio companies.
“We invest in many Korean stocks because their valuations are very cheap, and where we believe positive changes (in their business or their attitude to investors) can result in a re-valuation,” Lim says.
“We are encouraged by the increasing number of domestic investors adopting Korea’s Stewardship Code, most notably the giant National Pension Service, which owns significant stakes in many companies. In spite of the societal deference to the chaebol, the relatively recent tailwind of adopted soft laws means that opportunities still remain for investors to use constructive engagement to unlock corporate value.”
1 Source: MSCI, IBES, FactSet, Morgan Stanley Research
2 Source: Bloomberg