Recent headlines have been dominated by the resurgence of the Japanese economy, marked by a significant influx of capital over the past six months to one year. This shift in sentiment can be attributed to the implementation of corporate governance reforms, which are expected to enhance shareholder value, improve return on invested capital (ROIC), and reduce the cost of capital. These reforms signify a transition towards Western business practices.
Furthermore, there are indications of a turnaround in the inflation narrative, potentially leading to the discontinuation of the yield curve control strategy and a strengthening of the yen. An anticipated increase in Chinese demand will also be beneficial for Japanese equities perhaps, but this has been sluggish to date, with further cuts from the Chinese central bank being seen.
Given all the attention is on Japan, there may be a market that is receiving less love, but reaping similar benefits and sharing very similar qualities – South Korea. These two nations exhibit numerous cultural and economic similarities, such as a heavy reliance on exports to drive economic growth, as well as significant involvement in industries like automobiles, electronics, machinery, and high-tech sectors. Similarly to Japan, South Korea have had developments around financial reforms and boosting policies related to shareholder returns as of late, albeit receiving less attention in the media. Policy authorities last year spoke about levelling the playing field for foreign investors, improving dividend policies and overcoming the “Korea discount” which has been around for some time. Other similarities between the nations include poor demographics, very similar stock market sector compositions, and both being primary beneficiaries of China’s post lockdown recovery. Below we show a chart of the sector composition between South Korea (the KOSPI index) and Japan (the Nikkei 225 index) after making the semi-conductor weight equal:
Source: Bloomberg, Innova Asset Management
The reason for the correction in semiconductor allocations is to highlight the sheer similarities between the sector composition. Despite this, we are quite positive on the outlook for the semiconductor sector in South Korea anyway, as valuations are very reasonable, reflecting a slowing in global growth and lower chip demand. However, this is only in the near term, and chip demand medium to long term will inevitability be huge. We already saw cuts in CAPEX across chip manufacturers which usually signals that we’re closer to the bottom of a cycle. Below is Samsung’s P/B, as it is a major component of the KOSPI index and a semiconductor manufacturer:
Source: Bloomberg, Innova Asset Management
If we compare Samsung to the rest of the semiconductor universe, you can see Samsung is relatively cheaper and offers a promising earnings yield. Of course, the semiconductor market is very fragmented, and there are more speculative areas in the sector with lower immediate earnings. Those companies with their cash-flows further out in the future are particularly vulnerable to the adverse impact of prolonged periods of higher interest rates, which is the scenario we anticipate.
Source: Bloomberg, Innova Asset Management
The argument then may become, “well Japan has a much more robust and quality-based economy”, which is absolutely true. However, whilst there may be more “quality” embedded within the Japanese economy (higher return on equity, lower leverage, and overall robustness of the financial system), historically this defensiveness hasn’t consistently protected on the downside as perhaps expected.
Source: Bloomberg, Innova Asset Management
The average drawdown of Japanese equities was slightly worse than Korean equities (-29% versus -27.2%). We ultimately think this is a function of starting valuations when the downturn comes around – meaning that drawdowns were worse if the starting valuation was higher – pointing to one of Innova’s Core Investment Principles – price drives long term returns. Korea is currently much better placed on absolute and relative terms. Below highlights the valuation differences between Korea and Japan on both absolute and relative terms. Given we calculate these two as a “Z-score”, where the mean is 0 and the standard deviation is 1, we can see that Japan trades over 1 standard deviation above its long-term average, and Korea sits at a much more reasonable valuation level.
Source: Bloomberg, Innova Asset Management
In summary, it is unwise to blindly chase the current “hot” market, especially when the prices have already incorporated excessive hype. Instead, a more astute and value-driven strategy involves identifying other potential areas that benefit from similar factors but have not yet garnered the same level of attention.
South Korean equities have not experienced the same level of multiple expansion as Japan in the recent 2023 rally and possess a similar growth potential. We therefore see it as a market that allows us to reap similar benefits from an economic perspective, but with much lower valuation risk.
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