Although meaningful progress from the United States’ diplomatic overtures to North Korea has all but stalled since the June 2018 summit, Kim Jong-un continues to cooperate with President Moon Jae-in. With plans announced for a third inter-Korean summit this fall, the prospect of reconciliation on the Korean Peninsula looms.
While North Korea will probably continue to equivocate on its denuclearization agenda, Kim Jong-un is expected to cooperate with the South on humanitarian issues and inter-Korean economic exchanges. Since the North’s attitude shift to open dialogue with the South, financial markets have proven relatively unaffected by the attendant geopolitical risks.
Petra Capital Management, based in Seoul, manages a value-oriented concentrated portfolio of publicly traded South Korean companies. Lee and Petra co-founder, Albert H. Yong have tremendous optimism in South Korea’s cultural ascendance (hallyu) as a boon to foreign investment. Even though the KOSPI Index rose 32.7% in 2017, the Petra team believes Korea is still one of the most undervalued markets in the world.
Chan H. Lee, co-founder and PM of Petra Capital Management, sat down with SumZero to share his insights on Korean market opportunities and speculation on North Korea’s path to a normalized economy.
Avery Pagan, SumZero: Did the US-North Korea Summit on June 12 achieve enough positive signaling to open real market opportunities and stoke new foreign investment interest in the Korean Peninsula?
Chan H. Lee, Petra Capital Management: Not really. Although the summit gave some positive signals to investors, we think it is too premature to draw any conclusion at this point as the summit on June 12 left most issues open to further negotiations. Therefore, it will take some time to stoke new foreign investment interest as the details on how North Korea would dismantle its nuclear weapons and ballistic missiles have not been agreed yet (as well as economic concessions by the U.S. in exchange).
Pagan: Global markets have proven to be relatively inelastic since bellicose dialogue between Trump and Kim began in mid-2017. Why have the markets been so bullet-proof around inter-Korean and U.S. politicking?
Lee: Historically, incidents with North Korea have had almost no impact on the South Korean stock market in the long run.
Many sophisticated global investors seem to realize that North Korea has always used such bellicose rhetoric in the past in dealing with South Korea and the U.S. in order to maximize their bargain power. Kim Jong-un’s such tactic is nothing new or different from his father’s and grandfather’s.
Pagan: In April 2018, President Moon met with Kim to discuss economic incentives for denuclearization sponsored by South Korea. Why is it in SK’s best interest to normalize NK’s economy?
Lee: Of course, permanent peace to the Korean peninsula can bring in a big relief for Korean people to concentrate on their daily activities without worrying about potential aggression by North Korea. It is important that North Korea has a stable, sustainable economy.
Further, North Korea can become a meaningful addition to South Korean economy in terms of the domestic market size and labor forces. North Korea has 25 million people and many of them are eager to work. These workers may provide a long-term solution to the shrinking South Korean labor forces due to negative demographic trends. In addition, the construction of a railway that connects South Korea to the rest of the world (i.e., Russia, China, and Europe) will significantly lower transportation costs and open further potential business expansion opportunities for South Korean companies.
Pagan: Kim has acknowledged the country’s decrepit transportation infrastructure and low-yield energy generation programs. Are energy and transportation the most critical industries for South Korean intervention?
Lee: Yes, we agree that energy and transportation are critical industries for South Korea’s intervention given South Korean companies’ expertise and competitive edge in these sectors. As you may be aware, South Korea is known for its top-class infrastructure and has one of the highest internet/mobile penetrations in the world. But we also think that many South Korean companies in various industries are likely to benefit and get new opportunities in North Korea because most of North Korean industries, if not all, are very under-developed and need serious restarts.
Pagan: You cited the 2018 Bloomberg rankings which list South Korea as the world’s most innovative economy. What makes South Korea so innovative and how will SK find creative ways to capture the most value out of improved relations between North Korea and key trade partners?
Lee: Korea is a land without an abundance of natural resources. This meant Korea was forced to look elsewhere for income. And with this, the country developed a knowledge-based economy. But this did not happen overnight. The country has invested heavily in education, science and technology since the 1970s.
Innovation and technology are the key factors that have underpinned South Korean export competitiveness and fueled the country's remarkable economic rise over the past decades. Korea has had to make its own economic path in a region where it competes with China's low labor costs, and Japan's high-tech, capital-intensive industries. Spending more on R&D than any other economy not only reflects a domestic consumer base with a high demand for new technological developments, but also the government's objective to build a creative economy. Innovation is the key to South Korean companies as they are facing increasingly stiff competition in the global markets.
Within a generation, South Korea managed to transform its economy from one of the poorest to one of the richest in the world. This past experience will be very useful for South Korea to seize new opportunities in North Korea and work for the shared goal as the relations between two nations improve.
Pagan: Where else do you and the Petra team see value in the South Korean market today?
Lee: Many different types of market inefficiencies exist in Korea, including “net-nets”, special situations, preferred stocks, holding company discounts, etc.
Among them, holding or parent company discounts are unique and diverse which provide a fertile source for investors looking to uncover a holding company that trades a substantial discount to intrinsic value. We expect these mispricing opportunities to last for long term because more Korean companies are currently in the process of transforming into a holding company structure. Many holding companies are listed in Korea, and in most cases, their operating subsidiaries are also listed. Also, in many cases, the significant value of a holding company comes from one major operating subsidiary. This implies that there are two ways of investing in the same line of business. However, the market is so inefficient that the prices of a holding company and its major subsidiary do not always move in tandem in a timely fashion. Active investors can exploit this kind of opportunity in two ways. One way is buying a holding company stock as a cheaper way of buying a subsidiary stock. Another way is implementing long-short arbitrage strategies.
Pagan: With no legal framework for foreign business conflicts, heavy risk of asset expropriation, and deficient energy and water reserves, the North Korean opportunity seems to be more trouble than it’s worth.
Yet, almost 75% of South Korean businesses said they would be willing to invest after NK sanctions were lifted according to a Maeil Business Newspaper survey. What does this say about South Korea’s risk appetite for investment in the North?
Lee: We do not think that the above survey result is a good indicator of South Korea’s risk appetite for investment in North Korea. However, the survey result confirms the notion that many South Korean firms, in general, feel that they are in a relatively good position to explore North Korean opportunities in various ways. For example, North Korea is an attractive destination for South Korean companies to utilize their cheap labor forces. More and more Korean companies are moving their manufacturing facilities outside of Korea because the costs are becoming much higher relative to other developing countries. For example, most of companies that operated factories in the Kaesong Industrial Complex in the past (before it was shut down in 2016) have indicated that that the low-cost, hard-working laborers from the North made the industrial complex a favorable place to outsource production.
The proximity and language are two other major attractive factors of doing business in the North. The joint industrial complex, Kaesong Industrial Complex, for instance, is only about 60 kilometers away from Seoul. There is no language barrier as North Koreans speak the same language as South Koreans.
Pagan: How are industrial conglomerates like Hyundai, SK Innovation, and Korea Aerospace specially positioned to lead STEM educational efforts and other technical skill-training programs?
Lee: Based on their technology, experience and management skills, we believe they are more than equipped to help North Korea make the “inevitable” transition. However, it will come down to company specific objectives and incentives for these firms to actively participate in such programs.
Pagan: What is Petra’s outlook on North Korea’s recent diplomatic gestures and how will this affect Petra’s portfolio in the long run?
Lee: We believe North Korea will eventually open up to the outside world and become a member of the global economy. We expect North Korea to adopt a state-guided economic model along the lines of China or Vietnam but we also realize that it may take a bit of time.
We make an investment decision primarily based on a bottom-up investing strategy. Our investing approach is driven by fundamental analysis, a rigorous assessment of underlying value based on an understanding of a particular business. We believe that stock selection is a process of identifying situations where companies trade at a significant discount to intrinsic value.
Petra’s portfolio will not be affected much in the long run regardless of North Korea’s diplomatic gestures. However, whenever relevant, we will consider and incorporate possible upside potential from business opportunities related to North Korea when we analyze potential investment targets.
Pagan: Where else do you focus your research outside of the Korean Peninsula?
Lee: Although we focus our attention on a specific company rather than on the industry in which that company operates or the economy as a whole, macro is one of the important factors when we value companies. For example, when we evaluate an individual company, we take into consideration of macro factors in appraising the company’s intrinsic value, especially, if the company operates in the cyclical industry.
We also research and analyze multinational, global companies based outside of Korea because many of them are competitors to Korean companies in the global markets.