Spotlight on Korea - A SKAGEN Perspective
The major political flashpoints of 2017 have so far come from North Korea. While the current break in Kim Jong-un's missile testing programme will hopefully endure, it offers an opportunity to look at how our portfolio teams manage risk to optimise their funds' returns for our clients.
In this article we explore:
- Our view of political risk and how it is embedded in SKAGEN's investment process
- How we see the current threat from North Korea and a review of our Korean holdings
- Why emerging market political risk generally is falling relative to developed markets
With populist parties largely failing to gain the ground that many expected in this year's European elections and referendums, the major political flashpoints of 2017 have so far come from North Korea. While the current break in Kim Jong-un's missile testing programme will hopefully endure – particularly following Pyongyang's interpretation of Donald Trump's latest inflammatory taunts as a declaration of war – it offers an opportunity to look at how our portfolio teams manage risk to optimise their funds' returns for our clients.
Our starting point as stock-pickers is to look for the best undervalued companies; those where the differential between share price and our valuation provides the greatest remuneration for the risk in owning them. How political factors may derail a company's prospects forms a key part of this analysis alongside, for example, the potential threat to value creation from financial or operational risks.
Although our approach is always bottom-up, portfolio protection is provided through sensible diversification of our holdings by geography and sector, alongside consideration of other risk factor exposures. While, due to our unconstrained mandates, there are no fixed aggregate limits for country weights, we are keeping a close eye on North Korea given that Kon-Tiki, Global and Focus all have significant investments in South Korea-based companies. For Kon-Tiki, it is the largest single country exposure, concentrated mainly in Samsung Electronics and Hyundai (see chart).
South Korea continues to offer long-term investment opportunities based on a combination of improved corporate governance and attractive valuations. However, North Korean military aggression has caused political risk to increase and it is a situation we continue to monitor closely in respect of our holdings in South Korea.
In a world where information and trade are evermore interconnected, political threats are increasingly global and a company's country of domicile is often an inaccurate guide to the real-world threats and opportunities it faces. Samsung Electronics, for example, generates only 10% of its revenues from Korea and produces over 40% of the world's memory chips(1). Moreover, with over half of electronic components globally sourced from South Korea, any production disruptions from military conflict with the North could impact manufacturers of smartphones, tablets, televisions and computers far beyond Seoul.
While the country's proximity is clearly a concern in the event of full-blown war, threats from the North are nothing new for South Korea (nearly 100 missiles were fired from Pyongyang in the period 1984-2016) and its companies have long factored them into their business plans. Samsung's most recent Sustainability Report outlines a business continuity system for each worksite – it has 33 production bases across 17 countries in addition to five in South Korea – so that it can supply products and services for customers "as scheduled" in the event of an incident.
Hyundai Motor shows a similar story. South Korea only accounted for 13% of 2016 sales while domestic production, which peaked at 65% in 2007, has steadily fallen to under 35% with overseas factories in countries like China, India and the US picking up the slack caused by labour disputes and strike action at home(2). Hyundai has also said that it has detailed contingency plans in place to ensure that business continues under various situations.
Both companies have also revealed significant domestic investment plans this year. Indeed, Samsung announced a USD 18.6 billion project to expand semiconductor output in July amidst the missile tests, suggesting it is unperturbed by North Korea's sabre-rattling. Investors seem to share the technology giant's confidence. Samsung's share price has demonstrated minimal volatility on each day following the 15 missile tests carried out by North Korea since February, losing at most 2.2% after a launch in May and rising on nine occasions. The company's share price has risen 36.8% since the first test, outperforming the Korean KOSPI, itself 16.5% higher, while both are comfortably ahead of the broader MSCI Emerging Market (+8.4%) and MSCI All Country World (+0.3%) indices over the same period(3).
The VIX index of equity volatility paints a similar picture and has barely flinched in response to the missile launches. It peaked at 17.3 in August following President Trump's "fire and fury" comments, which remains well below the 2016 spikes after the Brexit vote (26.2) and US election (23.0).
Ultimately it is the job of fund managers to take risks, provided they are properly rewarded, and for our Korean investments this has proved to be the case. Three (Samsung Electronics, Samsung SDI and LG Electronics) feature among Kon-Tiki's top five 2017 contributors and two (Samsung SDI and E-Mart) for Focus, while Samsung Electronics was the best performer for both Kon-Tiki and Global last year(4).
We continue to see good value in South Korea, particularly in light of new initiatives to reform the country's chaebols through greater Board independence and protection for minority shareholders. We also expect our holdings to deliver strong financial performance, which should drive attractive shareholder returns as the 'Korea discount' narrows and dividends increase.
While we remain vigilant in monitoring the threats and will act if the risk-reward trade-off moves against us, for the moment it's business as usual. In keeping with our own investment philosophy, South Korean people and companies have learned to be patient with the North, allowing tantrums to blow-over, as they have always done before.
NB: All figures as at 31 August 2017 unless otherwise stated.
1. Source: Samsung Electronics 2017 Sustainability Report
2. Sources: Hyundai Motor 2016 Annual Report, Hyundai Motor 2007 Annual Report
3. Source: MSCI, 10/02/17 to 18/02/17, MSCI index performance in EUR
4. Source: SKAGEN Funds, based on % contribution to absolute NOK return 31/12/2015 – 31/12/2016, net of fees
A shift in relative political risk towards developed markets...
The dynamics of global geopolitical risk and investors' perceptions of the relative riskiness of emerging markets over developed markets should be reappraised, according to a recent report(5). The analysis by Eurasia Group highlights how "Developed markets used to differ from their emerging peers in that their politics were largely stable and predictable in their market outcomes. This is no longer true." The authors argue that longstanding political and ideological spectrums are breaking down in developed markets, "making it harder for traditionally stable countries to deliver on the type of governance required by markets to thrive."
The result of this fragmentation has been rising political risk in developed markets over the past few years while emerging market threats have remained relatively stable, as outlined in the following chart:
The risk for investors is that they underestimate these changes in regional dynamics and ascribe higher relative risk premia to developing counties than is necessarily the case. The result could see the actual risk-reward trade-off skewed in favour of emerging markets.