Investing in South Korea: Why This Emerging Market is a Perfect Contrarian Opportunity

by Louis Basenese

Investing in South Korea: Why This Emerging Market is a Perfect Contrarian Opportunity

by Louis Basenese, Small Cap and Special Situations Expert

Thursday, August 26, 2010: Issue #1332

The mere mention of this country's name can cause the "Risk-o-Meter" to nudge higher.

But it's got nothing to do with the nation's own economy or growth prospects.

Rather, the problem resides to its immediate north in the shape of the contentious Kim Jong-Il and the saber-rattling North Koreans. Their South Korean neighbors live with the constant threat of violence erupting at any moment - especially after North Korea allegedly torpedoed one of South Korea's warships in March.

But the likelihood of a full-blown war is slim. Why? Because the United States still has some 28,500 troops in South Korea. And thanks to the long-standing U.S.-South Korea alliance, any North Korean attack would effectively be an attack upon the United States, too.

Even Kim Jong-Il knows that's a bad idea and would end disastrously for his rogue nation.

And for investors, the overblown geopolitical climate is just one reason why I'm convinced that now is the perfect time to buy into this contrarian situation. But there are more...

Seven Reasons to Buy South Korean Equities

Here are seven other reasons why South Korea represents a perfect contrarian opportunity...

  1. Stocks Are Cheap and Trending Higher:

Three months ago, Korea's stock market (the Kospi Index) was trading close to its late 2008 lows, based on a forward price-to-earnings ratio. At the same time, stocks were valued at about eight times forward earnings, which was a full standard deviation away from the historical average.

In short, a reversion to the mean was in order. And it's materializing. Over the past three months, the Kospi has rallied by 11%, compared to a 5% decline for the S&P 500 index.

But even after the move, South Korean stocks are still undervalued. They currently trade for less than 10 times forward earnings and less than one times sales, on average. And the only thing better than cheap stocks are cheap stocks with positive momentum on their side.

  1. The South Korean Economy is Growing Solidly:

Based on estimates from The Economist and International Monetary Fund, South Korea's GDP is likely to grow by at least 5.75% this year.

  1. Inflation is in Check:

Consumer prices were only up 2.6% in July, year-over-year. But the Bank of Korea (BOK) is already on the scene to prevent inflation from topping 4%. In fact, the bank announced a surprise interest rate hike to 2.25% in July.

  1. The Currency is Undervalued:

Any way you look at it, the South Korean won is undervalued relative to the U.S. dollar. In fact, Barclays estimates the discount at approximately 35%. Meanwhile, The Economist's Big Mac Index pegs the discount around 20%. Even if stock prices stagnate, we can profit from an appreciating currency.

  1. The South Korean Government's Balance Sheet is Solid:

Unlike some countries, South Korea didn't overeat at the debt buffet. Public spending only accounts for about 25% of GDP, compared to 115% in Greece and 192% in Japan. Moreover, the country is enjoying a current account surplus, thanks to strong exports, particularly of semiconductors and automobiles.

  1. South Korea is on the Verge of a Promotion:

When MSCI reviewed countries for reclassification this year, South Korea narrowly missed getting promoted from emerging market to developed status.

As MSCI put it, South Korea "continues to meet most developed markets criteria... notably economic development, market size and liquidity."

An easily convertible currency and widespread access to stock market data are the only criteria holding it back. But improvements are being made on both fronts. And rest assured, when the promotion comes, it will legitimize the opportunity, bringing with it more investment capital and boosting equity prices. For now, South Korea remains one of the most developed emerging markets out there (i.e. - it's less risky).

  1. Mark Mobius is on Our Side:

When it comes to emerging markets, no investor has a better track record than Mark Mobius. He's notoriously the first to sniff out opportunities. And he has positive things to say about South Korea, including that he's "encouraged" by the recent pickup in new orders for South Korean manufacturers.

Even better, he's backing up his talk with capital. South Korea represents one of the top 10 countries for investment in his closed-end Templeton Emerging Markets Fund (NYSE: EMF).

Add it all up and you've got some compelling reasons to invest in Asia's fourth-largest economy. The only problem?

The ETF Route to Riches

Very few South Korean companies trade on the major U.S. exchanges.

According to the database at The Bank of NY Mellon, there are only nine! That's pretty slim pickings, especially since three of those stocks are thinly traded, with less than 50,000 shares trading hands each day.

Given that, I'm convinced that the best way to invest in South Korea is to invest in an emerging market exchange-traded fund. Specifically, the iShares MSCI South Korea ETF (NYSE: EWY). Why?

  • Access to the "Best of Breed": The ETF gives you access to 102 of the largest, most actively traded South Korean stocks. This includes major global companies like Samsung Electronics, Hyundai Motor Co. and LG Electronics.
  • Valuation: The ETF trades at a reasonable valuation. The average price-to-earnings ratio for stocks in the ETF checks in at 16.28 and the average price-to-book ratio is 1.93. It sports an affordable expense ratio of just 0.65%, too.
  • Diversification: The ETF is well diversified, with slightly higher exposure to the most attractive sectors.

If you're brave enough, I recommend considering an investment in South Korea before it's too late.

Good investing,

Louis Basenese

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