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Time to review the Korean discount?

The Korean discount describes the persistent lower price-to-earnings multiples of South Korean companies compared to global peers (Graph 1).

Graph 1: MSCI Japan, Korea and World indices comparison

Source: Bloomberg

Different theories exist about the reasons for the discount. While some have attributed it to the threat of North Korea1, the most consistent and commonly accepted reason is the poor governance of the country’s family-dominated conglomerates, the so-called chaebols. According to Bloomberg, the five biggest chaebols make up half of the constituents of the Korean stock index. (Graph 2)

Graph 2: The five Biggest Chaebol = Half of the Korean Stock index

Source: Bloomberg

Chaebols played a crucial role in rebuilding country after the Korean War ended in 1953. President Park Chung-hee, a general and father of the impeached president Park Geun-hye, handpicked a number of established businessmen, offered them government support, financing and tax cuts to encourage growth and the overseas expansion of their businesses. The companies rewarded the government by acting in line with national priorities and as a growth engine of the economy. However, the debt-heavy, export-driven business models of the chaebols were taught some painful lessons during the 1997 Asia financial crisis. A $60 billion bailout from the International Monetary Fund helped to avoid national bankruptcy.

Still, their influence remains strong today. The Federation of Korean Industries (FKI), a business group that controlled two foundations that accepted donations from the chaebols, is alleged to have been at the centre of the bribery and corruption scandal which led to the impeachment of the former president. Following the scandal, key chaebols such as Samsung, Hyundai, SK and LG terminated their memberships2 of the FKI. The federation also announced a major reform although it is reported to have made little progress. With the appointment of Sang-jo Kim, who has 20 years’ experience in lobbying for better corporate governance and has been dubbed the chaebol sniper, as the country’s fair trade commissioner, many chaebols appear to have taken action before the announcement of any concrete reform policies.

Taking action
Following a controversial vote at its 2015 AGM, Samsung took a significant step towards building investor confidence by announcing a share purchase plan aimed at closing the discount of non-voting preferred shares to ordinary shares3. Throughout 2016, discussions between the company and its investors on shareholder return and governance intensified and Samsung started considering changes to its board. It subsequently changed its articles of incorporation to allow an outside non-executive director to serve as chair of the board4. In early 2017, Samsung Electronics outlined the challenges of corporate restructuring to the market. To demonstrate its commitment to improved governance, it announced a share buyback programme of more than KRW9 trillion (close to $8 billion) for 2017 and kept the promise it made in 2016 to cancel all its treasury shares, which are worth more than KRW40 trillion ($36 billion). In April, the company announced that half of its treasury shares would be cancelled this year, with the other half set to follow next year5.

Treasury shares are buy-back shares that a company holds. They have no voting rights and pay no dividends but can be sold or given to other parties for specific purposes. We hope that Samsung has set a precedent for other chaebols.

There have been other pre-emptive actions from chaebols. In April 2017, Lotte Group said that it is transforming into a holding company, following an announcement of a transition study in November 2016 and the sale of its treasury shares in February 2017. The holding company will become the investment entity of its four key business units – confectionary, shipping, beverage and food – and each business unit will have its own operating company.

In 21 June 2017, SK Chemicals also announced that it is transforming into a holding company. It will establish an operating company to provide better transparency of management of all of its subsidiary businesses. In addition, it intends to cancel all treasury shares that can be retired.

At Hermes EOS, we have been monitoring the efforts and outcomes of corporate restructuring. We want to see better transparency of corporate structures that split into holding and operating companies and improved accountability and independence of decision-making by the management of operating companies. We have met senior executives of SK Holdings, a company that started its holding and operating company transformation in 2015. Over two years, its dividend payout has doubled – to over 30% in 2016. Although its dividend yield is still lower than the market average, this is a positive start. More importantly, its more transparent structure enables shareholders to better assess the performance and quality of assets of each operating company.

We also met the lead independent director of Hyundai Motor Company. In addition to encouraging an external board evaluation at a roundtable it had organised, which received broad support from the attending shareholders, we also pushed for improved transparency of the board’s decision-making about its widely anticipated6 restructuring.

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  1. 1The Korea discount Minority Report The Economist 11 February 2012
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