The Korean market has risen strongly. We see this as the initial phase of a medium term re-rating, allowing the valuation gap to close over time, helped by higher economic growth and solid macroeconomic fundamentals.
Investors tend to think in established boxes. One of these boxes applies to emerging markets. However, things change over time, and the boxes should change as well. If we takes a fresh look at the countries in the emerging market box, one needs to ask why some countries like South Korea and Taiwan are still placed in it, when they could arguably be placed in the developed market box. This is even more so, since Korea joined the OECD in 1996.
LetÆs take a closer look at South Korea, which is still part of the MSCI emerging market index. While many investors still consider South Korea to be an emerging market, the structure of the economy shows a different picture.
There are more computers per inhabitant in South Korea than in Italy, the per capita mobile phone usage is higher than in Germany, and the percentage of the population employed in the service sector is in line with the European average. Moreover, the average literacy level is as high as in Europe, while more people are living in cities and benefit from higher education.
From the macroeconomic point of view, South Korea fares very well compared to major developed countries. Its GDP per capita is higher than that of Greece or Portugal, which are both included in the MSCI developed market index (see Figure 1B).
Moreover, South KoreaÆs economy is showing strong momentum, and has surpassed the performance of the Eurozone economies, growing at more than double the pace of the Eurozone in 2005 and expected to grow twice as fast in 2006, thus starting to close the wealth gap to major Eurozone countries such as Germany and France (as highlighted in Figure 3).
South KoreaÆs finances are also in better shape than those of more established economies. Foreign debt to GDP is currently at 19.3% versus 66% for Germany and 108% for Italy. Moreover, unlike countries such as France, South KoreaÆs current account shows a healthy surplus.
Finally, South Korea presents much more favourable demographics compared to major European economies. Indeed, the demographic time bomb that is about to hit the Eurozone is less of an issue in Korea, where the population is younger and still growing (see Figure 1A).
All this points to a possible re-rating of South Korea and other candidates from emerging markets into the developed market indices in the medium term. A re-rating is likely to provide a strong boost to KoreaÆs stock market, as the amount of global funds allocated to developed markets is substantially larger than the amount allocated to emerging markets. Historically, countries leaving the emerging market indices and switching into developed market indices have strongly outperformed in the process. For instance, Portugal became one of the best-performing markets worldwide in the year it left the MSCI Emerging Market Index to join the MSCI Developed Market Index (see Figure 2).
South KoreaÆs strong economic fundamentals have already led to a re-rating of its debt. S&P has recently upgraded South Korean debt to A from A- in July, and Fitch put the country on positive creditwatch in September.
However, when we take a look at the equity market valuations of these countries, one has to wonder why they are still trading at a discount. For instance, in South Korea, the market trades at a discount of 25% on a forward PE level versus the Eurozone (see Figure 3), despite its similar economic structure and stronger economic performance.
As investors start re-rating emerging markets like South Korea, the higher risk premium incorporated in valuations is likely to disappear. We believe this has began and will continue to unfold over the next 2û3 years.
And Taiwan?
Though Taiwan has been an Asian underperformer since the technology bubble burst a few years back, the trend has become more pronounced since political concerns grew after the DPP became the ruling party and turned more provocative on the issue of Taiwanese independence. The exodus of funds has accelerated and confidence has turned south. However, we think 2006 will be a good year for Taiwan and expect the market to be by far the best performer within Greater China.
We are bullish on Taiwan for the following reasons:
Taiwan will likely register the strongest 2006 earnings growth in Asia. It is estimated to record 24.1% YoY growth, versus an average of 11.4% for Asia-Pacific. Valuation is cheap (12x PE and 1.9x Price-to- Book) and Taiwan has been trading near trough valuations. The extended market doldrums imply limited downside as most of the bad news, in our view, has been discounted and undue cautiousness, reflected by massively underweighted foreign and local investors, offers an upside opportunity when sentiment improves. An appreciating New Taiwan dollar underlines the reversal of the market downtrend and money inflows. The political setback in last DecemberÆs magistratesÆ election will likely influence the ruling DPP to adopt more pragmatic China policies.
We believe the outperformance of handset devices will be sustained into 2006 due to the convergence play into mobile phones, which will increase the popularity of 3G phones. Our preferred counters are High Tech Computer (2498 TT HOLD) and Mediatek (2454 TT BUY). For core holdings, we like Hon Hai Precision (2317 TT BUY) because of its sustained market share gains and successful cost-cutting efforts and TaiwanÆs leading foundry, TSMC (2330 TT BUY). For laggards, we prefer Quanta Computer (2382 TT BUY) on increasing notebook substitution of desktop computers and as an outsourcing play.
