Matthews Asia Insight
"A focus on strong R&D development, backed by a growing and highly educated young
workforce has led to an increase in the number of patents granted to Korean firms."
South Korea 2.0
Most investors have long been familiar with South Korea’s major brands, including those for automobiles and semiconductors that are exported all across the globe. These multinationals—the first wave of the country’s export-oriented companies—have propelled South Korea’s growth since the 1960s. They typically manufacture products that require hefty capital expenditure. They have also required very large economies of scale, were price sensitive and had relatively few research and development (R&D) necessities. While many of these export-oriented companies remain globally competitive and still account for a large part of Korea’s GDP, there is a new wave of lesser-known “second generation” firms leading Korea’s next stage economic and cultural growth.
These companies are making highly sophisticated products, based on years of heavy R&D investments. Their products are smartly marketed and distributed, perhaps less dependent on pricing but based more on quality and brand reputation. These firms make up what the analyst community has started to dub Korea 2.0.
In 2012, Korea became the first non-industrialized economy before World War II to join the so-called “20-50” club. The 20-50 club refers to a group of countries that all have more than 50 million in population, and GDP per capita exceeding US$20,000. Besides Korea, there are only six other countries that meet the criteria in the world today—Japan, the U.S., France, Italy, Germany and Britain.
Korea’s booming export industry gave birth to its vibrant and sizable consumer culture, as well as the companies that rose to meet such demands. Because this consumer sector has been open to foreign competition and is also market-oriented compared to other sectors, its firms have needed to invest heavily in marketing and R&D in order to stay competitive. This environment created a small but bourgeoning group of strong domestic companies that often out-competed global giants in the Korean domestic market.
Now, they are expanding into overseas markets, mainly into neighboring countries within Asia. For example, in the cosmetics industry, a few domestic champions are now expanding their reach into China. Korea’s cosmetics industry is gaining market share overseas. Skin care products, in particular, are quality-sensitive products, and the industry in Korea is quite sophisticated. This market was once dominated by U.S. and European companies. But now, Korean brands have gained cachet, and become the world’s second-largest exporter of cosmetics to China after France. Cosmetics exports out of South Korea grew 73% during the first half of 2015, outpacing Korea 1.0 product exports that included cars, chemicals and steels.
The rise in popularity of Korean cosmetics may have something to do with overall rising interests in Korean pop culture, dubbed K-pop. While the popularity of the “Gangnam Style” music video fad seemed to come overnight, the phenomenon, called Hallyu in Korean, actually started more than 10 years ago and grown incrementally each year since then. In the early 2000s, Korea exported roughly US$500 million in cultural content. A decade later, that number had grown to more than US$4 billion, according to Korea’s Culture and Information Service.
Last year, the televised Korean drama “My Love from the Star” became one of Asia’s biggest hits, most notably in China, and attracted more than 2.5 billion views online globally. When the final episode was broadcast, Chinese viewers were able to watch it in real time in China via an Internet video sharing platform that purchased the broadcasting rights. Among the biggest beneficiaries of this pop culture trend are Korean food and entertainment companies. In the romantic comedy “My Love from the Star” a woman and her alien boyfriend, the show’s main character, are rather fond of eating a Korean meal of fried chicken with beer. This translated into a real life upsurge in Korean-style fried chicken and beer at restaurants. When I visited major cities in China five years ago, there was usually only one type of Korean restaurant, Korean barbeque, usually owned by an individual proprietor. Now, there are Korean restaurants that feature many different varieties of Korean fare, including Korean fried chicken, Korean bakeries and Korean street food. Many are franchised restaurants owned by Korean companies. Korean packaged foods and snacks are also becoming very popular in China and other emerging countries. Korean products exported to these markets tend to be viewed as higher quality and more trustworthy compared to locally made products since food quality scandals have been more prevalent in emerging countries.
Another key difference between Korea’s older companies and its newer 2.0 firms are the target demographics and regional reach. Whereas the products of Korea’s more traditional and longer-standing exporters were geared toward developed economies, its newer cultural exports are a hit with more developing countries. In fact, such cultural exports—from industries such as travel & leisure and entertainment—are growing even faster than Korea’s overall export growth. Korea 2.0 related industries also appear to be more sustainable in nature and less cyclical since they are mostly domestically oriented consumer industries tied to domestic income growth. For Korea’s 1.0 industries, such as semiconductors and shipbuilding, demand is driven more by the health of the global economy.
Competitiveness Driven by Human Capital
With South Korea’s main cities just a few hours away by plane from most major Chinese cities, the proximity is a great benefit to trade with China. To boot, there are many cultural similarities that lend to shared consumer tastes. In 2014, South Korea was the most popular overseas travel destination for Chinese travelers. Furthermore, Chinese tourists became the largest spenders in Korea, outspending Japanese tourists. While having the biggest market as a neighbor and similar tastes is helpful for Korea’s markets, Korea’s human capital is also a big plus for Korean firms.
Korea boasts particularly high spending on private education, and parents are fiercely competitive when it comes to their child’s schooling. According to a 2014 article in The Wall Street Journal that cites calculations based on government data, an average Korean household with two children spends “more than 10% of monthly income—4 million won (US$3,946)” on private education. It also says that a 2013 report by management consulting firm McKinsey & Company called Korea’s education system an “arms race.” Not surprisingly South Korea has one of the highest ratios of higher education degrees earned among OECD (Organisation for Economic Cooperation and Development) countries and the highest in Asia for 25-35 year olds, according to the OECD and UNESCO.
Improving Shareholder Return
Another area that is changing in Korea is the shareholder return. Currently, Korea ranks among the lowest in terms of dividend yields, which partly explains why Korea’s stock market has traded at a discount to its peers. Recently, the Korean government announced various policies to encourage more dividend payouts and we are seeing some positive changes. In 2014, Korea’s biggest companies announced plans to increase dividend payouts by 40% to 50%, and are expected to announce additional shareholder friendly dividend policies. The trend is continuing this year as other companies have announced meaningful changes in their shareholder return policy and expect significant increases in total shareholder return. This is a very significant shift in thinking by Korean companies. In the past, they were focused on growth and less so on giving back to shareholders. Now, the thinking among the management is shifting toward managing both growth and shareholder return concurrently. Given the low yield environment in Korea, demand coming from individual shareholders for higher dividend payouts is also increasing.
This increase in dividends may potentially lead to a re-rating of the Korean market and bring market valuations to a level that is on par with others in the region.
Navigating Investment Opportunities
Most investors who use passive investment vehicles to find attractive investments in a single country are likely to miss out on the investment opportunities that Korea 2.0 presents. This is because most of Korea’s well-established export giants dominate the country’s major benchmark. For example, seven out of the top 10 holdings of the MSCI Korea Index are export-oriented companies. These exporters have more to do with how the global economy is doing than Korea and the rest of Asia itself. It is harder to define and dissect Korea 2.0 investment opportunities. Constructing a portfolio that fully benefits from the investment opportunities of Korea’s newer firms requires an approach that is bottom up.
Challenges and Korea 3.0
Korea has come a long way but its GDP per capita is still lower than Japan’s, even after Japan’s massive yen depreciation, and it is still about half of U.S.’s GDP per capita income. Rising incomes in South Korea should continue to provide a tailwind to many industries going forward.
Take Korea’s pharmaceutical industries, for example. While many are still small and at nascent stages of new drug development, R&D spending among major pharmaceutical companies has been rising. An increasing number of new drug discoveries are occurring each year. A focus on strong R&D development, backed by a growing and highly educated young workforce has led to an increase in the number of patents granted to Korean firms.
Globally, South Korea now ranks fourth in terms of the number of patents granted by the U.S. and ranks among the top in terms of the growth of patents granted since 2000. Many companies are also investing in bio-similar industries, aiming to become the major manufacturing hub of the bio-similar drugs. Medical tourism is also taking shape in Korea as many foreign patients, especially from neighboring Asian countries, seek high-quality health care treatments in Korea.
There are, however, still challenges to be overcome. Among them is a labor market that remains too rigid, and can make the transfer of labor sometime difficult. Large conglomerates also still sometimes hinder innovation by using their dominant market share to compete with smaller, more innovative companies. Further government deregulation is arguably needed, and more work needs to be done to ensure that stringent corporate governance practices protect minority shareholders. In my view, the financial industry also needs to continue to deepen its capital markets to make funding easier for entrepreneurs. Korean corporations should continue to focus on improving shareholder returns by balancing growth and dividends.
We remain optimistic about Korea’s future. It is a country that has continued to reinvent and restructure itself, and evolved from among Asia's poorest countries to one of the region's wealthiest in a relatively short span of time. But its economic advancements have notably been accompanied by its cultural gains. We will continue to monitor this evolution as Korea strives to reach its next stage of growth.
Michael Oh, CFA
The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Past performance is no guarantee of future results. The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information.