Visitors bowing in a show of respect for North Korean leaders Kim Il-sung and Kim Jong-il on Mansudae (Mansu Hill) in Pyongyang, North Korea.
North Korea has tested its most powerful nuclear weapon yet, believed to have 10 times the strength of the regime’s previous nuclear weapons. The North Koreans claim, and US intelligence agencies seem to agree, that the weapon is their first hydrogen bomb.
In response to the test, US officials in concert have escalated the rhetoric. UN Ambassador Nikki Haley said North Korea was “asking for war,” and President Donald Trump, in his typical diplomatic fashion, attacked South Korea on Twitter for “appeasement.” Defense Secretary James Mattis said “any threats” to the U.S. and its allies will be met with a “massive military response.” “Threat” is a carefully chosen word, as it could mean anything from a rhetorical statement to an actual military strike. As media outlets have jumped on the U.S. rhetoric and the potential of the crisis to escalate to war, the South Korean KOSPI index has fallen about 2% over the past month and has recouped the bulk of those losses.
Video: New North Korean sanctions won’t be effective, Gordon Chang says.
For these reasons, South Korea is a bargain. To illustrate that point, we look at several valuation factors including; earnings reports, analysts’ earnings forecasts as well as sales, cash flow and EBITDA. This combination gives us a broader view and one more sound, from the standpoint of forensic accounting. It also allows us to sniff out any improper manipulation.
This analysis is based on the research we did on South Korea at the end of June when we were engaging in our twice yearly international equity portfolio construction. It was attractively priced then, but the war of words that has erupted, first over North Korea’s miniaturization of a nuclear weapon, then its detonation of a likely hydrogen device, have driven prices even further into attractive territory.
Geopolitical risk is not as high as you think. But what about the national security issues? Perhaps South Korea is underpriced in comparison with history, but overpriced when one takes into account the madman with nukes in the neighborhood. Perhaps. But there are a few things to take into account when properly pricing that risk.
First, geopolitical risk tends to be exaggerated in headlines. This headline was bound to get a lot of attention because the president of the U.S. got directly involved. And this president in particular has a knack for publicity. He tweets; he makes off-the-cuff remarks; he speaks in colorful, quotable phrases that often seem designed to create a press reaction. And he has an adversarial relationship with the press. The press has been happy to play the role of adversary in the Korean crises by playing up how allegedly irresponsible Trump’s language is. It fit their need for critique for them to play up the military risks in order to tag Trump as taking intemperate rhetorical risks which might lead to nuclear war, as well imply some equivalency, psychologically or morally, between Trump and Kim.
Second, because geopolitical risks tend to be exaggerated in headlines, they also tend to be exaggerated in market reactions. During the crisis of early August, the KOSPI fell by 2.3%, but then rose 0.5% in the week after Kim stepped back from his threat to barrage Guam. This is the typical pattern; examples are too numerous to mention. An Iranian ship gets too close to an American ship in the Strait of Hormuz and the oil futures price spikes, for a day or two, then returns to normal.
Most crises do not become wars. But they make headlines and they move markets, usually only for a short time.
But even actual wars do not seem to reliably suppress long term market performance. Our friends at Ronald Blue Trust’s Investment Strategy Group have done some interesting research on stock market performance after crises and wars. They found no pattern of underperformance for those who invested at the beginning of a geopolitical or political crisis event. In fact, there’s more green on the screen than red in the chart below. (Thanks to Brian McClard, Jamie Spruyt, and Troy Madlom for permission to reproduce their work)
U.S. Stock Market Returns
|Soviets into Hungary
|Soviets into Czechoslovakia
|Soviets into Afghanistan
|Martial law in Poland
|U.S. invades Grenada
|U.S. invades Kuwait
|The EU is formed
|Serbians into Kosovo
|Sep. 11 attacks/U.S. invades Afghanistan
|Euro become common currency
|U.S. invades Iraq
|European Debt Crisis
|N. Korea sinks S. Korean Navy vessel
|Syrian Civil War/Refugee Crisis
|Rise of ISIS
|Russia into Crimea
In addition to this latest hydrogen bomb crisis, there are some other problems with the trend in South Korea: previous administration corruption led to a political upheaval. The new regime is center left rather than center right, which means some of the moves towards business freedom may be halted or perhaps even rolled back to some degree.
Despite all of this, South Korea is one of our favorite places to invest international money. And not just because of the attractive valuation which comes from screaming headlines about nuclear bombs. One of the most attractive features of South Korea is that it is a highly resilient country. This means that it is more able than most other countries to absorb financial and economic shocks as well as periods of general investor fear (which the press has dubbed ‘risk off’ periods). Though resilient in general, it stands out as particularly strong in fiscal fitness, especially due to very low deficits and a high domestic savings rate. Low deficits mean, of course, that the government is not borrowing much (at least in comparison with other countries) and high savings rates mean that however much the government is borrowing, the domestic population has the financial resources to help a great deal with that financing. This leaves South Korea at much less risk for a debt crisis than if it were dependent on foreign lenders, who are more apt to stop lending during times of fear. This phenomenon is known as ‘sudden stop’ and can be very disruptive to a nation’s financial system. South Korea is at relatively low risk for sudden stop.
In addition, South Korea has the kind of trade dynamics which make it more resilient than most other countries. For example, it has a solid score when it comes to reserves of foreign currencies. This means that if the Korean Won is attacked by short-sellers, it is able to preserve the value of its currency by buying back that currency in open markets with currencies that are widely accepted, such as U.S. Dollars. In addition, South Korea has a strong trade balance. It sells its goods to many nations and in exchange gets large flows of foreign currencies, which have earned it a solid score of foreign reserves. These types of factors were important factors driving the ‘Asian Contagion’ of the late ’90s.
South Korea is not perfect. It has stalled somewhat in moving towards greater business freedom. It’s quite free, but long-term returns tend to be a matter of shifts in freedom and not merely levels of freedom. There are some signs that the new administration is engaging in political ‘payback’ against the former administration (which was removed due to corruption) under the guise of an anti-corruption crackdown, selectively enforced (our friend Steve Forbes has written about this issue here. In addition, its interest rates have been shifting up relative to the rest of the world, and that can cause short-term performance problems. And there is always the possibility that this time, the North Koreans are not playing another game of chicken with the West but are about the business of something more serious than a shakedown. In that case, all bets are off.
*A version of this investment piece first appeared on Vident Financial’s blog.
Originally published on Fox Business.