EWY: South Korean stocks likely to be significantly undervalued

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iShares MSCI South Korea Capped ETF (NYSEARCH:EWY) is an exchange-traded fund that invests in South Korean stocks. The fund has an expense ratio of 0.57%, which is expensive but roughly in line with other country-specific ETFs. EWY is quite popular, with net assets under management of $2.83 billion in assets under management as of November 9, 2022. The fund had 112 shares as of the same date. This follows negative net cash flows over the past year of about -$955 million.

Net cash flows EWY

ETFDB.com

South Korean stocks are often seen as procyclical stocks. When the global business cycle is in decline, it makes sense for funds like EWY to underperform. Fidelity research suggests this will happen from the fourth quarter of 2022.

Global positioning of the economic cycle as of the fourth quarter of 2022

fidelity.com

I have often seen traders and investors refer to South Korea’s exports as an indicator of the global business cycle. The ones that recently dipped year over year in October 2022, perhaps a harbinger of recession.

Year-on-year exports of South Korea

TradingEconomics.com

I last covered EWY in August 2022 and suggested that EWY was probably undervalued but cyclically out of favor, which follows my previous train of thought. However, in this case the undervaluation has succeeded in suppressing the underperformance, with EWY up 1.38% since my last article vs. the S&P 500 US equity index down -2.83% (according to data from Seeking Alpha).

It is important to remember that the markets look to the future and tend to lead the real economy between 6 and 12 months. If a global recession is likely to be muted at least in duration, then it makes sense that the very beginning of a downturn would be marked at the very least in the stock market. This could be happening right now, and EWY would therefore function as a potential undervalued procyclical bet on the emergence of a new business cycle. The procyclical play is aided by the fund’s sector exposures (see below), which include large exposures to the materials, financial services, industrials and technology sectors.

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Key Sector Exhibitions EWY

morningstar.com

The largest holding in the portfolio is Samsung Electronics Ltd (OTCPK: SSNLF), which is a South Korean multinational electronics corporation that almost everyone is familiar with; a family name. As of November 9, 2022, Samsung represented a whopping 23.42% of the EWY portfolio. This follows the EWY benchmark methodology; the benchmark that EWY seeks to track is the MSCI Korea 25/50 Index. The capping methodology is such that no position can exceed 25% once rebalancings occur. the unbalanced version of the benchmark index reflects a Samsung position of 30%.

following the data of Morning Star, it would appear that as of November 4, 2022, the fund’s forward P/E ratio is in the region of 9.36x, with a P/B ratio of 0.77x. That implies a high future return on equity of 8.23% and a high future return on earnings of 10.68%. I usually take these two figures and look at them as a possible range of long-term future returns; given the narrow range here, I would already start to think that the potential future IRR of the fund is probably in the 8-10% region. That follows my last EWY review, when I calculated the main IRR just below 10%.

As of today, South Korea 10 years the yield is 4.09%. With an equity risk premium of 4.2-5.5% as a base, and applying the history of the fund five year beta At 1.30x, it would take the equity risk premium to around 5.46-7.15%. This is probably excessive, but applying the risk-free rate of 4.09% to this range would result in an estimate of the cost of capital of between 9.55 and 11.24%. With a minimum long-term earnings growth figure of 2%, the future earnings net of growth multiple (the inverse) would be around 10.82-13.25x. So the current multiple quoted above of 9.36x would suggest an undervaluation of between 16% and 42%, which is a wide range, but essentially suggests a very high underlying equity risk premium relative to what would be “fair.” in my opinion.

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Also, note that I have not included any near-term earnings growth potential greater than 2% (Morningstar’s consensus for three-to-five-year earnings growth is 12.88%), while the country risk premium according to the professor DamodaránThe January 2022 analysis is closer to 50 basis points. My country risk premium is factored into my beta-based quick estimate above, which would be 30% (of 1.30x beta) of my base ERP range of 4.2-5.5, or 1.26- 1.65%. That is substantially higher than 50 basis points. Taking these points into account, EWY probably deserves a much higher valuation, so it could certainly see an IRR above 10% in the coming years, not only based on organic earnings growth but also on an expansion of the multiple of Profits.

Personally, I think now is probably one of the best times to buy South Korean stocks for the long term. I would maintain a bullish stance on EWY.

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