December 2022 quarter ASX A-REIT market update
Investing | 4 minute read
The Cromwell Phoenix Global Opportunities Fund (GOF / Fund) searches for investments that are distinctly cheap and simple to value, yet hard to discover.
Owing to the unique nature of its economy, one such example can be found in South Korea (Korea). While not an individual stock, Korean preferred securities represent a class of stocks which appear to be one of the most attractive, underfollowed and inefficiently valued opportunities globally.
To many Australians, Korea may be famous for its barbeque and kimchi; however, it is also home to some of the world’s largest and most advanced companies. Korea is Asia’s fourth largest economy and is the 12th largest worldwide. Despite this, its share market is mathematically one of the cheapest in the world, with a price to earnings (P/E) ratio of only marginally above nine. This is despite the market being largely constituted of world-leading information technology companies.
Part of the explanation for the cheap valuations is the shareholding structure of many Korean companies. In Korea, many prominent companies - known as chaebol, or conglomerates - are controlled by an individual, powerful family. These chaebol have not always acted in the best interests of minority shareholders and, from time to time, have been embroiled in corrupt behaviour, or have abused close ties to the government. In recent times, chaebol have been incredibly politically unpopular in Korea, which led to comprehensive industry reform. Former president, Park Guen-hye, was recently impeached amid public pressure, in part due to her relationships with chaebol.
Several decades ago, the Korean government pressured chaebol to raise capital to de-lever their capital structure and protect Korean jobs; and, therefore, reduce any civil unrest. The problem for the powerful families was that a standard equity raise would dilute their company ownership and reduce their control. As a result, the owners created a new class of shares - preferred shares - which, unlike other preferred securities that are more fixed income-like in nature, have the exact same economic rights as regular equity, but do not have any voting rights. These shares were issued at slight discounts to regular securities and were mostly purchased by Korean retail shareholders.
Over time, the discount on the preferred securities has widened from small amounts to 30%-70% in many cases. Considering that many Korean equities trade at low valuations, the discounts provided on preferred securities are particularly attractive. Many institutions cannot effectively invest in Korean preferred securities due to their small free float and relative illiquidity.
Let’s take LG Electronics as an example. Yes, that’s the LG Electronics you know for making OLED TVs – previously marketed passionately in Australia by cricketer David Warner. LG is a globally recognised brand, which sells consumer electronics, home appliances, and home entertainment products. Based on broker estimates, LG’s ordinary share price implies a price to earnings ratio of somewhere between 5.5x and 7x - not a hefty price to pay for such a company. The company also has preferred shares on issue. As at 30 September 2022, LG preferred shares traded at a 53% discount to the ordinary shares. As a reminder, the only difference is the voting rights - the economics of the share classes are identical. Assuming LG’s ordinary shares trade at a P/E ratio of 7x (the conservative side of broker estimates), the preferred shares trade at an eye watering 3.3x P/E ratio. Unless you believe TVs (and other home appliances) are going the way of the dodo bird, this clearly presents a highly attractive investment opportunity.
Phoenix Portfolios chooses to access discounts like the one mentioned above for the Cromwell Phoenix Global Opportunities Fund through a basket of Korean preferred securities. Investing directly in Korean shares as a foreigner is a complex process, with challenges beyond the scope of this article. The Weiss Korea Opportunity Fund (AIM:WKOF) is listed in the United Kingdom, with an investment strategy of investing primarily in Korean preference shares trading at a discount to common shares of the same issuer. The fund has best-in-class corporate governance and a well-respected manager. The basket of preferred stocks owned by WKOF trade at an average discount of 53% to their common shares, and a trailing P/E ratio of 4.8x as of September 2022. Given all of the above, Phoenix has chosen to gain its exposure to Korean preferred securities through an investment in WKOF, although this may change in the future. WKOF is one of the largest holdings in the fund.
Since inception, WKOF has been a solid contributor to the Cromwell Phoenix Global Opportunities Fund’s returns. At current pricing, Korean preferred securities appear to be one of the most attractive, underfollowed, and inefficiently valued investment opportunities globally. While this alone does not guarantee success, we believe investing in these types of mispriced opportunities will assist in achieving strong returns over the long term.
Read more about the Cromwell Phoenix Global Opportunities Fund (Fund), including where to locate the product disclosure statement (PDS) and target market determination (TMD). Investors should consider the PDS in deciding whether to acquire, or to continue to hold units in the Fund.