EWY: South Korean Equities Likely Significantly Undervalued

iShares MSCI South Korea Capped ETF (NYSEARCA:EWY) is an exchange-traded fund that invests in South Korean equities. The fund carries 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 holdings as at the same date. This follows negative net fund flows over the past year of circa -$955 million.

South Korean equities are often viewed as pro-cyclical stocks. When the global business cycle is in decline, it therefore makes sense that funds like EWY would underperform. Fidelity research suggests that this is happening as of Q4 2022.

I have often seen traders and investors reference South Korean exports as a global business cycle indicator. Those recently dipped year-over-year in October 2022, which is perhaps a harbinger of recession.

I last covered EWY in August 2022 and suggested that EWY was probably undervalued but cyclically out of favor, which follows my train of thought above. Nevertheless, in this case undervaluation has managed to suppress underperformance, with EWY rising 1.38% since my last article against the fall in the S&P 500 U.S. equity index of -2.83% (per Seeking Alpha data).

It is important to remember that markets are forward-looking and tend to lead the real economy by 6-12 months. If a global recession is likely to be muted at least in duration, then it makes sense that the very beginnings of a contractionary period should be marked a bottom in the equity market. This could be happening right now, and EWY would therefore function as a possible undervalued pro-cyclical bet on the emergence of a new business cycle. The pro-cyclical play is helped by the fund’s sector exposures (see below) which include large exposures to the materials, financial services, industrials, and technology sectors.

The largest holding in the portfolio is Samsung Electronics Ltd (OTCPK:SSNLF) which is a South Korean multinational electronics corporation that almost everybody is familiar with; a household name. As of November 9, 2022, Samsung represented a very large 23.42% of the EWY portfolio. This follows EWY’s benchmark methodology; the benchmark index 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 reflects a Samsung position of 30%.

Following data from Morningstar, it would appear that as of November 4, 2022, the fund’s forward price/earnings ratio is in the region of 9.36x, with a price/book ratio of 0.77x. That implies a high forward return on equity of 8.23% and a high forward earnings yield of 10.68%. Usually I take these two figures and view these as a possible range of forward returns in the long run; given the tight range here, I would already start thinking that the forward IRR potential of the fund is probably in the region of 8-10%. That follows my last review of EWY, when I calculated the headline IRR just under 10%.

As of today, the South Korean 10-year yield is 4.09%. With an equity risk premium of 4.2-5.5% as a base, and applying the fund’s historical five-year beta of 1.30x, would take the equity risk premium up to about 5.46-7.15%. That is probably excessive, but applying the risk-free rate of 4.09% to this range would lead to a cost of equity estimate of between 9.55-11.24%. With a minimum long-term earnings growth figure of 2%, the net-of-growth forward earnings multiple (the inverse) would be circa 10.82-13.25x. The current multiple cited above of 9.36x would therefore suggest undervaluation of anywhere from 16-42%, which is a wide range, but basically suggests a very high underlying equity risk premium relative to what would be “fair” in my opinion.

Also, bear in mind that I have not included any potential for near-term earnings growth above 2% (Morningstar’s consensus for three- to five-year earnings growth is 12.88%), while the country risk premium per Professor Damodaran’s analysis as of January 2022 is closer to 50 basis points. My country risk premium is factored into my quick beta-based estimate above, which would be 30% (from 1.30x beta) of my 4.2-5.5 base ERP range, or 1.26-1.65%. That is substantially higher than 50 basis points. In consideration of these points, EWY probably deserves a much higher valuation, and so I could certainly see an IRR of above 10% over the next few years, not just based on organic earnings growth but also on an earnings multiple expansion.

I think personally that now is probably one of the best times to be buying South Korean equities for the long term. I would maintain a bullish stance on EWY.