Time for some honesty today. So far, my hope that emerging market equities might be well-positioned to outperform US equities has been totally wrong. EM equities are having a tough time despite a weaker dollar, with most investors worried by the prospect (distant in my view) of higher rates in the US. That said, we are only a few months in and everything could change over the next year or so.

In the meantime, those of us interested in hunting down value in the EM spectrum are presented with plenty of opportunities – we just need to be bloody patient.

Take South Korea for instance.

The local market appears in some developed world indices but it’s mostly seen as an emerging market. It has its own share of unique challenges, not least the dominance of a small number of very big mega large caps, especially Samsung. It’s also seen increasingly as reliant on China for export growth, though that’s only part of the story.

One listed fund on the UK market that is ideally positioned to benefit from any value bounce – in fact, it could benefit from a double value bounce – is the Weiss Korea Opportunity Fund (WKOF) which has tended to trade under the radar for most UK investors.

Marten and Co have recently brought out a useful note on the fund – though obviously biased, given its paid for research model – which can be downloaded here : https://quoteddata.com/research/weiss-korea-opportunity-fund-a-remarkable-success-story-mc/

The fund has had a startlingly good year to the end of February though as the table below reminds us, performance up till recently hasn’t been startling.

12 months ended Share price total return (%) NAV total return (%) MSCI Korea 25/50 total return % MSCI ACWI total return (%)
28/02/2017 23.1 24.5 44.9 36.7
28/02/2018 14.9 10.7 15.4 7.3
28/02/2019 (8.2) (10.1) (8.8) 2.7
29/02/2020 (4.5) (1.7) (9.2) 8.2
29/02/2021 92.3 93.1 51.7 19.0
Note : The MSCI Korea 25/50 Index is designed to measure the performance of the large and mid cap segments of the Korean market. It applies certain investment limits that are imposed on regulated investment companies, or RICs, under the current US Internal Revenue Code. With 106 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Korea.

The fund has a unique twist.

Not only is it a focused way of playing South Korean mid to large caps, it is also specifically “seeks to profit from the valuation gap between the non-voting Korean preference shares that make up substantially all of its portfolio and their equivalent common shares….Most Korean preference shares are effectively non-voting common shares and are generally entitled to the common per share dividend plus an additional fixed amount. Relative to their corresponding common shares, many Korean preference shares trade at a discount resulting in higher dividend yields and lower price-to-earnings ratios.”

So, to get some idea of the possible double discount considers the following stats. The price-to-earnings ratio for the MSCI Korea 25/50 index is looking to be in the 14 to 11 range based on this year’s numbers and next year’s forecast, while the Price to book ratio for 22 is at around 1.1. By comparison, the S&P 500 is around the 20 mark on PE and 3.6 on PB. So South Korean mid to large caps are already cheap. But preference shares are even cheaper. According to the Marten and Co note at “the end of February 2021, Weiss was monitoring 121 preference share issues. Of these, 68 were trading on discounts and hence were potential investments for WKOF. The median discount of this potential pool of investments was 38.3%. A 38.3% discount implies a potential upside of more than 62% if the discount closes.”

Now, back in the real world, I suspect that the chances of that discount narrowing for pref shares – or even South Korean stocks more generally – is probably fairly minimal, especially as I have a hunch that China’s economy will underperform expectations in the coming year (and those expectations have already been lowered). Nevertheless, one doesn’t have to be a complete optimist to think that this might be a smart, value-driven way into an interesting Asian economy.

Russia continues to languish

One of my other predictions for the next few years is that Russian equities just might outperform. I have an endless list of problems with the current management of Russia Inc but I also think the skepticism is overdone. A value-focused contrarian investor should be looking in more detail at Russian corporates, especially as oil prices look like they have stabilised above the $50 a barrel level.

Yet as Charlie Robertson at Renaissance Capital notes “since 14 January, MSCI Saudi Arabia is up 5.3% (all figures in $), while MSCI Russia is down 5.2% – with Russia trading pretty much in line with MSCI EM which is down 4.6%.”

Charlie asks, why the divergence between Saudi Arabia and Russia ? “ We think there are a few things at work here:

  1. Positioning: international investors are already quite overweight Russia, Saudi Arabia is still very underowned.
  2. Russian (local currency) yields have moved up more than Saudi (pegged currency) yields.
  3. The bank-heavy Saudi market tends to benefit from a steeper US yield curve; while the Saudi currency peg shields dollar returns from recent EM currency weakness
  4. Sanctions headline risk is arguably higher for Russia. Our base case is that sanctions be targetted on specific organisations and individuals rather than economic damaging, but international investors might adopt a weight and see approach. On Saudi Arabia, the US state department has said that it is focused on ‘future conduct’
  5. The upwards move in the oil price has been unexpected this year, but takes relatively more fiscal pressure off Saudi Arabia than Russia, given Saudi Arabia’s higher fiscal oil price breakeven. We assume Brent will stabilise at $65/bbl over the remainder of 2021 ($60/bbl in 2022), well above our calculations of Russia’s 2021 fiscal breakeven of $54/bbl, but not far off Saudi Arabia’s $69/bbl (much reduced from $106/bbl in 2014).”

The table below sums up these varying drivers.

Figure 1: Russia vs Saudi Arabia drivers
  Russia Saudi
Currency Rouble float – can absorb shocks tends to moves with oil and other EM currencies Dollar peg – a benefit when dollar strengthens / EM currencies sell off but requires harder fiscal adjustment to lower oil
Valuation 12M FWD PER of 7.9x, 33% premium to the 10yr average of 6.0x 12M FWD PER of 19.1x, 41% premium to 10yr average of 13.6x
Valuation relative 12M FWD PER 47% discount to EM, in line with 10yr average discount of 48% 12M FWD PER 29% premium to EM, above the 10yr average premium of 18%
Dividend yield 12M FWD DY of 7.8% exceeds 10 year RUB gov’t bond yield of 6.6% 12M FWD DY of 3.4% exceeds 2.7% yield on 10 year SAR gov’t sukuk
Sector skew Commodity heavy: 74% of MSCI Russia is energy and materials. Financials less important at 21% of MSCI Russia, banks profitability less driven by US yield curve. Banks heavy: 44% of MSCI Saudi Arabia is in financials. Banks profitability driven off US yield curve – steeper = more profitable. Commodities make up 36% of MSCI Saudi Arabia
Political risk US sanctions expected for SolarWinds cyberattack. Our base case is these are not targeted at Russian local debt/equities, but investors may decide to wait and see. Geopolitical realities and the US State Department stating that it is focused on ‘future conduct’ suggest harsh US Sanctions likely to be avoided but relations recalibrated under Biden. Yemen, regional geopolitics continued risk
EM fund positioning Well owned: actively managed, MSCI EM benchmarked, GEM funds have 3.9% allocation to Russia vs a benchmark weight of 2.8% (end-Jan). 65% of EM funds are overweight Russia. Very under owned: actively managed, MSCI EM benchmarked, GEM funds have 0.3% allocation to Saudi Arabia vs a benchmark weight of 2.4% (end-Jan). Only 23% are invested in Saudi Arabia at all.
Locals Local equity ownership has been rising with the fall in local rates and improved dividends but with some exceptions, price movements largely driven by international sentiment Driven by local sentiment: 97% of the Tadawul owned by Saudi investors; non-GCC investors own just 2.4%, and make up just 5% of turnover
Oil price fiscal breakeven We calculate around $54/bbl for 2021 We calculate around $69/bbl for 2021 (the IMF has $68/bbl for 2021 in their October 2020 Regional Economic Outlook)
Source: Renaissance Capital

Here’s Renaissance’s overall take:“We are overweight Russia vs Saudi Arabia, given valuations and our base case view that oil stabilises around current levels (we assume $65/bbl for 2021, $60/bbl for 2022), that US sanctions on Russia will be relatively light allowing a relief rally in the market, and that the dollar should trend weaker over the coming years. The risk case would be harsh sanctions on Russia (e.g. on the local debt market), a strong dollar/weaker EM FX and/or further steepening of the US yield curve.