The World’s Hottest Market – And It’s Not China

Which global economy grew at an annual rate of 11% in the second quarter, and will report a second-consecutive double-digit advance when it reports on Monday?

Hint: It isn’t China.

But you are looking in the correct part of the world.

The economy in question is South Korea, which has enjoyed an astonishing rebound since it reached a recessionary bottom last winter. One factor in particular should nurture this rebound: The Korean economy wasn’t pulled down by the U.S.-led subprime mortgage crisis, which infected many foreign banks that invested in mortgage-backed securities - the Asian Tiger was pole-axed by a collapse in world trade in the first three months of this year.

At the nadir in March, South Korean exports were down 40% from the same point in 2008. The banking system also had a liquidity crisis that required a government bailout - not because of investments in toxic U.S. derivatives, but because of similarly lackluster credit card loans and dodgy mortgage rubbish of its own.

The South Korean won declined by 40% against the dollar during the 12-month-stretch that ended in February. It has since recovered about half that drop, so it remains undervalued.

But the overall outlook is highly upbeat. From its low point in December 2008, the Korea Composite Stock Price Index (KOSPI) is up 65%. Exports have recovered, particularly on the back of surging demand from China - a trading partner that is growing a bit more slowly than Korea, but that has considerably more muscle with 27 times the population.

Korea’s current account balance once again shows a healthy surplus. Credit-rater Fitch Ratings Inc.,  which had placed Korea on “credit watch” for a possible downgrade from it’s A+ rating, recently announced that the downgrade would be unnecessary, and said that Korea could expect to run a budget surplus in 2011.

That demonstrates Korea’s true investment allure: The country is well run. It elected a pro-business government led by President Lee Myung-bak in the beginning of 2008 (Lee’s term lasts until 2013), and that government has coped pretty well with the global financial crisis.

Since its trade agreement with the United States is on indefinite “hold” in the Congress of U.S. House Speaker Nancy Pelosi, D-CA., Korea recently signed a similar pact with the European Union, which may boost exports somewhat.

Like nearly everywhere else, Korea’s government spent on “stimulus” - but only moderately - so the budget deficit is only expected to reach 4.5% of gross domestic product (GDP) this year, according to The Economist magazine’s panel of forecasters.

In any case, Korea’s government spending as a percentage of GDP is one of the lowest of the world’s most-affluent developed economies. That means it will be much less of a burden than on the Korean economy than will similar outlays in the higher-spending Japan, United States and European Union.

The forecasters at The Economist expect Korea to advance at a 2.8% rate in 2010, but that forecast looks way too low. After all, remember that even in the difficult, post-Asian-contagion years of 1998-2008, Korea experienced average annual productivity gains of 4.3% - more than double the rate experienced by the U.S. economy during the same period.

At first glance, Korea’s stock market looks expensive, trading at 19 times earnings. However, the earnings concerned are from the bottom of the recession, when several of the big exporters were operating in the red. The market is still below its mid-2008 level, when the overall Price/Earnings (P/E) ratio was only 11.

One admittedly annoying reality is that most large Korean companies abolished their dividends during the credit crunch, and have yet to restore the payouts.

Even so, Korea’s economy is a big benefactor of the torrid growth being generated by its much-bigger neighbor - Mainland China - which is why some of Korean stocks are magnificent China plays.

There are several Korean stocks that trade as American Depository Receipts (ADRs) on the New York Stock Exchange, and in sufficient volume to make them suitable profit plays. My thoughts on each of these companies follow:

• KB Financial Group Inc. (KB): A financial group that owns the largest bank in Korea, KB was hit badly by loan losses and problems in its Kazakhstan subsidiary, and by its badly timed (October 2008) conversion into a holding company.  It has rallied from its low, engineered a $900 million rights issue and currently trades at a P/E of only 8.8. In my view, however, it has a ham-fisted management team. HOLD.

• Korea Electric Power Corp. (KEP): Korea’s national electric power company recorded a loss in 2008 because of fixed tariffs. KEP’s steady growth should benefit from any acceleration in Korea’s economic growth rate, but it is forced to buy coal from overseas, which gives it a downside risk. Although it’s trading at only 54% of net asset value (NAV), but even so I think not. AVOID.

• KT Corp. (KTC): Formerly Korea Telecom, KT is Korea’s leading fixed-line telecom provider, which was privatized in 2002.  It carries a P/E of 18 on its trailing earnings, and it was one of the companies that last year cut its dividend. What’s more, I don’t like the sector. AVOID.

• Posco. (PKX): Korea’s largest steel company, with a P/E of 15 on the company’s trailing earnings, Posco has a large export operation to China, making it a direct participant in the Red Dragon’s explosive growth. Posco is the world’s No. 3 steelmaker, and is the most efficient in terms of output/man hour. Like KEP, Posco will suffer from rising raw-materials prices - in this case, iron ore. That key ingredient to the steelmaking process has been cheaper this year than it is now, and the price appears set to keep rising. The stock is right now trading at three times its 2009 low, and 1.9 times book value (BV). HOLD/BUY.

• Shinhan Financial Group Co. Ltd. (SHG): The third-largest financial group in Korea, Shinhan provides commercial and investment-banking services, but without KB’s large Kazakhstan exposure. The ADR right now is trading at 10.5 times earnings and 1.1 times net asset value. BUY.

• SK Telecom Co. Ltd. (SKM): Korea’s largest mobile phone company, with operations in Vietnam, SK Telecom is trading at 11.8 times earnings. It recently sold back its China investment for $1.3 billion, so it is no longer a significant China play. It is less attractive than it once was, and I don’t like the sector, but it’s still a better value than fixed-line player KT. HOLD.

• Finally, you could look at the Korean exchange-traded index fund, the iShares South Korea ETF (EWY), which invests in the Morgan Stanley Capital International Korea Index. It has a P/E ratio of 13, but a yield after expenses of only 0.8%.

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