EWY - EWY: Looking Forward To The Next Leg Of The Korean Rally

2023-09-11 13:23:23 ET

Summary

• Korean large caps have outperformed their Asian counterparts this year on the back of tech-driven tailwinds.
• With generative AI investments showing no sign of slowing down, the iShares MSCI South Korea ETF remains poised to benefit via its two largest holdings.
• The portfolio is priced at undemanding levels, offering investors many ways to win from here.

In line with my prior coverage , Korean large-cap stocks remain among the best-performing in Asia, with the iShares MSCI South Korea ETF ( EWY ) up ~9% this year. While there have been challenges in recent months amid a deteriorating Chinese economy and newly elected conservative President Yoon's business-friendly reforms suffering setbacks, there are still legs left in the rally, in my view. The big one remains EWY's exposure to the most exciting growth sector in the world right now, semiconductors, with its two largest holdings (Samsung Electronics ( OTCPK:SSNLF ) and SK Hynix ( OTC:HXSCF )) leading the way in generative artificial intelligence. With the broader memory cycle also showing signs of bottoming out, I would look through the sector's earnings weakness this year ahead of a cyclical upturn in 2024 (+50% EPS growth vs. the -36% decline in 2023).

Plus, there's an index inclusion catalyst in the pipeline for Korean bonds, paving the way for a lower risk-free rate and, by extension, improved equity risk premia. At the current 1x P/B valuation, EWY isn't pricing in too many positives and remains a reasonably-priced option to ride the next leg of the long-term Korean equity story.

Fund Overview – Gain Korean Exposure via a Tech-Heavy Portfolio

The iShares MSCI South Korea ETF tracks (pre-expenses) the performance of the MSCI Korea 25/50 Index, a basket of Korean large-caps subject to concentration limits. The ETF has seen an increase in its net assets in recent months, reaching $3.6bn at the time of writing. On the other hand, the 0.6% expense ratio is a drawback at the current ~40bps premium to the Franklin FTSE South Korea ETF ( FLKR ).

The portfolio size is now spread across a larger 107 holdings, though the tech-focused sector allocation remains intact. Information Technology has further gained share at 35.8%, followed by Industrials at 14.5% and Materials at 11.1%. The only other sector allocation over 10% is Financials (10.7%), with Consumer Discretionary losing share at 9.9%. With the top five sectors accounting for an even larger ~82% of the total portfolio, EWY remains one of the more concentrated Asian ETFs from a sector perspective. In turn, the fund's equity beta has been kept at an elevated 1.2 relative to the S&P 500 ( SPY ), so investors should expect some volatility with this ETF.

Not too much has changed from a single-stock perspective either, with EWY still heavily exposed to tech/semiconductor leaders Samsung Electronics and SK Hynix at 23.2% and 6.0%, respectively. Steelmaker company POSCO ( PKX ) is now the third-largest holding at 3.9% after a stellar run YTD, followed by battery/electronic materials manufacturer Samsung SDI ( OTCPK:SSDIY ) at 3.1% and LG Chemical ( OTCPK:LGCLF ) at 2.8%. At modestly higher 9.5x earnings and ~1x book value multiples, the EWY portfolio still screens inexpensively relative to the underlying fundamentals of its constituents.

Fund Performance – Steady Capital Growth Through the Cycles

After a stellar start to the year, EWY's rally has lost some momentum, but on a YTD basis, the +9.2% rally means the overall rate of compounding remains at a steady +6.2% pace (market price and NAV terms) since its 2000 inception. In line with its high beta, however, the fund's performance has been volatile, with multiple low-double digit drawdowns over the last five years punctuated by a +39.7% return in 2020. As a result, the fund's three and five-year annualized returns stand at a lackluster +5.0% and +0.1%, respectively, paling in comparison to EWY's early years.

Given the fund's outsized cyclical tech exposure, EWY investors shouldn't expect a consistently high distribution yield. The current trailing twelve-month yield, for instance, is down to 1.0% (1.1% on a 30-day basis), though the ETF has seen significantly higher yields during upcycles. Instead, I would keep an eye on the portfolio valuation, which remains undemanding at 1x book and 9.5x earnings.

Still Plenty of Tailwinds at Play

Generative AI-driven growth isn't slowing down, as shown by Nvidia's July quarter outperformance. In particular, a lot of the investment has been focused on the infrastructure to run these AI applications, directly translating into upside for the 'pick and shovel' plays in the EWY portfolio, SK Hynix, and Samsung Electronics. Thus far, the market has rewarded both stocks for their AI leadership, with SK Hynix at the forefront , given its leadership in high bandwidth memory. Samsung is currently trailing its Korean peer but has several initiatives in the pipeline to capitalize on the AI wave. Either way, EWY is poised to benefit from a growing AI contribution.

I wouldn't rule out a cyclical upswing on the ex-AI side of the chip businesses either – recent global semiconductor sales data from the Semiconductor Industry Association, for instance, showed revenue is already bottoming out. Similarly, recent management commentary across the supply chain indicates the worst may finally be behind us. Alongside a new iPhone 15 cycle into the back half of the year, Korea's tech leadership in memory should eventually shine through, boosting earnings growth for the tech-focused EWY fund.

Also on the horizon is a potential monetary boost – having seen its economy slow significantly from an accelerated tightening cycle (in line with the Fed), the setup for rate cuts is now compelling. Alongside the cyclical downturn in semiconductors (ex-AI) through H1 2023, the ongoing slowdown in China (one of Korea's largest trading partners) poses downside risks to the Bank of Korea's (BOK) modest 1-2% full-year GDP growth target. At the same time, inflation is easing, and the property market is looking increasingly vulnerable, given the outsized percentage of floating-rate Korean mortgages. In addition to rate cuts, expect further downside pressure to the Korean risk-free rate (via an influx of passive flows) should the country's sovereign debt gain FTSE World Government Bond Index (WGBI) inclusion (likely sometime in 2024, assuming a two-year timeline).

Looking Forward to the Next Leg of the Korean Rally

Korean equities have flatlined following a positive start to the year, but I wouldn't rule out further outperformance just yet. While the country's ties with a slowing Chinese economy are a concern, along with President Yoon's faltering pro-business agenda, Korea's heavy exposure to memory semiconductors means it remains levered to generative AI tailwinds. Plus, the cyclical downturn for the ex-AI side of the chip business is showing signs of a reversal, which bodes well for 2024 earnings (currently pegged at +50% per consensus estimates).

Relative to a depressed 2023 earnings base, the current 9.5x P/E ratio isn't pricey at all, leaving ample room for the multiple to re-rate ahead of a likely BoK pivot. Additional catalysts include the pending WGBI inclusion for Korean sovereign debt (likely later next year), as well as the upcoming legislative election cycle.

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