EWY ETF: South Korean Equities Are Cheap In 2022 (NYSEARCA:EWY)

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Seoul city skyline

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iShares MSCI South Korea ETF (NYSEARCA: EVE) is a publicly traded fund that offers investors exposure to South Korean mid- and large-cap stocks. The fund had 112 holdings as of June 10, 2022, with assets under management of $ 3.58 billion. That follows a year of net outflows, as illustrated below, of more than $ 1.4 billion.

EWY net cash flows


Global equities have recently fallen as risk sentiment has deteriorated due to high inflationary pressures and higher long-term interest rates. EWY is no exception. It may be more useful to measure EWY with the US S&P 500 Equity Index to detect relative change; this EWY / SPX relationship is illustrated below and shows mostly low long-term performance.



It is difficult to outperform US equities as they are home to most of the world’s most popular individual names, especially in technology, while the US stock market in general attracts worldwide investment flows given the relatively high corporate productivity in the US. Also, the US The stock market is simply very large and therefore can withstand large capital inflows, although valuations are usually more expensive in the United States as a result. South Korea doesn’t have the same charm, but it can still outperform the U.S. market from time to time.

It is also worth noting that South Korean stocks, which are denominated in South Korean won (KRW for short), naturally fall in USD terms as the USD / KRW exchange rate increases. The USD / KRW has risen sharply since early 2021.

USD / KRW price action


South Korea’s current account (scaled by GDP) is also positive, implying a possible underestimation of the currency, although, as illustrated below, the current account (relative to GDP) it has softened a bit in recent years.

South Korea's current account in GDP


Meanwhile, The Economist’s gross but useful purchasing power parity model suggests that the KRW is 15 to 16% undervalued as of January 2022.

USD / KRW Big Mac Index


Since January 2022, the USD / KRW has risen 7-8% more. Meanwhile, the 10-year yield spread between US and South Korean bonds is negative and stable.

10 year USD / KRW yield differential


Therefore, in general, the USD / KRW is likely to be overvalued and therefore there could be constructive exchange rate pressure on EWY, favoring the rise with a stronger South Korean won. It is virtually impossible to make an FX move reliably, but the point is that there should be some winds against FX right now (EWY supports in dollar terms).

EWY itself aims to replicate the performance of its chosen benchmark, the MSCI Korea 25/50 index, which is in itself a limited weighted version of the normal MSCI Korea index. Data are only available from MSCI for the latter index; in the fact sheet until May 31, 2022, the price / earnings ratios at the end and in the long term were 10.21x and 8.92x, respectively, with a price / book ratio of 1.10x. The dividend yield was 2.12%, with earnings distributions of about 22%. These figures also imply an overall return on capital of approximately 12%. Meanwhile, Morningstar estimates an average earnings growth of three to five years at around 10.96% for EWY more specifically, with a price-to-earnings ratio of 8.60x and a price-to-book ratio of 0.90x ( although from June 9, 2022, more recently).

If I base myself on the MSCI numbers in the first instance, and assume a fall in the return on equity of more than 12% to 10% over the next few years as the portfolio “shrinks,” and assuming no there is a repurchase at the moment, with a risk-free rate of around 3.5% (South Korea’s 10 years currently produce around 3.6%), my average earnings growth rate of three to five years is less than Morningstar’s, 6.6-8.2%, but my implicit IRR is very high above 19%.

However, the IRR is lower (around 9.6% per year) if we only value dividend distributions without assuming any repurchase.

EWY IRR indicator

Author’s calculations

Keep in mind that South Korean inflation was 5.4% in May 2022, so profit growth fell to about 3% over the next few years is unreasonable. The first-year estimate of 14.46% in the table above is based on the best MSCI estimate for next year for the components of the MSCI Korea index as a whole (and therefore a reasonable indicator for in the EWY portfolio, a similar figure was found referring to Morningstar). Therefore, even with an unrealistic earnings growth trajectory and a return on capital that falls to 10% in the sixth year (our final year) and keeping multiple gains the same, EWY offers an attractive IRR.

If we valued EWY today in a multiple of terminal gains, we could assume a maximum risk premium of 5.5% equity (which would be high for the US market, but perhaps just for a significantly higher equity market riskier or at least less popular as now). such as South Korea), and a risk-free rate of probably no more than 4% in the long run. In addition, we would assume a growth rate of nominal earnings of at least 2% in perpetuity. Thus, the net discount rate would be the sum of these, or 7.5%. Dividing 1 by 7.5% gives us a forward P / E multiple of 13.33x, and this is also potentially a conservative multiple. Therefore, even today it could be argued that EWY has an increase of approximately 49% based simply on the multiple expansion of earnings (13.33x compared to the current 8.92x).

All in all, given the possible subsequent foreign exchange winds and a likely undervalued long-term earnings flow, and the high uncertainty implicitly valued in the multiple of gains, I think EWY (i.e. South Korean stocks) they remain undervalued. Last year’s big outflows are also symptoms of a high equity risk premium that I think deserves to be contracted.

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