A Look Under the Hood of iShares South Korea

I was catching up on some reading of the Nikkei Shimbun (Japan's leading financial daily) this evening since I don't get the NFL Network as part of my cable TV package. So much for the 3rd NFL game on Turkey Day. Anyway, I came across an article on South Korea I'd like to share.

The Nikkei published the top-10 South Korean companies based on net earnings for the quarter ended in September. Seven of the 10 reported lower year-over-year net income, and all of those seven were down double-digits, ranging between 15%-47%. The Korea Futures Exchange provided the data and it also reported that among listed firms, earnings were down 9.8% in the quarter.

Overall, Q3 earnings totaled KRW11.5 trillion ($12.3b) for firms listed on the Korea Stock Exchange. Profits were actually up on a q-o-q basis (despite being down nearly 10% y-o-y as mentioned above), and there's hope of a stabling won and the same for oil prices.

Below is a list of the top-10 earners as published in the Nikkei Shimbun. It was mentioned that Samsung Electronics accounted for 19% of the market (it also accounts for over 20% of iShares MSCI South Korean Index ETF (EWY) holdings)!

Top-10 South Korean Companies by Q3 Net Earnings in S. Korea Won (y-o-y +/-)

1. Samsung Electronics -- 2.187 trillion ($2.34b) (+16%)
2. Korea Electric Power (ADR: KEP) -- 1.207t ($1.29b) (+19%)
3. POSCO (ADR: PKX) -- 879.8 billion ($942m) (-17%)
4. Kookmin Bank (ADR: KB) -- 678.1b ($726m) (-28%)
5. SK Telecom (ADR: SKM) -- 456.8b ($489m) (-22%)
6. Hynix Semiconductor -- 383.8b ($410m) (-25%)
7. SK -- 332.4b ($356m) (-23%)
8. KT Corp -- 317.5b ($340m) (+4%)
9. LG Card -- 308.6b ($330m) (-15%)
10. Hyundai Motor -- 282.7b ($303m) (-47%)
* US$ figures are for convenience and may not reflect the current forex rate

Note: Korea Electric Power is EWY's 6th largest holding at 2.89% of assets, POSCO is 3rd at 5.87%, Kookmin Bank is 2nd at 7.74%, SK Telecom is at 1.63%, SK is at 2.27%, KT is at 1.29% and Hyundai Motor 4th at 3.58%. (Source: Morningstar.com)

As the article points out and as anyone investing in Korean stocks already knows, there are two important factors threatening the South Korean economy: the strong won and high oil prices. Two additional threats which should not be taken lightly are the labor situation with strikes having been a nagging problem and drag on earnings at some firms, and also North Korea's nuclear weapons program and its reclusive position in general.

South Korea is best known for its exports, especially in electronics and increasingly in autos. It has other strengths such as in steel and shipbuilding. Thus, it's not a surprise to see the iShares South Korea Index (EWY) dominated by Samsung, and having heavy exposure to the above industries.

So far this year the ETF has performed well if you look at the year-to-date return. It reached an all-time high in May before tanking along with most of the world's equities markets. Since it bottomed out in early summer, it is back up near $50/share again (see charts).

EWY year-to-date:

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And here's a 5-year chart:

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The key determinants whether EWY and Korean stocks will continue the up trend or meet resistance in near-term trading are of course the won and oil prices. More specifically the strength of the won hurts repatriation of profits, and perhaps most importantly, hurts South Korean competitiveness. Most of the focus is on the won trading at its highest levels (in at least 5 years) against the Japanese yen, with the focus due to competition in autos and electronics, among other things (see chart).

South Korea Won, Japanese Yen 5-year chart:

Click to enlarge image.

Another risk to keep in mind is the state of the U.S. economy (read consumers). A slow down in consumer spending and/or poor reports of holiday sales would seemingly put downward pressure on EWY. Likewise, keep an eye on consumer spending in the EU. Lastly, the currency situation should improve once the Bank of Japan raises rates in '07 to narrow its wide rate gap. Meanwhile, the strong won has boosted returns of EWY compared to the KOSPI Composite Index (see chart).

iShares South Korea, KOSPI 1-year chart:

Click to enlarge image.

iShares MSCI South Korea (EWY), S&P Dep Receipts (SPY) and iShares MSCI Japan (EWJ) Year-to-date chart:

Disclosure: The author owns iShares Japan call options but does not own a position in other companies or funds mentioned in this article.