The Days Ahead:

  • Inflation report and retail sales.

This Week:

  • South Korea’s export economy.
  • Exports have rebounded quickly in 2024.
  • And the country has set out major governance reforms.
  • It’s also moving into the top ranks of defense contractors.
  • The Mag 7 have had a great run but it’s not over.
  • Earnings and sales growth will continue.
  • Bank lending is down which is a headwind for small businesses.

South Korea Rising

South Korea publishes its monthly trade numbers the day after the month-end. The U.S. publishes its numbers about six weeks later. No one matches the South Koreans for on-time reporting. The country has a $1,800 billion economy with exports accounting for 48% of GDP. Imports are another 48%, putting South Korea at the top of most league tables for trade-dependent economies.

South Korea had a solid rebound from Covid-19 and its economy has grown some 12% since 2020. But it’s also faced problems.

South Korea finds itself in the political middle every time there’s a flare up with China over the South China Sea. China has border disputes with over 20 countries (but not South Korea) and recently extended its “9-dash map” of its boundaries to a “10-dash” map, which extends its reach to 1,300 miles from the mainland. South Korea keeps friends with a lot of people.

It is an aging country with 20% of the population aged over 65. It will jump to 44% in 20 years. In Japan it’s 28% and headed to 40%, and in China it’s 14% and headed to 30%. The U.S. is at 16% and headed to 25%. South Korea and Japan are live cases of what a rich country must do to thrive in smaller and ageing societies. Robotics, health care, transport, mobility, and open API and AI are pushing ahead in both South Korea and Japan.

South Korea’s largest export market is China where it sold around $16 billion of goods per month in 2022. That fell to $9 billion by early 2023. It’s about the same level today. U.S. exports went the other way from around $4 billion a month in 2022 to around $12 billion by late 2023.

Many of South Korea’s exports are in highly cyclical businesses like chips, autos, industrial goods, ship building and batteries. As the global economy, especially China’s and the EU’s, slowed in 2023, so too did South Korea. Its stock market fell some 35% from 2021 to mid-2023. There’s also political disarray around the first lady and a Dior handbag and a heightened debate about conscription.

But there are changes and first is the growth in exports.

The blue bars show the annual percent change in exports and confirm some very big swings. The green line shows the earning per share on the KOSPI, South Korea’s leading stock market index. There’s an almost perfect overlay. As exports grow, so do earnings, and vice versa. This makes sense. Samsung, the largest weighting in the stock market at 25%, drives 86% of its revenue outside South Korea. Companies like LG Electronics, SK Hynix (semiconductors) and Hyundai and Kia, make up another 20% of the market and sell 60% to 70% of their goods overseas. Some 60% of the sales of all South Korean stocks are international.

January exports showed a 90% increase in memory chips, 18% in batteries, 83% in semi-conductors and 25% in autos. Nearly all Asian economies from Japan, China, and the ASEAN nations will see higher growth, lower inflation and an end to rate increases in 2024.  The export market looks much improved and earnings will follow.

Secondly, South Korea is the world’s ninth largest arms manufacturer and exporter. That may not sound impressive but China and Russia are the second and fourth largest and their customer base is, well, narrow. China’s defense industry exports fell 23% in the last four years. Russia’s fell by 31%. Even the UK and Germany were down over 35%. But South Korea’s defense exports are up 74%. Its own defense budget is set to grow 4% and is well over 3% of GDP, just shy of the U.S. at 3.1%.

The names may not be well known but companies like KAI, Hanwha Aerospace, Hyundai Rotem, Samyang Comtech and Satrec Initiative make things like the KF-21 Fighter Jet, the KUH-1P helicopter, ubiquitous in South Asia, the K2 Black Panther Tank, unmanned aerial vehicles, sophisticated self-propelled howitzers, drones, flight controls, surveillance aircraft and vehicles. It’s the third largest exporter of combat aircraft and the largest of tanks and artillery. Some of these stocks have done very well, up between 50% to 790% since 2021. But they remain cheap and have order books running for decades. South Korea will probably rise to number four in the rankings of global arms exporters within a few years.

Finally, the government took a leaf out of the Japan Stock Exchange’s playbook with a “name and shame” plan to resolve the “Korea Discount.” They will adopt a number of tax-favored investment programs, like supercharged IRAs.

The big plan is to improve governance (crossholdings are rife in South Korea) and require companies to draw up plans to raise their stock prices above a price to book value (P/BV) of 1.0. Around 70% of the market trades at a discount to book value with an average discount of 33%. Less than 3% of the S&P 500 trades at a discount to book value. In Europe, it’s less than 20%. It’s the kind of change which would raise foreign ownership and interest in the market. It worked for Japan. In the last two years the Japanese stock market rose 34%.

The government has also made procedural changes to make the stock market more attractive to foreign buyers by abolishing registration requirements, scrapping capital gains taxes, and adding more disclosures. It also set a goal of having the South Korean market included in the MSCI EAFE Index, a leading non-U.S. stock index followed by global investors.

There’s also a strange phenomenon in South Korea companies where treasury shares, which are shares authorized but not issued, are not cancelled by companies. This makes the practice of share buy backs nonsensical and means company share counts are way too high. It’s a defensive move for many companies but the practice is archaic and very unfriendly to shareholders.

There’s  more to come next month but one idea is to replicate Japan’s JPX Prime 150 Index, which tracks companies that have exceeded the P/BV ratio of 1.0. If there’s an index, an ETF will follow. And if there’s an ETF, it makes it easier for retail investors to buy.

South Korean stocks often trade at a price earnings ratio of 10, a yield of 4% and returns on equity of around 12%. Those are the sorts of valuations that value investors notice. Change is coming.

That’s a lot on South Korea. But it’s 16% of the Emerging Markets index and 3.3% of the All Country Ex-US Index. We don’t know if it’s about to take off but there are real catalysts and world-beating companies. And that always gets our attention.

Mag 7: The Director’s Cut

We’ve avoided talking too much about the Mag 7 because most stock market snappy titles have a short shelf life. In the last few years, we’ve had FANG, FAANG, FANGMAN, meme stocks, SAAS, BAIT stock, peak-oil, BRICs, and further back things like dotcom, Nifty Fifty, Japan in the 1980s. Much of the talk today is about the Mag 7, the seven largest stocks by market capitalization in the S&P 500 as of end 2023.

The Mag 7, of course, comes from the 1960 John Sturges film “The Magnificent Seven”, which in turn was a remake of the Kurosawa epic “Seven Samurai”. Neither film ends well. Four of the seven don’t make the final reel, one enters rural anonymity and two head over the horizon to early retirement. But today’s Mag 7 are going to be around for a while.

Who are they? Microsoft, Apple, Alphabet, Amazon, Nvidia, Meta, and Tesla. Tesla has had a rough time of it recently and sits at number nine behind Eli Lilly and Berkshire Hathaway. The value of the first big 5 on the list draws comparisons to 2000 when there was a similar concentration of stocks…and subsequent fall from grace. The big 5 back then were Microsoft, Cisco, GE, Exxon and Intel. There were also several tech high- flyers trading at price earnings ratios of over 100. Names like AOL Time Warner, Yahoo, Sun Microsystems, Nokia, JDS Uniphase and EMC Corporate either split up, merged or changed business.

We looked big 5, which account for 25% of the S&P 500 but also 18% of its earnings before interest and tax and 9% of its sales. We then compared them to the five largest in 2000.

The lower red line shows the combined value of the then big 5 as a percent of the total stock market from 1996 to 2005. Their share of the S&P 500 doubled from 1998 to 2000 to reach 18.5%. They then sank to 11% by 2005. Today they’re around 9%.

The upper blue line shows today’s top 5 companies. They took around 8 years, from 2017 to today, to double their share of the S&P 500 to 27%.

We also looked at the growth of the top 5 plus Meta:

By any standard, these are rapidly growing companies with phenomenal earnings power and, while they’re not cheap, they don’t exceed the broader market by much.

We’d also point out that while they’re all seen as tech companies, they serve very different clients in multiple industries. Between them they’re big players in retail, devices, industrial machinery, content origination, advertising, search, enterprise software and cloud computing…and of course AI.

As one of our colleagues, Hugues Le Bras, mentioned, we shouldn’t put these companies into the same basket or view them as a bubble. They are not a homogenous group trading on a single theme. Unlike the original Mag 7, this group should be healthy and profitable for a long time.

Bank Lending Down

Four times a year, the Fed asks loan officers at banks what they’re seeing on loan demand, credit worthiness and their desire and ability to lend. It’s called the Senior Loan Officer Opinion Survey and goes by the awkward acronym of SLOOS.

Last year, most of the loan officers saw a tightening of credit standards, which measure things like loan to value, covenants, collateral, spreads over the prime rate and loan maturity. In nearly every category, banks tightened standards.

By the end of the year, we saw almost no demand for bank lending. Companies simply didn’t want loans. The growth of banks’ commercial loans went negative.

Commercial loans for small banks in the blue line fell 2.3% and for large banks, in green, line fell 2.0%

These are nominal numbers meaning they are not adjusted for inflation. In real terms, with inflation rising 3.4% in 2023, bank lending fell nearly 6%. The latest survey from the National Federation of Independent Businesses (NFIB), which surveys companies with five to 200 employees, showed that the average borrowing rate for small businesses was 9.8%. The real borrowing rate is at its highest in over 20 years.

There may be some relief from non-bank lenders, like private debt firms, venture capital or insurance companies but in most cases, the sums are too small to attract those lenders. We’d expect both lenders and borrowers to remain cautious.

The Bottom Line

Stocks have pressed ahead on the back of good earnings. Around half of the S&P 500 companies have reported and 72% have made a positive surprise to earnings, meaning they beat what analysts thought they would make. Some companies have revised down their expectations for 2024, but it doesn’t seem excessive despite wider talk of an economic slowdown.

The S&P 500 traded within a whisker of 5,000. Markets seem to have irrational reactions to round numbers. It’s at record levels, up 37% from 2022 lows and 4% from the previous record high in January 2022. We’ve written a fair bit about Japan over the last year. The 28% gain from 2023 has extended into 2024 where the market is up 10%….but less if you’re a dollar-based investor. The 10-year Treasury stayed at around 4.1% all week despite record debt issuance. It seems the market took the U.S. Treasury’s forecast of higher debt issuance in its stride.

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Art of the Week: Phyllis Shafer (b. 1958)

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