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S. Korea Inc. 2.0 comes out the shadows

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Tourists from Shanghai shop at a branch of Innisfree, AmorePacific's budget cosmetics brand, in central Seoul.   © Reuters

Over the past few months, financial headlines have been dominated by the threat of an economic hard landing in China. South Korea is already reeling from slowing Chinese demand, given that China is its biggest export destination by far. Since 2011, a combination of weak global demand and currency strength has put enormous pressure on South Korea's traditional growth engine of exports in electronics, automobiles and machinery.

     Despite this challenging backdrop, the benchmark KOSPI index was up 4.23% for the year to date on November 10, according to Bloomberg, in part due to aggressive monetary easing by the central bank. Also, as a net importer of resources, South Korea is a relative beneficiary of the global collapse in commodity prices. As a result, for this year at least, the country has been a relative safe haven amid widespread volatility.

     Even more impressive is South Korea's smaller retail-driven KOSDAQ market. While the KOSPI is populated by the large industrial stocks of South Korean chaebols (family-controlled conglomerates), the KOSDAQ is comprised of small and mid-sized players in healthcare, consumption and information technology. For the year to Nov. 10 South Korea's second board was up 20.95%, benefitting from an abundance of domestic liquidity on the back of the central bank's super-easy monetary policy. The KOSDAQ's five-year slumber has been broken, with net buying of around $2.5 billion by retail investors in the year to date.

     The relative performance of the two bourses is telling. The KOSPI reflects a market that represents the golden era of South Korea's rise as a major exporter. In the 20 years from 1989 to 2008, South Korea's exporters, led by the chaebols, turned the country into a global powerhouse on the strength of their industrious, price competitive and volume-driven model.

     That South Korea Inc. 1.0 formula is quickly approaching its expiry date amid weak global demand and China's successful emulation of the same formula for success. On the other hand, we see companies emerging from the shadows of the chaebols, whose dominance has stifled smaller players for decades. These companies are nimble, entrepreneurial, and better at adapting to the low-growth environment the world is facing.

     Companies that can embrace the structural shift from the traditional Asian export model represent the corporate standard bearers of a new era; we might label this new age South Korea Inc. 2.0. These companies are emerging from their own home markets, whose traditional customer base is the domestic consumer. An example is the cosmetics industry. Traditionally focused on the domestic market, cosmetics is turning into a major export business on the back of an emerging consumer class in China.

Wild popularity

     Just as Chinese state-owned enterprises used the chaebols as benchmarks for their business models, a growing population of Chinese consumers is benchmarking South Korean consumption trends for its lifestyle aspirations. Already, South Korea's K-pop music and TV dramas have achieved wild popularity. During the 1990s, South Korean consumers had similar aspirations, taking cultural and consumption cues from their Japanese counterparts on everything from TV shows and "manga" comics to food and beverages.

     Geographical proximity helps. South Korea is one of the fastest growing tourist destinations for mainland Chinese tourists, which is giving South Korea's consumer brands more exposure, providing opportunities for sustainable growth in cultural and related exports.

     If other consumer companies are to emulate the spectacular success the cosmetics industry has enjoyed, it is important to leverage the current wave of tourists. South Korea is planning to build Asia's largest duty-free shopping hub to take advantage of this boom. While this has been a very successful investment theme for equity investors, more exciting is the exposure to hundreds of South Korean consumer brands that these tourists are getting.

     The proliferation of e-commerce -- again, especially in China -- is another major factor behind the South Korea Inc. 2.0 phenomenon. Thanks to online platforms, smaller companies with good products can access markets that previously required huge investments in distribution and marketing. Indeed, the success of South Korean cosmetics companies in China is notable for distribution outside traditional channels such as door-to-door, department stores and specialty stores. Instead, we see strong growth in online and duty-free sales allowing smaller companies to access China without costly investments over many years of commitment.

     The key challenge in making this transition is embracing the B2C (business to consumer) model and the creation and maintenance of a consumer culture of brand following. Conversely, the B2B (business to business) model used to such success by South Korean chaebols of the past is increasingly being adapted by Chinese SOEs. The B2C model is not a trait that is intuitive to typical South Korean companies, but mastering it will determine the ultimate success of the transition to the South Korea Inc. 2.0 model. In this regard, consumer companies in retail, food and beverages and entertainment already enjoy a head start over traditional export companies. The stock market has been reflecting this premium for domestic sectors, with valuations now at historic premiums.

     The South Korean economy is undergoing an urgent transition from an economic model that has worked wonderfully for over two decades. But the world has changed. To make adjustments from a model that has worked in the past requires vision, risk-taking, and business execution. Investors also need to change. Global investors have historically focused on the chaebol-led exporters. In the next decade, investors should look for companies that display entrepreneurialism, original branding and good corporate governance. Companies represented in the KOSDAQ, and the domestic players on the KOSPI, will provide some of the best opportunities for generating long-term returns.

Peter S. Kim is a managing director and investment strategist at KDB Daewoo Securities. This article reflects the personal views of the author.

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