[INTERVIEW] Inheritance tax reform may resolve ‘Korea discount,’ says Israeli investment guru

Finance

Published: 16 Feb. 2024, 07:00 Updated: 16 Feb. 2024, 09:41

[INTERVIEW] Inheritance tax reform may resolve ‘Korea discount,’ says Israeli investment guru

Ohad Topor, founder and chairman of Topor&Co. Korea, or TCK Investment Management [TCK INVESTMENT MANAGEMENT]

As resource-strapped nations with limited landmass, Korea and Israel have a lot in common — marked by their strong pursuit of higher education and technology development, not to mention that both are grappling with ever-present geopolitical tensions in their respective regions.

Despite such parallels and even a war raging in the Middle East between Israel and Hamas, there seems to be no “Israel discount,” whereas Korea is struggling to deal with chronic undervaluation of its stocks.

Contrary to popular belief, Ohad Topor, founder and chair of a Seoul-based investment management and consulting firm Topor & Co. Korea (TCK), does not attribute the infamous “Korea discount” primarily to the country’s unfriendly, missile-firing neighbor to the north.

“I think this discount has structural, behavioral, and geopolitical causes, but contrary to your readers‘ expectations, I don’t think the geopolitical cause is the most important one,” said the Israeli investor and entrepreneur in an interview with JoongAng Ilbo, an affiliate of the Korea JoongAng Daily, on Wednesday.

Inheritance tax reform might be a dealmaker, the chairman suggested, as Korea’s far heavier inheritance tax compared to its global peers “might create the wrong incentives that hold back the local stock market from being fairly valued.”

Topor also pointed out that the Korean stock market lacks a solid foundation, or what he called "the deepest layer," of long-term investments to mitigate volatility. Institutional investors such as sovereign wealth funds often provide a company with a stable, predictable basis where smaller investments can ebb and flow, which many Korean stocks are missing, the chairman said.

The following are excerpts of the interview, edited for clarity and length.

Q. Do you see Korea’s stocks actually undervalued in general?
A. It is evident that Korean public companies are always cheaper than similar companies in other countries.

I think this discount has structural, behavioral, and geopolitical causes, but contrary to your readers‘ expectations, I don’t think the geopolitical cause is the most important one. I think the other two are more significant.

There are many metrics to assess companies in the public markets, such as price-to-earnings ratio (P/E), and price-to-book (P/B), which are basic metrics that global investors use. Korea is undervalued on both these metrics. Persistently.

Currently, more than 50 percent of the companies listed in Korea have a P/B ratio of less than 1x, which is a measure of broad undervaluation. The Kospi as a whole has a P/B of 0.83x, compared to 2.6x for global equities, a 68 percent “discount” based on this metric.

This is especially notable because Korean companies are, for the most part, fundamentally great companies with great success but the value assigned by public investors locally and abroad is low.

All Korean public companies combined are less than 1.3 percent of the value of global public companies. This is considered small relative to its size and potential. Japan accounts for 5.4 percent, the United Kingdom 3.5 percent, France 2.8 percent and Switzerland 2.3 percent.

This is potential wealth that Korea missed out on, and could have used.

The higher your companies are valued, the more wealth is distributed to your people — as shareholders or entrepreneurs — and your country, and the more taxes the government could have generated from capital gains tax or income tax on dividends.

This happened in real estate, but I hear from locals that many think it has gone too far in real estate-overvaluation.

What do you think is the cause of the Korea discount?
We should start by clarifying what an investor wants when they choose companies: they want to see steady or increasing earnings so that they can anticipate getting dividends, or accretive share buybacks that boost share prices; a management team that they can assess and comprehend; a reliable legal system in which the investor can trust the market and also that the company operates in a stable system.

These three factors are key to enabling long-term investors to have a background that helps them forecast future earnings. These fundamental drivers should not be forgotten. This applies to any company in any country across the world.

It‘s important to remember that most of the money in the world and most global investors speak English and usually require a good reason to invest outside their comfort zone.

Another important concept to understand is that shareholders of a public company usually have different types of investors. We can view these types of investors as layers. The first layer, like with sand, the deepest layer of investors is long-term, often institutional, such as large global investment funds, sovereign funds, or pension funds.

They keep a company for a very long time, and don’t move much, because they believe in the future of the company. If the stock price drops, they typically buy more which supports the price.

On the other hand, there is a top layer which are investors that switch in and out of a stock, sometimes for a year or less, based on trends, stories, or news. This, like the top layer of sand, can move and change with the wind. If there is not enough deep sand, this layer creates large volatility in price.

I think that in Korea, most companies have too much of the top layer of sand and not enough of the deep layer.

This creates more price fluctuations. This volatility means smaller investors can‘t forecast the swings and they don’t trust stocks to be a source of long-term wealth creation.

Foreign investors that gain confidence in Korean companies can serve as a deep layer.

Moreover, stocks tend to have higher value when they have a local investor base in their home country that knows the companies and supports the long-term holding of these stocks. This implies that it will be harder for a stock to achieve full value in Korea if Koreans don‘t trust it or buy it. A stock that is more widely held and followed attracts more research by analysts, which makes it simpler for global investors to access information.

Foreign access to the market is also key to widening the investor base and improving valuations. Until very recently, it was nearly impossible for foreign individual investors to trade Korean equities, due to Korea’s registration requirement introduced in the early 1990s. Though this requirement is now finally being removed, Korean stocks still remain substantially unknown or understood by people investing from outside Korea.

What do you think is the most urgent and important task to solve the Korea discount?
One change that I think would have the most lasting positive impact, if I had to pick one, is a change in inheritance tax.

I have witnessed how tax codes can produce unwanted outcomes in my career. The government should approach a tax code like a CEO approaches compensation and incentive schemes.

First, the way incentives work at a company has a huge effect on the company‘s success. Second, small differences can have a big effect. Third, sometimes when you design a scheme, it can create the wrong focus.

I think that because inheritance tax is so high in Korea, many business leaders and owners have to spend too much of their time planning on how to keep the company in the family. This leads to suboptimal growth for them and their shareholders.

In effect, an owner of a business has an incentive for the company to be lower value because it’s easier to later pay tax. I do not believe that they are intentionally reducing the value of the company, but why would you want a tax code that incentivizes lower valuations for family-led businesses? This is at odds with the economic interests of the nation to have a fully-valued stock market.

One well-known thing is that Korea‘s effective inheritance tax rate is above the Organization for Economic Cooperation and Development (OECD) average.

Inheritance tax accounts for approximately 1.5 percent of total tax revenue in Korea, a higher share than any other OECD country, where the average is roughly 0.5 percent. Inheritance tax can reach as high as 60 percent for holders of listed firms in Korea, again far higher than the typical rate seen in the OECD.

I have worked in different parts of the world for a long time and I observe that this is particularly high in Korea, and might create the wrong incentives that hold back the local stock market from being fairly valued.

As an example of contrast, albeit an extreme one: In Israel, there is no inheritance tax. Israel is similar to Korea in that it is an export-driven, entrepreneurial economy, with a heavy focus on research and development, which means the domestic market is too small and companies need to work hard and take risks to succeed in foreign markets. This rewards risk-takers for making bold moves and succeeding.

Israel, despite having a lot in common with Korea and even going through a war right now, hasn't seen its stocks being undervalued in the market. Why is that?
Although there are other examples in the world, I do think Israel’s example is interesting for Korea because I believe Korea has the best chance to continue to grow and excel in the next decades if it focuses more on technology and innovation. Like Israel, areas that require even more risk-taking and where the upside of success is celebrated and not overly taxed.

Particularly, tech entrepreneurs can choose to relocate and launch businesses in different countries, so it is very important that the local tax system is more favorable and friendly.

Some may argue that it is unjust for family business owners or entrepreneurs to keep their power indefinitely, which is a matter of opinion for Korea to decide, but I will only touch on two things that are relevant to investing and economics.

First, research indicates that family-led companies, particularly in markets like Korea, generally exhibit superior long-term performance compared to professionally-led companies. This superiority is attributed to their long-term vision, personal nature of the competition, adaptability to drastic changes, and a strong commitment to success.

The vast success of Korea‘s economic development is one of the most evident examples of this; family-run chaebols have played a crucial role in this success — helping Korea keep pace with international competition in many industries for many generations.

Second, allowing the value of these companies to increase, coupled with reduced incentives to maintain lower values, can establish a positive cycle of wealth creation.

As the population owning stocks in these companies through their savings witnesses their wealth grow, the generated tax from the increased value through capital gains tax can offset the reduced inheritance tax.

BY KIM KI-HWAN [shin.hanee@joongang.co.kr]