Some thoughts about incentives of Korean insiders

Why these stocks maybe deserve to be cheap

I had a little bit of a moment when looking at Korean stocks. I looked at pros and cons (mostly tax wise) for insiders to actually return more capital and came to the conclusion that a lot of these net nets will likely stay cheap forever. Or until some drastic new legislation goes into effect (which I don’t see evidence of). And that this effect is far more pronounced with large insider ownership, where the more control insiders have, the more their incentives are basically diametrically opposed to minority holder incentives. Funnily enough the opposite is kind of true for Hong Kong stocks.

Let’s look at CS Holdings (000590) listed in Korea. The stock trades at about 25% of net cash + real estate investments, most of which is cash and investments. They have a dividend payout ratio of about 4% of earnings and trade at approximately 4x earnings with a core business that generates a fairly high ROIC (not counting non core assets on bs etc) selling welding materials.

Now you might say, eventually something will happen so it could be attractive to buy here? The problem with that is that insiders control 82% of shares (assuming they cancel treasury shares). There are four outcomes, a buyout, large dividends, acquisitions or status quo. And the problem is that insiders, most of the time, are strongly incentivized to choose option 4: status quo. Even if they could buy out the remaining 18% for a large discount. And the status quo can last for a loooong long time.

If they bought out minority holders, insider families gain no real advantage and actually lose the prestige of being listed. And they would have to do an independent appraisal if a large holder dies and much higher inheritance taxes have to be paid.

If they were to actually pay out the excess cash they would pay ~30% taxes on it (assuming a 25-40%+ payout), so right there a huge leakage. And now every generation would in turn also lose up to 50% in inheritance taxes on the full amount paid out. So a combined loss of 65% by taxes alone over time. Vs status quo where they pay inheritance taxes on only <20% of fair value and have no leakage through dividend taxes. Plus insiders get essentially almost nothing in return when managing this wealth in private vs just holding their wealth in CS Holdings as they likely would keep it in CDs and some real estate anyway.

Of course acquisitions sometimes happen which is why I think you have so many Japanese companies with random businesses that have nothing to do with each other. The problem is you need the heirs to actually care about business. And those acquisitions cannot destroy value for this option to be attractive (which is very easy to do in the wrong hands) If insiders have a mostly passive role and are risk averse they will just park the cash in government bonds and maybe some real estate and call it a day.

So in essence the public minority holder is basically used here to keep inheritance taxes down. And without serious new laws cracking down on this (or much lower taxes) this can go on indefinitely. And discount to net cash value offers no real protection. The only real protection is the actual payout % used for insider consumption. I would not be surprised to see some Korean stocks trade at 5% of book value 10-15 years from now. When as a minority investor you are being used to keep taxes down it makes little difference if the stock trades at 5% 20% or 40% discount to net cash. And a stock at say 30% of net cash does not really have a real bottom above 5-10% of net cash value. And without eventual large dividends a few isolated buybacks aren’t the end all be all. Let’s say founders increase their stake from 40% to a whopping 80% through buybacks and share price doesn’t move much. Your 30% of NAV goes to 15% and you are now facing only a tiny dribble of a dividend for the next 30 years, congrats.

And really strange things like the amount of insider offspring and their spending habits start to matter much more than book value or earnings multiples, as they will predict what % of earnings you as a minority investor will actually see. If the fertility rate of insiders is very low that is probably bearish for the future dividend payout. Preferably you would want some kind of Elon Musk wannabe who has 50 kids who all need to get paid (or demand greater control over their wealth) to see significant shareholder returns above 30-40% of earnings. And again this can easily last well beyond the investment horizons of most investors. With minor temporary increases in between as inheritances taxes need to be paid.

Of course there is a limit and currently there is a bill being discussed in Korea that would set a lower limit of 80% of book value for inheritance taxes. It was nixed, but the president has again ordered the government to reconsider its proposal. This could create some interesting situations and especially increase upside for companies with old founders who hold large stakes. Although you have to be careful with this logic as there are exemptions in place where a large insider with active involvement can transfer shares on a much lower tax scheme of 10% to a successor family member while still alive.

Are there exemptions to these tax avoidance incentives? I think there are:

• Public companies with no large insider ownership do have a greater incentive to pay dividends. Much easier for activists to get in there too.

• Public companies controlled by another much larger public company that has no large concentrated inside ownership (or is in a jurisdiction with low/0% dividend/inheritance taxes)

• Companies with large insider ownership, but the children get nothing/owners believe the government deserves it more than their children. Or insiders simply have no children. This is usually not public info though.

• Companies where there is no real insider involvement anymore that are bought out by a large competitor for a price that is too attractive to ignore. Although if inheritance taxes are high enough there might not be a price that is attractive enough even.

And now incentives for Hong Kong insiders:

• 0% inheritance tax

• 0% dividend tax (beyond 5-10% WHT between China -> ex-China company)

• Insiders are limited in what they can invest in when holding cash inside a Chinese company due to capital controls. So a direct incentive to get the cash out through their Hong Kong listing.

• Weaker property rights are an incentive to stash a significant portion of net worth overseas (discount from this is usually much smaller than from being stuck in a value trap with no prospects of significant dividends).

Finally I think to a lesser extent this is true in Europe as well. Although Europe has plenty of tax havens that wealthy controlling families can move to. I don’t think this is really an option for many Koreans or Japanese people. The step to move from France to Switzerland or Monaco or something is far smaller than to move from Japan/Korea to Singapore or Hong Kong. Both culturally and distance wise.

Just kind of a rambling post about incentives that can prevent/realize the value of Asian net nets. Since I saw so few Korean stocks with a healthy dividend payout %. If you think I missed something let me know in the comments!