CALCULATING how much to pay for an investment is rarely straightforward. But it’s a particular challenge when your equations somehow have to capture the antics of the unpredictable leader of a secretive pariah regime.
This is the dilemma facing investors in South Korea. The death of North Korea’s Kim Jong Il, whose health has been in doubt in recent years, could also trigger sudden chaos.
“The risks relating to North Korea range from the potential for war to huge unification costs,” said Goohoon Kwon of Goldman Sachs in a new report. “Hence, tensions on the peninsula or signs of unrest in North Korea have typically led to market sell-offs.”
According to conventional economic theory, the price of any asset reflects the market’s view of the level of risk involved.
But this assumes that a meaningful value can be put on the risk. Economists often distinguish between the concepts of risk and uncertainty. Risk can be quantified, if you know the probability of an event happening, and the consequences if it happens. Uncertainty covers situations in which an event’s probability or impact cannot be known with any meaningful degree of accuracy. A growing body of theory — pioneered by trader and author Nassim Nicholas Taleb — suggests that in the real world, unquantifiable uncertainty is far more common than risk.
“What causes severe mistakes is that outside the special cases of casinos and lotteries, you almost never face a single probability with a single (and known) payoff,” Taleb wrote in an essay this year, giving the example of earthquakes or wars. “You have a risk of different levels of damage, each with a different probability. ‘What is the probability of war?’ is a meaningless question for risk assessment,” he wrote.
For some investments, this is less of an issue. There is always the chance that disaster may strike, but the risks are so low that they can usually be ignored. But for South Korea, the dangers posed by the North cannot be dismissed as negligible and their impact on South Korean asset prices could be enormous. Uncertainty generated by North Korea is a “known unknown”, to paraphrase former US Defense Secretary Donald Rumsfeld.
This uncertainty is easier to handle than the most radical kind — catastrophic risks we don’t even know are out there, called “unknown unknowns” by Rumsfeld and “black swans” by Taleb.
But even known unknowns pose profound challenges for markets and investors. The evidence suggests that while markets are aware of the risks from North Korea, nobody has much idea of how much they impact prices, or even if they are priced in at all.
Many analysts argue South Korean assets are persistently cheaper than regional peers because foreign investors are wary of the country — a phenomenon known as “the Korea discount”. They note that price-to-earnings and price-to-book ratios for Korean equities have tended to be the lowest in Asia in the past decade.
Yet there is very little agreement on the reasons for the discount, its size, or even whether it exists at all.
While analysts have cited North Korean risk as one reason for the discount, they have also blamed lax corporate governance, poor protection of minority shareholders and low dividend payments as reasons Korean stocks are relatively cheap.
Analysts polled by Reuters in the past month generally said the Korea discount was real, but added it had narrowed in recent years. Most said North Korea was one factor, along with the economy’s sensitivity to external shocks.
But several said the key issue was that South Korea is still rated as an emerging market by foreign investors and this is reflected in asset prices. A 2005 study by the Samsung Economic Research Institute came to the same conclusion after surveying 500 companies from 10 economies to check if Korea fared worse.
“The Korea discount, as it is generally presented, doesn’t exist,” said Hyun-Soo Park, senior economist at the institute. The market reaction to shocks from North Korea provides further evidence that many investors and analysts struggle when it comes to digesting political risk. The usual reaction is a brief knee-jerk sell-off followed by a recovery within days. That suggests many investors simply ignore geopolitical risk until something happens and they are spooked into selling.
So how can investors be smarter in dealing with major unquantifiable risks such as North Korea? While some uncertainty is inevitable, investors can make better decisions by reducing their uncertainty as much as possible. We may have no idea whether Kim Jong Il will launch a suicidal war, but by analyzing his motivations and strategy we can get a better idea of the risk.
Also, even if risks cannot be quantified, they can still be hedged — investors can diversify their portfolios to include assets that would be boosted by war or reunification.
