SEOUL/TOKYO South Korea's stock market has been the clear winner this year over rival Japan and looks set to keep outperforming in 2010, despite a rising won currency, due to a robust economic outlook and cheaper valuations.
South Korea was one of the first economies to emerge from the global financial crisis and its benchmark KOSPI .KS11 index has jumped nearly 40 percent this year, far surpassing a roughly 10 percent rise in Japan's Nikkei share average.
The two near-neighbors are long-standing rivals in North Asia and their manufacturers compete closely in key sectors such as electronics and autos.
"When comparing things with Japan I think you probably can't go too wrong buying South Korean shares while selling Japan," said Goro Fukami, senior portfolio manager at Japanese asset management firm DIAM Co Ltd.
South Korea's won has been strengthening for much of 2009, but still remains well below its pre-global financial crisis levels. That weakness, bolstering the trade competitiveness of South Korean manufacturers over their Japanese rivals, has been a major factor in Seoul's performance.
While some market players expect the won to rise around 20 percent against the yen over the next year, if not earlier, such gains are unlikely to change the broader picture.
South Korean's close ties with China's booming economy is one reason to be bullish, as is the fact that its stock market is on the cusp of shedding its emerging market status and gaining broad recognition as an advanced market, boosting the demand for South Korean shares from international fund managers.
Equity valuations also favor South Korean shares.
"My conclusion is that the Korean market will continue to outperform the Japanese market," said Claude Tiramani, fund manager for BNP Paribas Asset Management.
Global investors seem to broadly agree, judging from their differing appetite for South Korean and Japanese shares.
Foreigners bought nearly $22 billion in Korean shares this year, more than five times the $4 billion worth of Japanese stocks they purchased, according to Nomura International.
"For people conducting global allocation, being underweight Japanese stocks is probably a given, and the only question is by how much," said Tetsuro Miyachi, general manager of Franklin Templeton Investments Japan Ltd's investment planning department, adding that his comments reflected his personal opinions and not the views of his company.
The 12-month forward price/earnings ratio on the MSCI Japan stood at 21.6 as of November, twice as high as the 10.8 forward p/e ratio on the MSCI South Korea, according to Thomson Reuters I/B/E/S.
Earnings momentum is also brighter in Korea, with the one-month change in forward earnings estimates up 3.1 percent in Korea -- the second highest in Asia -- against just 0.5 percent in Japan, among the lowest in the region.
"Investors on the outside probably wonder what the rationale should be for buying into Japan since valuations are not cheap and growth is not high," Miyachi said.
According to analysts at ING, the Korean's won's inflation- adjusted and trade-weighted value fell by 33 percent from January 2006 to early 2009, compared with a relatively mild 13 percent drop in the Taiwan dollar and a 21 percent gain in the yen's nominal trade-weighted value.
"We think a more competitive Korean won cushioned the demand shock in Korea and explains much of the shock differential impact across the three North Asian economies," ING analysts wrote.
A rise in the won could hurt South Korean exporters and hold back their shares, but the impact is unlikely to be huge.
"The latest strength in the won could however weigh on exporters, and could dampen stocks' upward momentum a bit, but South Korean companies have already won strong market position in their respective industries," said Hwang Chang-joong, head of investment strategy, at Woori Investment & Securities.
"Their shares and earnings will continue to outperform."
South Korean firms such as Samsung Electronics (005930.KS) and LG Electronics (066570.KS) have wrested market share from the likes of Sony (6758.T) and Sharp (6753.T). Underlining the shift, Samsung posted a record quarterly net profit last month, while Sony posted a fourth consecutive quarterly operating loss.
Economic fundamentals are likely to remain in South Korea's favor next year, with South Korea's economy expected to grow 5 percent in 2010 against 0.8 percent growth for Japan, according to forecasts by Japanese brokerage Nomura Securities.
And economists expect deflation to persist in Japan until at least the second quarter of 2011, adding to the pessimistic outlook for asset prices.
Another tailwind for South Korean equities was FTSE's upgrade of Seoul to the advanced market category in September, which likely prompted global investors such as tracker funds and ETFs to add South Korean shares to their portfolios.
MSCI Barra is expected to follow suit in the near future, and investors are also watching to see whether Citigroup will add South Korea to its widely tracked World Government Bond Index.
Such factors could help push up the won, but that may even be a blessing for Korean stocks, said DIAM's Fukami, as historically a good time to buy emerging market equities has been when their currencies appreciated after having been left undervalued.
The performance of Chinese shares before and after China revalued the yuan, underscores this point.
China revalued the yuan in July 2005, removing the currency from a formal decade-old dollar peg. Since the end of that month, China's benchmark stock index .SSEC has roughly tripled.
A final reason to be bullish about South Korea's economy and equities is its close ties to booming China.
Fukami said his calculations showed South Korean exports to China in 2008 accounted for roughly 20 percent of South Korea's nominal gross domestic product, while Japan's exports to China accounted for 2.5 percent of its nominal GDP.
In absolute terms, that would value South Korea's shipments to China last year at $186 billion and Japan's at $123 billion.
"The way South Korea is leveraged now to China is extraordinary," he said.
(Editing by Alex Richardson)