Forget China, this market is Asia's sweet spot

Currency dealers monitor exchange rates in a dealing room at the Korea Exchange Bank in Seoul, South Korea.
Jung Yeon-Je | AFP | Getty Images

China stocks remain in the spotlight amid attractive valuations and the promise of growth, but some analysts believe another Asian market offers better opportunities: South Korea.

"China looks 'ok' in the H-share market, but South Korea now warrants a bit more attention," said Joshua Crabb, head of Asian Equities at Old Mutual Global Investors, noting that China stocks have risen too quickly.

The Shanghai Composite is up around 27 percent year to date following last year's over 50 percent surge. Meanwhile, Hong Kong's Hang Seng index has risen 17 percent this year.

"When you have moves like that, you have to temper your views," Crabb told CNBC on Wednesday.

"Markets in South Korea are starting to look more interesting because they have become the cheaper market now, which will benefit from improvements in U.S. and China. I like markets where expectations are low and valuations are supportive," he said.

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Upswing factors

That might explain the surge in interest among offshore investors, whose continued flow of funds pushed the benchmark Kospi above the 2,100-point barrier for the first time in nearly four years on Tuesday.

The Seoul bourse is around 11.7 percent higher since the start of this year and posted its biggest quarterly gain in three years during the January-March period.

Foreigners scooped up a net 2.96 trillion won (approximately $2.7 billion) of local stocks in March, according to data from South Korea's financial regulator, up sharply from 573 billion won in February. For April, offshore traders have been net buyers for 7 straight sessions as of Wednesday, Thomson Reuters data show.

"Part of the performance [thus far in 2015] can be attributed to the fact that at the end of last year, many mutual funds were very underweight Korea. As such, some portfolio re-balancing has taken place, which I argue is a key driver of the market," Herald Van Der Linde, head of equity strategy for the Asia-Pacific region at HSBC, told CNBC.

It was a vastly different sight at the start of the year; South Korean shares were out of favor after falling 4.8 percent in 2014. J.P. Morgan and Standard Chartered cut their overweight ratings to underweight and neutral, respectively, citing worries about a strong won, risks from rising interest rates in the U.S. and the lack of earnings growth.

However, markets are betting on improved corporate earnings for the first quarter amid a consolidation in the Japanese yen and as the Federal Reserve remains on a tightening cycle. Sectors that have benefited from the optimism include cosmetics makers and brokerage houses, whose top performers such as Amorepacific have soared 183 percent from a year ago to hit all-time highs this week.

UBS, for one, wrote in a note that "earnings growth will likely be meaningful for the first time in five years with more visibility in tech, petrochemicals, utilities, internet, steel, telecoms and consumer sectors." The investment bank also raised its 2015 earnings growth estimate to 12 percent from 5 percent, and upgraded its target for the index to 2,250 from 2,150. That represents a 6 percent upside from current levels.

The upward trend of the Kospi index also follows the Bank of Korea's decision last month to slash its key interest rate to a record low of 1.75 percent. As such, there are expectations for the local bourse to cross the 2,200-point mark by June, said Samsung Securities analyst Park Jeong-woo.

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Note of caution

Not all analysts are optimistic, however.

Stephen Sheung, head of Investment Strategy at SHK Private, says South Korean stocks are still less attractive than Chinese stocks.

"We think there's more upside in China, but South Korea is the second best in terms of presence and valuations. South Korea stocks have been trading at a discount to emerging markets overall, but the discount will narrow down because the Federal Reserve is tightening," he said.

Credit Suisse slashed its overweight position to 5 percent from 15 percent earlier this month, labelling South Korea an emerging market that "destroys value."

"With 12-month forward return on equity (9.8 percent) some 270 basis points inferior to the cyclically normalized 12-month forward cost of equity (12.5 percent), Korea [is near] the bottom of its 10-year historical range and some 290 basis points inferior to that of overall emerging markets," analysts wrote in a note.

The competitive threat from a weaker yen and tepid export demand are also concerns, they said.

Meanwhile, Standard Chartered remains neutral on Korea stocks amid a "mild improvement in the earnings momentum". But Singapore-based investment strategist Audrey Goh said upside may be limited as the index is hovering near the high end of its ten-year trading range.