By Josh Kaplan and Steven Schoenfeld of BlueStar Global Investors LLC–October 12, 2012
This monthly column produced by BlueStar Global Investors LLC discusses Israeli equities traded worldwide. The relevant benchmark for our perspective is the BlueStar Israel Global Index(“BIGI” BLS:IND on Bloomberg), which we believe represents the opportunity set of Israeli equity investments better than other benchmarks (such as the TA-25/TA-100 and MSCI Israel).
It is becoming widely known that Israel has one of the most resilient economies in the world and that its technology sector plays an integral part in the global technological revolution. Fewer are aware of the global footprint of Israel’s companies in other sectors, and fewer still are aware of how to make their knowledge of the Israeli economy actionable. This column helps investors gain insight into the macro forces (including the geopolitical environment under which Israel’s economy operates) and the individual company investment opportunities that have contributed to global Israeli equities’ outperformance of U.S. equities by nearly 1,500% over the past two decades.
One key reason why the BlueStar Israel Global Index (BIGI) is more relevant to North American investors than the TA-100 or MSCI Israel indexes is that BIGI includes Israeli companies that are listed on exchanges outside of Israel, including NYSE and Nasdaq, thus providing investors with a benchmark that is balanced across key sectors. (for example, BIGI has a 31% tech weighting, while MSCI has a 13.5% tech weighting). In addition, BIGI caps the largest constituent by weight at 12.5% to attenuate the impact of any single stock on the index.
In this column, we discuss BIGI’s performance over the previous month, including the largest percentage gainers and losers, sector performance, technical analysis, and key industry-specific and policy developments. We also touch upon relevant domestic and international economic and geopolitical events. Readers are encouraged to use the trends and ideas presented in this column and take the time to research specific investment opportunities further.
Strengthening the Market’s Foothold
In September, Global Israeli equities rebounded strongly off long-term support. Global Israeli equities were led higher by domestic-oriented companies as the European debt crisis and slowing global economic growth weighed on Israel’s technology exporters. Also in September, Israeli GDP estimates were revised upwards, the housing market continued to show strength, and Israel’s economic policy management was rewarded when both Moody’s and Standard & Poor’s reaffirmed Israel’s credit ratings with a stable outlook. Investors also continue to look forward to the development of Israel’s energy industry and the economic stability this will bring. On the geopolitical front, September was generally quiet along Israel’s borders, and Prime Minister Netanyahu delivered a widely-followed speech to the UN’s General Assembly on the Iranian threat Israeli markets were closed for several days towards the end of the month on account of the lengthy Jewish holiday season. The pent-up demand for Israeli equities was unleashed in the last days of September and in the early goings of October leading to further gains.
BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices Since Jan 1 201
Israeli equities, as measured by the BlueStar Israel Global Index (BLS:IND), gained 5.52% in September. Though Israeli equities outpaced U.S. equities by over 200 bps, we cannot say that U.S. and Israeli market have “re-coupled”, as there is minimal evidence of correlation between the two markets in the past several months. However, the divergence between Israeli and U.S. equities over the past sixth months or so represents the largest performance differential between the two markets in recent years, and we attribute this mostly to overblown fears of geopolitical risks in the local market. As we have seen repeatedly, investors in Israeli markets typically overreact to geopolitical risks and long-term investors are rewarded with strong outperformance once fear-based selling subsides. [See the chart at the end of the column on this subject].
Geopolitical and political risks still exist, however, and they will likely continue to pressure Israeli equities well into the first quarter of next year after both U.S. presidential and Israeli Prime Ministerial elections are over. [For more on political and geopolitical risks, see the “Economic and Fiscal Outlook” section towards the end of the column]. The slide in Israeli equities in 2011 and the first three quarters of 2012 was not due to geopolitical risks alone. Other factors pressuring Israeli equities, as we have mentioned for several months, have been the “growing pains” of the Israeli economy and capital markets, including regulatory reforms and changes in asset allocation and international investment flows, and social pressures to reduce the cost of living in Israel. In September, the dynamic nature of Israel’s economy overcame the risks mentioned above as domestic-oriented stocks and non-technology exporters led Israel’s market rally.
The broad Israeli equity universe – which includes companies listed in Tel Aviv, the U.S., and elsewhere – provides investors with exposure to Israel’s economy as well as exposure to several diverse and globally-oriented economic sectors.
September 2012 Sector Performance and Winners and Losers
In the months preceding August, the Financials and Telecommunications sectors dragged Israel equity benchmarks down sharply; last month, these two sectors led Israeli equities higher, a result of indicators that the major regulatory and economic hurdles facing these sectors were built into market prices. We noted that, if these two sectors were indeed bottoming, Global Israeli equities would be likely to rebound as a whole. In September, Global Israeli equities were once again led by the Financials, and though the Telecommunications sector did not lead equities higher, that group still gained.
In September, the Financials gained 2.75%, led by Bank Hapoalim (12.82%), Bank Leumi (10.80%), Mizrahi Tefahot Bank (14.03%), and Israel Discount Bank (13.5%). Many of the large holding companies included in the financial sector also gained, despite pending corporate debt restructurings and regulatory reforms. Bank Hapoalim reported a quarterly drop in net profit of 50.4% on a year-over-year basis while Bank Leumi reported a drop in net profit of 36.4% for the first half of 2012 on a year-over-year basis; however both banks’ capital adequacy ratios rose. Financials as a whole gained on easing concerns over the stability of Israel’s financial system attributable to: positive developments regarding Israel’s sovereign debt rating stability, stable interest rate outlook, rising mortgage and real estate markets, and reduced exposure to PIIGS (Portugal, Italy, Ireland, Greece, and Spain) debt. Regarding PIIGS sovereign debt, Israeli banks have the largest exposure to Spain at NIS 714 million, followed by Italy and Ireland. They have less significant exposure to Greece and Portugal.
In August, the Bank of Israel, on recommendations of the Committee on Concentration in the Economy, ordered banks to eliminate certain fees considered to be predatory or unfair to consumers. This will hurt banks’ profitability. An additional risk to Israeli banks, especially those with high exposure to the mortgage market (like Mizrahi Tefahot Bank), is that the Bank of Israel is keeping a close eye on developments in real estate prices; though bank officials say no action is currently necessary, they may need to intervene in the mortgage market at some point. Given global economic growth concerns, it is unlikely that the Bank of Israel would raise interest rates to cool the housing market, so direct intervention is more probable if any action will be taken at all.
Basic Materials stocks were up 0.89% in September, led by Koor Industries (15.48%) and Israel Chemicals (11.48%). Israel Chemicals reported a 2% rise in revenue in Q2 2012 on a year-over-year basis, though net profit fell 4.5% over the same period. Israel Chemicals is being supported by growing fertilizer demand in Brazil and China in the face of lower demand from North Amercia and Europe. Israel Chemicals was also ranked 60th by “Forbes” in the rankings of the World’s Most Innovative Companies. Israeli Basic Materials companies, like many Israeli exporters, exemplify the resiliency of the Israeli economy through diversification of export markets.
Global Israeli healthcare companies were lead higher in September by Clal Biotech (21.93%), Perrigo Co. (5.64%), and Teva (2.26%). Perrigo announced it will be expanding into the veterinary medicine market through its acquisition of Sergeant’s Pet Care. Teva, on the other hand, is selling its U.S. animal health business to Bayer Healthcare; the company is committing itself to focus efforts on human health and its core expertise in generic and branded medicines.
Shares of companies in the Oil & Gas industry were up once again in September on the heels of the August recommendations of the Tzemach Committee, which decided that gas partnerships will be allowed to export between 50% and 75% of gas reserves depending on the size of the reserve. As we noted last month, a factor holding back Israeli Oil & Gas exploration shares throughout the months before August included the recognition that a global oil major would be needed to help finance and support the development of Israel’s Oil & Gas program and that, without the allowance of exports, there would be no economic incentive for an oil major to participate.
Oil & Gas companies were up 0.62% in September, led by Paz Oil (20.65%), Avner (14.46%), Delek Energy Systems (21.57%), and Delek Drilling (16.96%). There is a constant news flow in this developing industry and the key developments in September were:
- No gas was found at the previously-promising Myra 1 well
- Leviathan Partners (Noble Energy, Avner, Delek Drilling, and Ratio) received offers for acquisition of up to 30% of rights to natural gas licenses in Leviathan fields: Total SA and Gazprom are the supposed front runners and Australia’s Woodside Energy is supposedly interested as well.
- “’By 2018-2019, gas from Eastern Mediterranean may find its way to Greece and through Greece to the rest of Europe, providing diversification and security of supply as well diversification of routes,’ Interconnector Turkey-Greece-Italy pipeline (ITGI) director of international activities Dimitris Manolis told ‘Reuters.’” (as reported in a “Globes” Sept. 12 article )
- Israel agreed to open talks with the Palestinian Authority to develop the marine natural gas fields offshore from Gaza.
- Drilling at the Sarah license commenced and the target depth is supposed to be reached by early November. This well has an estimated 1.5 trillion cubic feet of natural gas with a 54% rate of success.
Profiles of Key Company Movers in September
Discount Investment Corp is one of the largest holding companies in Israel with both domestic and export-oriented holdings in various industries. The top domestic holdings are: Cellcom, the largest cellular operator in Israel; Shufersal, the largest grocery store chain in Israel; and Property and Building Corporation, one of the largest real-estate groups in Israel. International holdings include: Makhteshim Agan (via its holding of Koor Industries), which is a global leader in manufacturing generic agrochemical products; Eloron, a high-tech investment company; Given Imaging, a medical device company which created the PillCam, a tiny pill-sized ingestable camera; and Maariv Holdings, a player in the media and publishing industry. Each of Discount Investment Corp’s holdings or respective industries made headlines in the past two months which helped to stop each of their respective stock price slides.
In September, Partner Communications was once again the second largest gaining global Israeli equity. Partner is a mobile telephone network operator in Israel whose services are marketed under the brand name “Orange.” In Partner’s Q2 2012 earnings release, the company did not state it would be cancelling its dividend policy; however, in September, it conceded to the industry-wide margin squeeze and cancelled its 2012 dividend policy. The new competitive landscape in Israel’s telecommunications industry led S&P to place Partner’s bonds on watch with an AA- rating and a “negative” outlook; the company cited liquidity concerns in meeting the company’s debt obligations as reasons for halting its dividend. A September Barclay’s report stated that the new entrants to the Telecommunications sector entered the market on an “unsustainable disruptive pricing” business model, and that though pricing pressure and net margins may continue to be squeezed in the short run, the new entrants and investors may have underestimated the major players’ (Partner, Bezeq, and Cellcom) ability to slash prices and compete in this new environment.
Two of the BlueStar Israel Global Index’s top-ten holdings, Verifone Systems and Mellanox Technologies, were among the top three declining global Israeli equities in September. Verifone Systems is a global leader in secure electronic payment software and systems. The company announced a significant drop in Q3 2012 earnings on account of a fire in a Latin American factory, though it reaffirmed full year earnings guidance. Analysts and traders are not optimistic about Verfione’s ability to fulfill the growth potential that the once-lofty stock price suggested in light of new smaller competitors, and payments systems running through mobile devices such as iPads and Tablets. The company’s CEO is still confident, however, that Verifone will continue to provide the leading players in all the industries the company serves with all-in-one state-of-the art payments solutions. The stock recently pushed through long-term support at around $30 per share after dropping from nearly $60/share earlier this year. Though we love the story and the prospects of Verifone Systems, we believe the stock will continue to come under pressure until there is some clarity as to how much market share new entrants will actually be able to achieve.
Mellanox Technologies has been one of the largest gaining stocks in both the Israeli and U.S. markets in 2012. In September, the stock pulled back from all-time highs on conflicting reports on the sustainability of Mellanox’s extraordinary growth rates. Mellanox is a leader in end-to-end Infiniband and Ethernet connectivity solutions for data centers and cloud computing. Both Clal Finance and Deutsche Bank have a price target of $140/share for Mellanox, and Deutsche Bank sees Mellanox operating in a virtually competitor-free environment for the next 2 to 3 years. The company has beat rising earnings expectations for the past several quarters. Though slower global economic growth is concerning, we believe that the cloud computing and data storage businesses will continue to grow and businesses will continue to upgrade technology. We remain cautiously (note the stock sports an 81 P:E ratio) bullish on shares of Mellanox, as the stock bounces along new support at the $100/share level but pulled back sharply in early September from the $120/share level.
Market Trends – Technical Analysis and Market Fundamentals
Technical Analysis of the Israeli Market
The technical picture for Israeli stocks, as measured by the broad-based BlueStar Israel Global Index (BIGI), has become more constructive, though a bullish trend is not yet confirmed. BIGI repeatedly tested key support during Q2 2012 around the index level of 195/200 (see solid red support line on two-year chart), and tested this level repeatedly throughout the third quarter which just ended. As indicated by the solid black downtrend line on both the two-year and five-year charts, the short/medium-term outlook for Israeli stocks remains challenging, with a breakout above the 225 index level needed to confidently reassert a bullish trend. What makes us more constructive for the fourth quarter and early 2013 is that the vital support levels of 194/197 did (just barely) hold during the summer and, after BIGI successfully reclaimed the 200 index level, it managed to hold above 200 during September and the start of October. We now consider the 200/205 level as new support for BIGI, with a break above the aforementioned one-year downtrend line (on the two-year performance chart below) as a distinct possibility.
The longer-term outlook for Israeli equities could become bullish only if the index breaks back into – and ideally through — the channel connecting the 2008/2009 lows, as illustrated in the BIGI five-year chart, which spans the entire 2008-2009 global financial crisis. This corresponds with the 225/230 level mentioned above. As we mentioned in last month’s column, the first sign that this might be possible would be a pulse above 212/215 between now and the end of the Jewish Holiday season in early October, which indeed occurred.
To review the long-term analysis of the patterns on the five-year chart, BIGI, like other Israeli indexes, bottomed in late October 2008 and again in early March 2009, followed by a powerful rally into spring 2010. After a short correction, BIGI surged to lifetime highs in late 2010 through spring 2011, only to correct deeply again amidst Europe’s financial crisis, Israel’s domestic social protest and nuclear threats from Iran. It found solid support during late 2011 at the key technical level of 195. This corresponds with an uptrend beginning with the early 2009 bottom (solid red uptrend line), and the horizontal support zone dating back to autumn 2007 (solid red line), also at approximately the 195 BIGI level. As noted above, this level was repeatedly probed in June and July 2012, and again later in the summer, and by the end of last month and Q3, support at this level was confirmed.
If the 200/205 level is maintained during October and Q4, a rally toward the downtrend line (solid black line) which began in mid-late 2011 at the 225/230 index level, can occur. If this is broken, a rally to strong resistance is projected to be at 239/240, as highlighted by the solid green line. If this resistance is broken, we see the projected upside potential of the index to be at the 300 level by early-2013, though most likely following a consolidation at the 2011 high of 275.
From a risk management perspective, the revised stop-loss at the 195/197 level articulated in our September Outlook remains valid, but those with a shorter-term perspective should move their stop-loss up to 200/205 in BIGI for the remainder of autumn. If these levels are breached and confirmed with a weekly close of BIGI below 195, the longer-term outlook will shift dramatically, and any rallies should be sold. A breach of 195/192 will increase the likelihood that the spring 2011 peaks represent the ‘head’ of a massive ‘head and shoulders’ pattern which would project a major decline to around 135, just above the autumn 2008/March 2009 lows. However, if these newly-adjusted higher stop-loss levels hold, and a rally can lift BIGI decisively above the 225 level, there is some hope that this major multi-year support level will have held, and can potentially form a base for a sustained rally. If the latter scenario develops, we would expect medium/long-term targets as high as the 270/275 level for BIGI by spring 2013.
This is the third month in which we reiterate the following as we look for the bounce in September to represent an inflection point for Global Israeli Equities: “In May 2012, the Israeli public’s financial portfolio consisted of NIS 374 billion of stocks, about 14.6% of portfolios. This is down from a year ago, though Migdal Capital Markets says that historically there has been an inverse relationship to the public’s exposure to the stock market and equity price performance. The Ministry of Finance is set to study the effects of the January 2012 5% increase in the capital gains tax on declining trading volumes, which have plunged over the past 12 months. In 2011, volumes on the TASE fell by 15% and volumes are down by a similar rate in the first half of 2012. One strategy for reviving trading volumes would be to include Israel in the MSCI Europe index. This would force index and portfolio managers to trade Israeli shares to gain the proper exposure to Israeli stocks.”
Non-Israelis invested a net $260 million in TASE-listed shares and $40 million in non-TASE listed Israeli companies in May and June 2012 according to a September 5th article, Globes revealed that. If this flow of international funds into global Israeli equities continues, it could mean that significant reversal of the low volumes which have plagued global Israeli shares over the past couple of years is underway.
Additionally in September, the Knesset Finance committee passed the trapped profits bill to allow companies to use profits accumulated in Israel for foreign investment so long as they pay a (reduced) tax on these profits and 50% of these profits are used to invest in one of the following: productive assets at plants, Research and Development, or hiring new employees. The ministry hopes this bill will increase tax revenues for the state and open up NIS120 billion for investment in Israel and abroad by Israeli companies. This is a bullish development for the investment component of GDP growth as well as for the Government budget deficit.
The main risk factors for global Israeli equities have been the European sovereign debt crisis and weak economic growth globally. The latter appears to be easing somewhat, and European debt and equity markets rallied substantially in August and early September. Other risk factors for global Israeli equities include regulation and policy issues; upcoming corporate debt restructurings; and rising inflation expectations.
As we mentioned in the opening paragraphs of the column, the geopolitical situation is not lacking in intriguing developments. The geopolitical risks and rocket attacks on the country of the past few months have helped hold Israeli equities down and contributed most to the divergence between Israeli and other developed-market equities. In late September and early October, we started to see the effects of Western sanctions on Iran, which had the goal of deterring the country from developing a nuclear weapon. The Iranian currency continues to plunge and inflation remains in double-digits; protesters began taking to the streets in Tehran. Additionally, we learned from Prime Minister Netanyahu in his address to the UN General Assembly what his “red line” is and that any Israeli strike against Iran will not occur until early-mid 2013. We believe these developments have led to the release of much of the geopolitical pressure on Global Israeli Equities.
Economic and Fiscal Outlook
In September, the Central Bureau of Statistics raised its expectations for Israeli GDP for 2012 to 3.5%, which is higher than the recently raised BOI estimate of 3.1% and Ministry of Finance estimate of 3.2%. The bureau expects that business product growth will fall to 3.4% from 5.1% in 2011; private consumption growth will slow to 2.8% from 3.8% in 2011; investment spending growth will slow to 2% from over 17% in 2011; export growth will rise to 6.3%; and industrial exports growth will rise to 7% despite a 35% drop in diamond exports and 0.5% drop in tourism services.
The Bank of Israel’s monetary committee kept the interest rate for October at 2.25%, citing an unexpected 1% rise in the CPI for August, revised growth forecasts, stable home prices, and qualitative easing programs by leading central banks as reasons for keeping rates unchanged. The BOI warned in its statement that the level of economic risk around the world remains high. September was yet another month in which a record amount of mortgages were granted by Israeli banks, raising concerns over a real estate bubble. Real estate prices, though, have been stagnant. The Bank of Israel says it believes supply is sufficient to cover growing demand in the housing market but is keeping a watchful eye on the situation.
On September 3rd, Moody’s investor services reiterated Israel’s A1 government bond rating and gave this rating a stable outlook “underpinned by the country’s high economic, institutional and government financial strength, but the rating is constrained by significant social and political challenges, which lead to moderate susceptibility to event risk.” This reiteration of Israel’s government bond rating is significant as fiscal policy and the growing government budget deficit have been taking center stage recently and weighed on Israeli equities most significantly in July.
Then, on September 30th, S&P reaffirmed its Israel credit rating described in this quote taken from a “Globes” article: the “Israeli economy continues to generate solid economic growth and enjoy a net external asset position, even though the current account has temporarily turned negative. The stable outlook reflects our view that there is sufficient political will to prevent a sizeable increase in the government’s debt burden, and the major security risks will be contained.” S&P also forecasts that by the middle of the decade, Israel’s domestic natural gas production will be a positive contributor to external and fiscal balances.
Given sector-driven, geopolitical, and macro economic developments that are on-balance positive, combined with our technical analysis view of the Global Israeli equity market, we remain bullish on global Israeli equities for the second month in a row. We see a positive risk-reward relationship despite the ever-present geopolitical currents in the Middle East. From a sector perspective, we would remain overweight the financials and oil and gas sectors (though the oil and gas sector is still in somewhat of a speculative phase), and we are paying close attention to economic developments in Europe and the U.S. to judge when to become more bullish on Israeli technology companies.
Amidst significant geopolitical and global economic challenges, Israel’s economy continues to outperform its OECD peers, as well as many Emerging Markets. Its equity market has, unsurprisingly, been buffeted by Europe’s economic crisis and the global downtrend in stock markets. However, the long-term attraction of Israeli stocks remains intact, and the global nature of Israel’s equity market makes it naturally diversified vis-à-vis regional tensions in the Mideast. We continue to believe that a broad selection of Israeli stocks provides exposure to both global and domestic economic growth. Such broad-based Israeli equity exposure potentially offers ‘the best of both worlds’ — Developed Market stability, and the demographics and growth potential of an Emerging Market. In addition, Israel’s robust high-tech sector continues to drive scientific, info-tech, agricultural and defense-tech advancement around the world.
Editor’s Note: Steven Schoenfeld, co-author of this article and the Founder and Chief Investment Officer of BlueStar Global Investors LLC, is also the Founder and Publisher of IsraelStrategist.com. He is the Editor of Active Index Investing (Wiley Finance 2004/Toyo-Keizai 2006/China Press 2009). Josh Kaplan is a Research Associate at BlueStar Global Investors LLC.