Josh Kaplan & Steven Schoenfeld: BlueStar Israel Equity Market Outlook–Nov. 2012 in Review & Dec. 2012 Outlook
By Josh Kaplan and Steven Schoenfeld of BlueStar Global Investors LLC–December 10, 2012
This monthly column produced by BlueStar Global Investors discusses Israeli equities traded worldwide. The relevant benchmark for our review 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.
Ready for Takeoff
November was a good month for Israeli Global Equities. Several major developments this month support our previously-stated view that Israeli Global Equities are recovering in the fourth quarter of 2012, and that a bullish trend is likely emerging. November witnessed Israel’s first serious military conflict since Operation Cast Lead in 2008/2009, and the markets came out of it stronger: the events of November provide an opportunity to explore the local market reaction to geopolitical events and how these events relate to real economic activity and market technical behavior. Other important developments during November included a flurry of corporate earnings announcements and real and potential deals involving Israel’s emerging energy industry. Developments that did not heavily impact Israeli equities in November but are sure to come into play in the near future are simultaneous budget and trade deficits, market impact of recent mortgage restrictions, the looming US “fiscal cliff,” the continued recession in Europe, and potential geopolitical hurdles. These risks are known, but the months-long rally in Israeli equities—on the backs of a strong financial system and both developed and emerging industries—shows strength in the Israeli Global Equity investment theme that is difficult to ignore.
BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices Since Jan 1 2010
Israeli equities, as measured by the BlueStar Israel Global Index (BLS:IND), gained 2.47% in November after rising 2.83% in October. Israeli equities outpaced US and emerging market equities. Last month, we wrote in this column that we were “not surprised to see Israeli Global Equities playing catch-up based on strong economic fundamentals, a stable shekel, and geopolitical risks pushed forward.” (The assessment that geopolitical risks were being pushed forward was in regard to a potential conflict with Iran based on October’s address to the UN by Prime Minister Netanyahu.). Israeli Global Equities continue to play catch-up.
Israeli Global Equities outperformed the S&P 500 by 219 bps this month after outperforming last month by 481 bps. The divergence between Israeli and US equities (with US equities outperforming) over the past twelve months or so represents the largest performance differential between the two markets in recent years. We attribute this mostly to overblown fears of geopolitical risks in the Israeli market and slightly increased correlation to European equities. 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- a topic we will delve into later in the column.
The broad Israeli Global 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 vibrant and globally-oriented economic sectors.
November 2012 Sector Performance and Winners and Losers
The Financials continued to lead Israeli Global Equities, gaining 1.17% in November after rising by 2.14% in October, in line with our assessment in last month’s column that Financials would continue to gain but at a slower pace. In general, real estate and other holding and insurance companies were the leading Financials subsectors, but the rise in the Financials was again broad-based as 19 out of the 21 Financials stocks gained in November. This sector’s performance is continuing to reflect recent affirmations of Israel’s sovereign debt rating and stable outlook despite increased restrictions on fees charged to banks’ customers. Also, banks have been rolling out plans to streamline their operations. Israel’s banks in general have strong capital adequacy ratios and have taken prudent measures to help insulate the Israeli financial system from the most foreseeable shocks such as a flight of capital due to geopolitical events and a prolonged recession in Europe.
We continue to hold an overweight position in the Financials sector for the reasons stated above and previously in this column over the past several months. Additionally, we are encouraged to see net inflows to mutual funds and an overall rise in Israeli equities—which feeds directly into the rise in the stock price of many Israeli holding companies. Lastly, the mortgage restrictions imposed on Israeli banks last month had no effect on the housing market which is a positive sign for banks for the time being. The biggest risk here would be a sudden drop in housing prices, increased mortgage restrictions, or some sign that the mortgage restrictions already imposed are beginning to have a meaningful effect on banks’ mortgage lending practices.
Basic Materials stocks were flat in November after being among the best performers in September and October. However, we want to point out that Frutarom gained 9.58% this month. Frutarom is a global Israeli growth company that creates and markets high quality flavors and fine ingredients for customers in the food, beverage, fragrance, and pharmaceuticals industries. It has employed a successful synthetic growth strategy over the years to reach markets all over the world, from Western and Eastern Europe to Asia and South America. Frutarom reported record profits on double digit revenue growth for the third quarter 2012. This is an attestation to what we think has been one of the best truly global Israeli growth companies over the past years, though Frutarom stock has only recently begun to reflect the company’s success. Frutarom broke out above the NIS 39/share level early in Q4 2012.
The Oil and Gas sector was again among the leading Israeli Global Equity categories, gaining 0.65% in November. There were two theoretical developments in this sector in November regarding export markets and international cooperation. First, Israel, Cyprus, and Greece began discussions about an “energy corridor.” This “energy corridor” would enable Greece to be the primary export destination for Cypriot and Israeli natural gas; from Greece, the gas could flow to other European markets. Second, Turkish official Mithat Rende, who is director for multilateral economic affairs at Turkey’s ministry of foreign affairs, said that “construction of a pipeline to Turkey is the best way to export natural gas, both in terms of economics and in terms of energy.” Former Israeli Ministry of Foreign Affairs director Alon Liel said in response that “a man like Rende would never say what he did without the backing of his superiors.” Only a year ago, it appeared as though Turkey would be a thorn in Israel’s side rather than a potential partner. Later in November the Turkish foreign minister confirmed that there were talks between Israel and Turkey to restore bilateral ties.
The major headline for the industry came in early December when Australia’s Woodside Energy purchased 30% of the rights to Leviathan licenses. This deal gave the Leviathan reserve a valuation 70% higher than Deutche Bank’s valuation. There are reports that Woodside also met with representatives of the Pelagic permits to discuss opportunities there. The CEO of Ratio Oil exploration, a Leviathan partner, said about Woodside: “This is a company with an excellent reputation that will position Israel as an important player in the global LNG market…it is impossible to minimize the important impact of this process of Israel’s energy sector and the economy in general.”
Other Oil and Gas developments this month included:
– The antitrust authority declared Tamar gas reserve a monopoly with effect beginning in mid-2013; this means that any of Tamar Partners’ interest in other reserves is also under the scrutiny of antitrust laws
– There was a toxic leak at the Meged 5 oil well
– Shemen and Zerah received permission to drill the Yam 3 well
– Norwegian company Subsea 7 SA is in talks to participate in the construction of Israel’s energy infrastructure including construction of undersea natural gas pipelines
– Ratio Oil signed a farm-out agreement with Italy’s Edison International for the Gal permit; the Italian company would be the well operator and own 20% of the licenses
– The national planning and building commission approved two sites for gas terminals in the North
For the past two months, we have written that we would hold an overweight position in the Israeli Oil & Gas sector. One of the greatest risks with this sector is that future drilling will not yield best estimates, as was the case at the Myra and Sarah wells in recent months, significantly undercutting Israel’s ability to meet strategic domestic and export market demands. Another risk, which comes with investing in any country’s oil or gas companies, is the chance of spill or leak that would result in legal-related expenses and loss of marketable resources. But, despite the recent run-up in this sector’s market capitalization and the risks mentioned above, we continue to hold a long term overweight in this sector.
Profiles of Key Company Movers in October
Retalix (RTLX:NASDAQ, RTLX:TASE) rose 33.07% in November after an announcement that the company is being acquired by NCR of the US for $30/share. Retalix is a global leader in providing software solutions and services for high volume consumer goods retailers and distributors. Its customers include supermarkets, groceries, convenience, fuel, health and drug, and department stores.
EZchip (EZCH:NASDAQ, EZCH:TASE) rose 19.63% in November, helping to lead Israel’s technology sector out of a recent slump. Although announcing disappointing earnings, the company beat analyst estimates with EPS of $0.09 on $9.1 million in revenue. The Company did, however, announce that two new large customers will begin contributing to revenue in Q4 2012 and more strongly in 2013. EZchip provides Ethernet network processors for networking equipment.
Gilat Satellite (GILT:NASDAQ, GILT:TASE) rose 15.41% in November after First Israel Mezzanine Investors Fund scooped up another 4% of the company, now owning 18.5%. In September, First Israel Mezzanine bought 11% of Gilat Satellite Networks. Gilat Satellite Networks designs, develops, and markets satellite and hybrid networking products.
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), became more constructive in September and breached important trend lines in its move upward in October. In early November, Israeli stocks failed to break the 220 resistance level represented by the dotted green line on the two-year chart. Instead, as Operation Pillar of Defense progressed, Israeli equities retreated to the key technical area of 200-205. As we noted last month, the solid red line at the 200 index level is initial support for the index. We also noted that, if Israeli equities pulled back, we would look for them to test the solid black downtrend line which it broke through in October. Indeed the BlueStar Israel Index pulled back sharply, touched this very significant support zone of 200-205, and launched smartly upwards from there. This month we have added a new black uptrend line connecting the two-year low (the probe below 195 back in Q3 2012), the test of the 195 level which followed (represented by the thick solid red line), and the recent bottom of the sharp pull back during Operation Pillar of Defense. We now consider this a high-probability new uptrend line. The short-term outlook for Israeli Global Equities is solidly bullish now as the BIGI index broke through six month highs in late November, and is again trying to break the 220-225 resistance area. If this level is surpassed, and holds, we expect the near-term upside to be around 230-235, represented by the solid green resistance line on the two-year chart.
The longer-term outlook for Israeli equities is now cautiously bullish and will become more 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 220-225 levels mentioned above. BIGI breached the lower band of the channel but did not break through it in October, and subsequently dropped back to test the 200 level, as noted above.
If BIGI enters into and remains within the aforementioned channel, a rally to strong resistance is projected to be at 239/240, as highlighted by the solid green line on the five-year chart. If this resistance is broken, we see the projected upside potential of the index to be at the 300 level by early-mid 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 and October Outlooks remains valid, but those with a shorter-term perspective should keep their stop-loss at 200/205 in BIGI for the the start of winter and the new year. Investors can also view a pull-back below the newly established upward trend line, currently at the 207-208 level, as a warning signal. 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 would 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, as these higher stop-loss levels have so-far held, a rally of BIGI decisively above the 220 level, this would confirm that this major multi-year support level will have held, and will potentially form a base for a sustained rally. If the latter scenario develops, we would expect medium and long-term targets as high as the 275 and 300 levels, respectively.
The predominant geopolitical event in November was Operation Pillar of Defense. The persistent exchange of attacks between Hamas in Gaza and the Israeli Air Force throughout the year finally came to a tipping point in mid-November. As rocket fire from Gaza intensified, Israeli leaders warned that Israel would retaliate strongly, including targeted attacks on leaders of Hamas, if residents of Southern Israel continued to suffer rocket attacks. The escalation in rocket attacks from Gaza and retaliation warnings from Israel began to weigh on the TASE around November 12. On November 14th / 15th (depending on your time zone), Israel assassinated the leader of Hamas’ military wing and began Operation Pillar of Defense. The market wasted no time in discounting the risks of the unknown of the situation: how long the operation would take, whether ground troops would be used, what damage to enterprises in Southern Israel would be done, whether rockets would fall in Tel Aviv or Jerusalem, and how nations friendly to Hamas would respond. In short order, there was an Israeli stock sell off by nearly 8%, long and short term government debt fell, and the Shekel took a beating.
Once panic-driven selling subsided and it became quite clear that the major financial and economic hubs in Israel would not be affected, Israeli Global Equities changed direction. Even as the military operation entered its final days, Israeli equities rallied and, once a cease fire agreement emerged, Israeli Global Equities took out six-month highs.
The chart below shows that, almost across the board, Israeli equities don’t react, except for in the first couple of days, to geopolitical events such as Operation Pillar of Defense. It is interesting to note that, throughout the summer, as the war of words between Israel and Iran intensified, Israeli equities suffered from more persistent pressure over a longer period of time. This sort of geopolitical pressure is different from the fear-based selling witnessed in November, which was short and to the point.
Time and again military operations with neighboring countries provide great buying opportunities for investors. The opportunities presented by these temporary market dislocations are greatest in Israel’s financial and banking sector which would likely be most affected by a destabilized currency and a flight of capital that could emerge from a prolonged military conflict. Israeli banks have contingency plans though, and are built to deal (although not perfectly) with such scenarios. Other sectors, such as technology, which are heavily diversified geographically with regard to sources of revenue and currencies and locations of operating facilities, also experience the greatest stock price dislocations during such geopolitical events.
This is not to say that military conflicts such as Operation Pillar of Defense should be ignored or do not pose risks. We would not recommend buying Israeli equities at the beginning of a military conflict before the unknowns become known. However, investors would benefit from exploring how to use sharp market pullbacks seeded in geopolitical fears as buying opportunities.
As for the real economic impact on Israel’s economy from the operation in Gaza, the Manufacturer’s Association of Israel released data: Damage to enterprises in the south was NIS 120 million across all 430 enterprises within 40 km of the border with the Gaza strip; 80% of employees showed up to work (those called up for reserve duty clearly did not); most employees did not show up for night shifts; only one publicly traded company, Kafrit Industries, sustained damage to production facilities. Israeli banks made a NIS 10 billion provision for war as a result of a stress test including flight of capital and Israelis seeking to convert shekels to foreign currencies.
Israel’s other geopolitical concerns include the potential spillover of the Syrian conflict into the rest of the region, the fragile position of the King of Jordan, and Iran’s enrichment of nuclear materials. These concerns are theoretically different than the conflict in Gaza because, due in part to the Arab Spring, they are new and different issues that Israel has not faced before. The outcomes are less predictable than a war with Hamas. However, until there is actual conflict or conflict becomes clearly imminent, selling Israeli equities based on these issues would be counterproductive, only allowing investors looking to gain long exposure great entry points.
In October, Stanley Fisher, Governor of the Bank of Israel, said the following about the geopolitical effect on business and the economy in Israel: “There is a certain effect felt in the stock market in a particular way, but my feeling is that if there is an impact, then it is small.” During the recent military operation, the Ministry of Finance said: “the Minister of Finance and the Governor [of the Bank of Israel] agree that, for the time being, the markets appear to be performing properly. Foreign and local investors recognize the ability of the Israeli economy to emerge from a security crisis of various scopes without any significant harm…”
In October, debt and equity mutual funds raised NIS 2.4 billion while redemptions of money market funds were NIS 520 million, according to initial estimates from Meitav Investment House. Withdrawals from equity mutual funds totaled NIS 20 million in October, which is 80% less than in September.
Nonresidents invested a net $60 million in TASE-listed shares in September and $110 million in government bonds. Direct foreign investment through Israeli banks in September totaled $200 million mostly in the manufacturing and high-tech sectors.
Economic and Fiscal Outlook
In Q3 2012, Israel’s GDP slowed to an annualized 2.9% after growing by an annualized 3.4% in Q2 2012 and 3.1% in Q1 2012; exports of goods and services and investment in fixed assets both fell. Private consumption rose an annualized 1.5% in Q3 2012, but consumption per capital fell by an annualized 0.5%. The Bank of Israel confirmed that economic indicators are consistent with its research department’s forecast of 3.3% GDP growth in 2012 and 3% growth in 2013.
There is a growing concern over the standard of living of working Israelis; the drop in private consumption per capital includes a 20% drop in expenditure of durable goods, which is a leading indicator of living standards. Israel’s unemployment rate rose to 7.3% in October 2012 from 6.9% in September; however, the average salary rose to NIS 8,994.
Israel’s trade deficit increased to NIS 9.8 billion in October 2012, the highest level in several years. The trade deficit was complemented by a rising government budget deficit, which presents a concern for Israel’s economy going forward. The budget deficit in October 2012 was NIS 2.9 billion. Analysts believe the budget deficit in 2013 will reach 3.5% of GDP and some predict a deficit of 4-4.5%. The OECD, in its economic outlook for November 2012, said the following about Israel’s budfet deficit: “Whatever the outcome of January’s parliamentary election, fiscal challenges will remain prominent. Further easing of deficit targets should be avoided, and the government should assure outlays are in line with its expenditure rule and be prepared for further revenue raising in 2014.”
The Shekel troughed at $3.96/NIS in mid November then recovered to $3.82/NIS by the end of November. The Bank of Israel kept the December policy interest rate at 2% after lowering the rate by 25 bps last month. Its rationale was that Israel’s inflation is well balanced and within the target inflation rate of 1-3%. The bank also said that worldwide inflation continues to be low and provides support for Israel’s current level of inflation.
We’ll end this column with a quote from Merrill Lynch’s Wealth Management EMEA Chief Investment Officer, Bill O’Neill, on investing in Israel in 2013: “Growth should begin taking over from policy as the key focus for investors next year…this leads us to favor equities over bonds in 2013. The notable valuation gap between the two asset classes, now at its most favorable level for stocks in over 25 years, adds to our conviction here.” 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.
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.