Josh Kaplan & Steven Schoenfeld: BlueStar Israel Equity Market Outlook–Apr. 2013 in Review & May 2013 Outlook
By Josh Kaplan and Steven Schoenfeld of BlueStar Global Investors LLC-–May 8, 2013
This monthly column produced by BlueStar Global Investors discusses Israeli equities traded worldwide. The benchmark for our review is the BlueStar Israel Global Index (“BIGI), which we believe represents the complete opportunity set of Israeli equity investments.
Israel has one of the most resilient economies in the world and its technology sector plays an integral part in the global technological revolution. Yet few are aware of the global footprint of Israel’s companies in other sectors, and fewer still know how to make their knowledge of the Israeli economy actionable. This column aims to help 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 2000% 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 exclusively on exchanges outside of Israel – including NYSE, Nasdaq, and the LSE – thus providing investors with a benchmark that is balanced across key sectors. (For example, BIGI has a 31% tech weighting, while MSCI Israel has only a 13.5% tech weighting). In addition, BIGI limits the largest constituent member to a weight of 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 assess the trends and ideas presented in this column and take the time to research specific investment opportunities further.
Feeling Good but Not Much to Show Yet–May 6, 2013
Despite the fact that April saw the BlueStar Israel Global Index’s (“BIGI”) first monthly decline of 2013, it was generally a “feel-good month” for Israeli equities and Israel’s economy. In April, BIGI lost 0.63% while major global equity indexes rose. We continue to be quite bullish on Israeli Global Equities in the long term and believe there is upside potential in the short to medium term as well.
The greatest contributor to this “feel-good” month was the performance of the New Israeli Shekel (“NIS”), especially as compared to many of the world’s leading currencies. Israel’s currency was the strongest developed market currency in the first quarter of 2013. As we have discussed for over a year now, the key factors contributing to the stability and strength of the NIS are Israel’s prudent fiscal and monetary policy, and the expectation that Israel’s domestic energy will have a future positive impact on its Balance of Payments. Much of the analysis in our autumn 2011 essay on the effect of Israel’s natural gas industry on the rest of the economy and region– “The Economics and Politics of Israel’s Offshore Energy Discoveries”— remains valid, and we encourage readers to revisit that article by clicking on the link above.
Shekel strength is a vote of confidence in Israel’s financial stability–thus a certain degree of risk has been or will be removed from Israel’s capital markets and equity valuations via lower discount rates. Indeed, we see global investors realizing the benefit of holding assets (traditional financial instruments or alternatives) denominated in Shekels. Though we cannot expect the NIS to strengthen forever, its performance versus the dollar–especially as the dollar strengthened versus other global currencies—should be comforting for those who are averse to Israel’s unique risk factors.
Other positive developments in April and early May include the following: more clarity on how Israel’s political leaders will handle its budget deficit problem, with the new Finance Minister finalizing a fiscally-responsible budget; positive economic indicators, including cues from the labor market; and a brightening picture for other Developed, and Emerging Market equities. Lastly, we see positive signaling from some of the lesser-known Israeli Global Equities in continuing to build the case for a turnaround for technology stocks in the second half of 2013.
One of the most troubling recent developments for Israeli Global Equities has been the worsening civil war in Syria which is drawing in Hezbollah fighters and Iranian arms shipments. In response, Israel’s military has stepped up its pace of defensive activity in the north of the country, as well as across the Lebanese and Syrian borders. As this report has stated often, we hesitate to allow such developments to weigh on our investment decisions until actual military conflict on the ground in Israel is imminent. For those seeking exposure to Israeli equities, we believe that the omnipresent geopolitical risks in Israel make choosing a portfolio of Israeli Global Equities prudent. The biggest risk factors, though, remain the same as last month: further deterioration in the European economies and Israel’s government budget deficit. The assessment of risks to Israel’s economy will change if the Syrian conflict spills over onto the ground in Israel. But, so long as the IDF can keep the conflict on Syrian (or Lebanese) territory, the geopolitical risks for investing in Israel are secondary.
BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices since January 2010
Israeli Global Equities–as measured by BIGI–underperformed other developed and emerging market equities but outperformed other Israeli equity benchmarks in April 2013. As we stated last month: “The past nine months or so have witnessed the greatest performance differential between Israeli Global Equities and other equity benchmarks, especially the S&P 500, in several years. This played out against a backdrop of better-than-OECD-average GDP growth and one of the most stable banking sectors in the world. Thus, we attribute last year’s underperformance to overblown fears of geopolitical tumult. As we have seen repeatedly over the past 35 years, when fear-based selling of Israeli Global Equities subsides, long-term investors are rewarded with strong outperformance.”
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 in which Israeli companies are leaders.
April 2013 Sector Performance and Equity Winners and Losers
The best performing stock in BIGI during April was Prolor Biotech (PBTH:NASDAQ). In early April, Prolor announced that it was in talks to commercialize its therapeutic protein products but was not in talks to sell the company. A week later, it was announced that Opko Health would acquire Prolor Biotech for $480 million, a 30% premium over the company’s market value at the time of the announcement. Babylon Ltd. (BBYL:TASE), which provides online translation services, rose by 19.26% in April on a favorable deal with Yahoo, relatively cheap stock valuation, and the possibility that the company will list is shares on a New York Exchange in the near future.
Developments in Israel’s Telecommunications sector, which continued its recovery in April with a gain of 0.18%, supported the stock prices of Israel’s three largest telecommunications service providers: Bezeq (BEZQ:TASE), Cellcom (CEL:TASE,NYSE), and Partner (PTNR:TASE,NASDAQ). Some see the cell phone market in Israel as stabilizing after over a year of declining stock prices for Bezeq, Cellcom, and Partner. Israel’s cell phone market was dominated by the big three service providers before the Ministry of Communications opened the Israeli market to competition. Now, new entrants are ratcheting down their competitive pricing schemes and the big three companies have downsized their operations to allow for earnings growth and product innovation going forward.
CaesarStone (CSTE: NASDAQ) was a loser in April as Tene, a leading private equity firm, sold most of its shares in the company on the open market. Though we don’t know the specifics of why Tene chose to sell its stake in the company, we believe that the lowered share price could be a temporary price dislocation. It is also possible that the firm is exiting because it believes the company’s stock is overvalued or that the life of the fund is nearing completion and the firm is cashing out after an extremely successful IPO. For the time being, we stick to the view that April’s decline was caused by structural market forces and that it doesn’t signal a change in the underlying business or dilution of shares (were are cautiously bullish on CaesarStone shares and looking for higher earnings to justify the stock’s trading multiple).
There were some notable positive and negative contributors to the 0.53% decline of the Technology sector in April. Radware (RDWR:NASDAQ) lost 60% of its market value almost overnight on concern that the company would post its slowest annual sales growth in seven years in 2013. Mellanox (MLNX:TASE,NASDAQ) continued its slide, which began last August, with an 8.16% decline in April. It lowered its second quarter revenue guidance and stated that it was experiencing weak demand for its products by large customers like Hewlett Packard and IBM.
On the other hand, some companies showed or are beginning to show notable turnarounds. First, DSP group (DSPG:NASDAQ), which was not a top-ten BIGI performer in April, saw its stock price rise by 25% between April 22and May 6. The company is the leading provider of chipsets for cordless phones, a market which has been in a steady decline since the advent of the cell phone. The company’s stock trades at decent levels relative to cash, revenues, and book value, yet most analysts dropped coverage of the stock as its primary industry was in a secular decline. Since then, the company made what we believe to be an important strategic acquisition of another Israeli company, BoneTone, which provides proprietary voice-recognition technology. The company is also seeking to become a major player in home automation and gateways, as well as VoIP and unified communications in the home and enterprise markets. The company’s management, in discussing its Q1 2013 results, reported that it “exceeded guidance in almost every financial metric…return to GAAP operating profitability is a powerful demonstration of our successful turnaround, especially in light of the uncertain market dynamics.”
Second, Orbotech (ORBK:NASDAQ), which was also not a top-ten BIGI performer in April, beat both revenue and earnings forecasts in its Q1 2013 earnings release. We believe that Orbotech’s stock appreciation may be signaling a turnaround in consumer and other technology stocks. The company designs, develops, manufactures and services automated optical inspection systems. Its imaging and computer-aided manufacturing and engineering technologies enable electronics manufacturers (printed circuit board and flat panel display manufacturers) to achieve increased yields and throughput. The positive signs from companies like Orbotech (and other larger and well-known technology giants like Intel and Miscrosoft) combined with suppressed technology stock prices during the broader market rally over the last year or so could enable the technology sector to become amongst the equity market leaders in the second half of 2013–barring systemic macroeconomic shocks to the recovery of the global economy.
A leading story in the news of Israeli Global Equities has been about a potential takeover of Israel Corp.’s (ILCO:TASE) Israel Chemicals (ICL:TASE) by Canada’s Potash. Israel Chemicals reported lower revenues during Q4 and full year 2012 and, in late March, discussion of a sale of Israel Chemicals to Potash ceased, sending shares of Israel Chemicals and its parent company, Israel Corp., sharply lower in April. We believe that the sell-off in Israel Chemicals shares could be a good opportunity to buy a high-yielding, shekel-denominated equity, whose outlook was good enough for another chemical giant to warrant at least exploring a takeover. Also in April, UBS stated that it saw a 60% upside in shares of Israel Corp. (one of the largest holding companies in Israel), asserting that the market did not appreciate the potential of IC power and Qoros Auto and chose to focus too much on Better Place and Zim.
Not much has changed for the long-term outlook for the Oil & Gas sector since last month, when we stated:
“The Oil & Gas sector continues to be a leader within Global Israeli Equities. This industry is still in its infancy but is maturing quickly. The first deliveries of natural gas from the Tamar reservoir arrived in Israel as of the first of April. For several quarters we have promoted an overweight in the Oil & Gas sector, especially beginning in December 2012, when GDP projections for 2013 began to emerge. Projections for Israel’s 3.8% growth were said to sound better than they actually are because one-third of that growth would come from the Oil & Gas sector.
At that time, we stated the following: “From an equity investment perspective, one way to proceed would be to continue overweighting the energy sector. Growth in this industry may not immediately lead to a multiplier effect through the broader economy. Instead of a portion of revenues flowing into the pockets of would-be employees and the government through taxes, a portion of revenues will flow into companies’ balance sheets or will be spent by them to invest in growth-yielding projects. For this reason, holding an overweight position in Israeli energy equities and LP’s will aid in insulating investors from lower-than-expected economic growth in Israel [outside the oil & gas sector].” Additionally, though this sector currently holds a small weight in the BlueStar Israel Global Index, the weight will likely grow over the years and decades to come; overweighting smaller growth sectors, we believe, is a prudent long term investment strategy. It is certainly not expected that this group of stocks will rise in a straight line. There will be times when the group is over-valued or when certain risks are not discounted fully, but we are viewing this sector as a buy-and-hold long term investment.
Oil & Gas sector highlights in April include:
- Shell is considering selling its 23% stake in Woodside, fearing an Arab boycott
- Noble Energy raised the Tamar field’s gas estimates to 10 TCF; Tamar’s five subsea wells are now producing 300 million cubic feet of gas per day
- Companies began bidding for licenses to explore for Lebanese gas
- Cyprus’ industry minister said that linking the Tamar field to Cyprus was the best way to export Israeli gas; the country wants to sign a letter of intent with Delek Group for the construction of a multi-billion dollar LNG facility
- No significant gas at the Aphrodite 2 well in the Ishai license
- Israel Opportunity allowed to acquire the Pelagic, Gal, and Neta licenses; Neta and Roy licenses granted: 70% to Ratio, 10% to Israel Opportunity, 20% to Italy’s Edison
- The price of gasoline fell, again, in April
Market Trends – Technical Analysis and Market Fundamentals
Technical Analysis of the Israeli Market
After breaking important trend lines in November (during Israeli Global Equities’ rebound from the sharp drop at the beginning of Operation Pillar of Defense), the BlueStar Israel Global Index (BIGI) consolidated in December and resumed its upward movement in January and February. The market selloff during Operation Pillar of Defense to the 200 index level for BIGI confirmed that this is a significant medium and long term level of support for the index. On the three-year chart below we see that BIGI is now consolidating, within a trading range, following the rebound from mid-2012 just described. The range is depicted by the dotted green and red lines and for now, the range is occurring within the context of an upward trend. We see a greater probability of the index breaking above the upper end of this range in a meaningful way than breaking down below the lower end of this range. If this occurs, we see the index rallying strongly to the 250-260 level and then consolidating before a move higher to perhaps 275 or 300 by the end of the year.
At this point, we are comfortable saying that 229-230 has been confirmed as support at the lower end of the above-described range. This area will become an even more significant support level if it is tested and holds for a third time. If the lower end of the range is broken we would look for the lower band of the upward channel, just above the 220 level, to be the first level of support and a soft stop- loss level, followed by the 200 level being our hard “stop-loss” level.
The longer-term outlook for Israeli equities continues to be firmly bullish as the index has re-entered the channel connecting the 2008/2009 lows, as illustrated in the BIGI five-year chart, which spans the entire 2008-2009 global financial crisis. The longer-term outlook will become even more bullish if Israeli Global Equities decisively breaks through the upper band of this channel which has crept up to the 240 level. If this breakout occurs, we see the projected upside potential of the index to be at the 300 level by the end of 2013, though most likely following a break at the resistance level of 250-260 (depicted by the solid green line on the 6-year chart below) and a consolidation at the 2011 high of 275.
Risk management parameters for those with a shorter time horizon have changed slightly since March and should include a “soft” stop-loss activated with a daily close below the lower band of the consolidation zone on the three-year chart at around 229 and “hard” stop-losses with weekly closes below 220 and 200. For the longer-term investor, if these levels are breached and then 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 stop-loss levels have so far held, the close of BIGI decisively above the 220 level has confirmed that this major multi-year support level has held, and is most likely 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 key issues in the fundamental and structural outlook for Global Israeli Equities include foreign investment and liquidity on the Tel Aviv Stock Exchange; regulatory risks aimed at increasing competition in the broader economy; Israel’s corporate structure problems (ie: “corporate pyramids”); and geopolitical events.
The TASE and Global Index Categorization
In March, the Tel Aviv Stock Exchange extended its trading hours to 5:30 p.m. Israeli time with the hope that the extended trading hours would lead to higher volumes on the Tel Aviv Stock Exchange (as more trading hours per day would overlap with markets in different time zones around the world). In April, Morgan Stanley Capital International (MSCI) announced that it will decide whether to include Israel in its European regional indexes by end-June. Israeli exchange officials and regulators are hopeful that MSCI will decide to include Israel, which would allow managers of European portfolios to include Israel in their investment universe and bring more investment to Tel Aviv-listed shares. We are more skeptical, and believe that the chances of Israel’s inclusion in MSCI Europe are less than 30%, as the decision-process is heavily skewed toward the views of MSCI’s institutional users in the EMEA region… But we’d be thrilled to be wrong in this view!
Foreign investments in Israeli start-ups are rising and Globes’ reported in April that 43% of venture capitalists expect the number of high tech exits to grow in 2013. We are excited to see that many Israeli companies, such as Israel Corp. (ILCO:TASE), Teva (TEVA:TASE,NYSE), Elbit Systems (ESLT:TASE,NASDAQ), and Orbotech (ORBK:NASDAQ) are engaging with and expanding operations in the Far East. This adds to the geographic diversification of Israeli Global Equities’ income statements and fosters stronger ties with an important region of the world. Prime Minister Netanyahu’s early May trip to China is also expected to deepen Israeli business ties with the world’s second largest economy. In late April, the Israeli Cabinet approved an open skies agreement with the European Union despite a short strike by employees of Israel’s three airlines. The agreement is intended to allow lower ticket prices and liberalize air travel between the EU and Israel. Its implementation is likely to bolster Israel’s tourism industry and lower travel costs for Israeli residents.
Regulation and Corporate Pyramids
The new Israeli government seems to be very serious about increasing competition and fixing the problem of corporate pyramids in Israel’s economy. In April, the Prime Minister’s cabinet approved the “Concentration in the Economy Law.” This law addresses three main issues: the overall weight of concentration nationwide and competitiveness in privatizations made by the government; restrictions on business pyramids; and separation of financial and non-financial holdings. The goal of increasing competition in Israel is good for consumers because it leads to economic growth as it lowers barriers to entry for new innovative businesses. As barriers to entry are broken, the cost of living goes down.
Corporate pyramids create huge moral hazards in decision-making by executives at some of Israel’s largest financial and non-financial institutions. The Concentration in the Economy Law seeks to resolve the problem of corporate pyramids in part by placing restrictions on board members and by restricting financing options for companies which have been funding operating expenses or dividend payments with funds that typically wouldn’t be available to them if not for the corporate pyramid structure. Furthermore, by separating financial and non-financial holdings, the Law will even further reduce the moral hazards and asymmetric information problems that come with corporate pyramids. Furthermore, the divestment of former group companies to new and motivated independent ownership should unlock hidden value and faster corporate growth.
Israel’s relations with Turkey are improving, which is generally a positive development, though it might have had the negative effect of solidifying alliances between nations in the region that are hostile to Israel. It should be noted that trade with Turkey barely slowed in the past two years, except in the tourism and defense equipment areas. Israeli airstrikes on weapons depots in Syria in April and early May could, unfortunately, result in a range of worrisome outcomes. We continue to monitor military developments in the north of the country but the conflict does not currently present a threat to the Israeli economy or capital markets. There have also been small skirmishes on the Israel-Gaza border. Lastly, there are anti-Israel activist groups seeking to do harm to Israel’s economy. For example, the European Union is considering labeling any Israeli export products that are manufactured in the West Bank and Golan as being made in “settlement territories.”
Economic and Fiscal Outlook
The Bank of Israel’s State of the Economy Index rose in March by 0.1%, a lower rate than in January and February of 2013. The rise in the index in March was the result of increases in industrial production, and in the trade and services revenue indices. Negative factors in March were exports, consumer product imports, and imports of manufacturing inputs. The unemployment rate fell by 10 basis points in March to 6.5%. The average daily number of available jobs rose by 1.6% between Q4 2012 and Q1 2013 against a back drop of a rising number of layoffs. This indicates that the Israeli economy is creating new jobs at an encouraging pace. The chairman of the Histradut threatened a general public sector strike to combat government policy aimed at reining in government spending. There was a disruptive strike at Ben Gurion Airport in April which ended promptly. Prime Minister Netanyahu said that his government will not be threatened or deterred by such strikes.
With the continued rise in home prices and mortgage lending, the Bank of Israel suggested for the first time that the government consider new taxes to cool the housing market. The housing minister sees home prices falling slightly in 2014 as contractors and builders need time to bring more supply to the market. It is important to watch how the government responds to rising home prices by changes in its issuance of building licenses as well as in the tax code.
In Israel, the tax laws that encourage investment in Israel are designed to create jobs in some of the less developed areas of the country. For example: the lowest tax breaks are given to corporations in Tel Aviv and higher tax breaks are given to corporations in more rural areas of the country. If there is a change to this law (as there may be), the result could be that fewer jobs will be created in these “remote” areas of the country. This would put further strain on the housing markets in the larger cities where jobs are more plentiful. Also, transportation plays a key role in relieving housing prices in the larger cities, as Israelis can choose to live in more remote places if they can commute to their jobs in the cities more easily.
Given the combination of a modestly rising CPI, rising home prices, steady but fragile economic growth, and balance of payments changes, we do not see the Bank of Israel changing its policy interest rates in the next several months. While we view the strengthening shekel as a positive for the Israeli consumer and as a vote of confidence in Israel’s government, corporate creditworthiness, and prospects for economic growth, the rising shekel does have the negative consequence of making Israeli exports less competitive on the pricing front. As the Israeli natural gas industry brings the country closer to energy independence and to being a net exporter of energy resources, it will become increasingly necessary for the Bank of Israel to add to the supply of shekels in the foreign exchange market, which will grease the wheels of economic expansion. In April, once the shekel firmly crossed the NIS 3.60/$ level, the Bank of Israel began to intervene, but the Shekel continued to appreciate. This is an important development for global investors to follow closely. We believe that, despite the strains on Israel’s exporters, investors will view the strong and stable local currency as desirable and seek to own Shekel-denominated financial and alternative assets going forward.
The government budget deficit tripled in Q1 2013 from a year earlier and ended March at 4.5% of GDP on higher expenditures and lower tax receipts. The government is planning a series of tax increases and spending cuts, though the finance ministry admits that it will miss its budget targets in 2013 and 2014; the ministry may raise its target budget deficit level from 3% of GDP in 2013 to over 4% of GDP in 2014 in order to manage expectations.
Despite the budget concerns, Fitch rating agency reaffirmed Israel’s A credit rating and expects Israel’s 2013 GDP growth to be 3.7%. Fitch also rated the Shekel A+ with a stable outlook. It stated, regarding the Israeli economy: “Israel has strong and well developed institutions and a diverse and advanced economy. Human development indicators and GDP per capita are significantly higher than peers and the education system and business environment promotes innovation. The macro-economic policy framework is well developed and has been supportive… Israel has been more resilient and less volatile than peers.”
Overall, we remain quite bullish on Israeli Global Equities in the short, medium and long term. We were not deeply discouraged to see Israeli Global Equities consolidating or pulling back in April. We believe the upside potential from these levels outweighs the downside risks, and retaining or opportunistically adding to an Israeli equity overweight during consolidation or on sharp pullbacks would be prudent.
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.
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 – www.ActiveIndexInvesting.com ). Josh Kaplan is a Research Associate at BlueStar Global Investors LLC, and a Contributor to IsraelStrategist.com