Israeli Equities

Emerging market growth with developed country volatility

Originally published in the June 2007 issue

To those less familiar with the country, the word “Israel” conjures up many emotive images of war, bombing and geo-political risk. Most do not associate it with investment opportunity, and would therefore be surprised to discover that despite experiencing considerably more actual stress tests and shocks than the vast majority of other markets across the globe, Israel’s economy has kept growing at a pace well above trend in recent years. This strong growth, which looks set to continue, offers an excellent backdrop for an equity long/short strategy.

The resilience of the Israeli economy allowed its index to reach new heights less than a month after the Lebanese war of 2006, with the actual cost of the war to GDP estimated to be somewhere between 0 and 0.5%. Israel is currently enjoying near zero per cent inflation, 5.5% expected annualised growth, a strong currency which appreciated over 10% against the dollar last year and interest rates of 3.25%. Combined with strong leadership for the economy (Stanley Fischer, ex Citibank Vice Chairman, has taken the role of Governor of the Bank of Israel), the fundamental macro economic backdrop of the country has never looked so positive.

The market has seen major liberalisations over the past couple of years, which has led to substantial “smart money” flows into Israel, beginning with VC funds and followed by the likes of Warren Buffet’s Berkshire Hathaway investing $4 billion for the acquisition of Iscar Holdings, a metal works company. York Capital invested circa $1 billion for controlling interests in Gilat Networks and Psagot Asset Management. Apax and Saban Group acquired controlling stakes for over $1 billion in the privatisation of Bezeq, the national telecommunications company. Markstone raised a first time $800m private equity fund from major US institutional investors to invest in Israeli based companies, and the Bronfman family purchased controlling interests in a number of local assets including Discount Bank and Blue Square Supermarkets, to name just a few.

The markets in Israel have also over recent years become a great deal more investor friendly, with active and transparent capital markets, a strong banking system, a robust venture capital sector, relaxed currency regulations, comprehensive protection of intellectual property and numerous free trade agreements. It is significant that Israel was re-classified as an OECD country a few weeks ago.

It is fairly widely known amongst the investment community that Israel has the largest foreign presence on the Nasdaq. It is often assumed that the resulting (and accurate) image of Israel being a leader in the technology sector is at the expense of diversification in its economy. The listed corporate sector in Israel is, however, fairly well diversified.

Shore Capital, a London Listed Investment Banking Group specialising in alternative assets, has been involved in cross-border business with Israel for over ten years and, as a result, identified the attractiveness of equity investment in Israel. The company embarked on an extensive process of due diligence of the market before subsequently entering into a partnership with a local hedge fund group, Sphera Funds Management, and launching Puma Sphera, a multi-currency denominated Dublin listed hedge fund, at the beginning of December 2006. Puma Sphera has the same equity long/short strategy as Sphera’s productfor Israeli investors but has been structured to be investible by global hedge fund investors.

Sphera Funds Management has been managing the Sphera Fund for the past 51/2 years, and is one of around only a dozen local hedge fund players. Israel’s development as a hedge fund centre is at an early stage, analogous to the US in the 1980s, Europe in the 1990s or Asia in the early years of the current decade, with a small number of hedge funds enjoying the fruits of an uncrowded market place.

The highly educated workforce in Israel, together with the liberalisation of its regulations and markets, has already led to firms such as Brevan Howard establishing activities in the country. Sphera, however, is the largest local presence by a considerable margin, managing over $220 million in assets. Having generated an annualised return of over 21% with a volatility of 11% since launch, but only 6% volatility in the last year and with a proven track record in both strong and weak markets, Shore Capital believes that Puma Sphera is achieving emerging market like returns with developed market volatility.

Puma Sphera is a classical fundamentally driven long/short equity strategy focusing on stock picking ability and emphasising the importance of close contact with, and knowledge of, company managements. The focus of the fund is Israeli and Israeli- related equities; those listed locally, and on the Nasdaq and other international exchanges.

Howard Shore, of Shore Capital, commented that “both their local presence and their size relative to other hedge funds certainly gives Puma Sphera an ‘edge’, especially versus some other emerging market hedge funds which dabble in Israel, but aren’t actually based there.” Ron Senator, Puma Sphera’s manager, emphasises the importance of their local presence, saying that they “enjoy good access to company managements and industry sources, and being on the ground are quick to spot turnaround situations after Wall Street has thrown in the towel”.

The belief is that the recent trends seen in Israel are set to continue. Another contributing factor comes from the pension industry: in the past around 70% of pension fund monies were invested in designated non tradable government bonds yielding around 5.5%. With pension reforms a few years ago this has changed entirely. The market has become much more competitive, with investors no longer locked in to their managers. This has led to pension funds putting higher proportions of their portfolios in to the capital markets in search of the higher returns. It is estimated that just 10% of current pension portfolios are invested in equities. It will add great impetus to the market if this increases to developed market levels of 30% to 40% as expected.

The strong fundamentals of Israeli equities and these technical factors have given an excellent backdrop for the launch of Puma Sphera. Puma Sphera was launched in December 2006 and over its first 5 months to the end of April 2007 has gained in excess of 11% with volatility of around 6%. Puma Sphera’s managers believe that the positive conditions which enabled this excellent performance remain in place.