This Ignored Country is Booming

Emerging markets have been the success story of 2009.

While more developed economies such as the United States and Europe have struggled to recover, countries like Brazil, Russia, India and China are on a roll.

Country (Index) YTD Return
Russia (Micex) +118%
China (Shanghai Composite) +80%
Brazil (Bovespa) +80%
India (Sensex) +77%
U.S. (S&P 500) +23%

Another emerging economy is also rocketing. Morgan Stanley Capital International has upgraded this market, and it will make the coveted leap to “developed” market status in May of 2010.

It’s Israel. This tiny nation on the Mediterranean Sea might not be the first place that comes to mind when investors think about international diversification, but it should be at the top of the list.

The Tel Aviv 100, a benchmark of Israel’s 100 largest stocks, is up +69% this year.

Israel’s currency, the shekel, has gained ground against the dollar.

Investors may be reluctant about shouldering political and geographic risk. Israel is surrounded by enemies and has been plagued by the constant threat of violence. Yet that has been true since its founding in 1947, and Israel has nevertheless developed into one of the world’s most innovative economies.

Israel’s workforce is among the most educated and is renowned for its entrepreneurial spirit. The country has one of the highest numbers of patents filed in the world and is crawling with start-up companies. The World Bank notes it consistently ranks near the top in per capita research and development spending.

#-ad_banner-#After years of GDP growth at about +5.0%, Israel’s economy — along with the rest of the world — experienced a mild recession last year. Now, it’s rebounding: GDP grew +2.2% in the third quarter of this year and should grow by +2.9% next year, according to a Barclays Capital forecast.

The downturn in Israel was brief enough to make the Bank of Israel the first major central bank to raise short-term borrowing rates, a sign of strength signaling confidence in the economy. The central bank has held the rate steady the past two months, but could announce another rate hike by the end of the year.

Part of Israel’s success can be attributed to its status as the Silicon Valley of the Middle East. Tech has been the best performing sector in the market this year, gaining more than +55% compared with the S&P’s +23%. About 75% of Israel’s exports are technology products, so it should be a prime beneficiary if this trend continues.

Two funds offer the best broad exposure to Israel: iShares MSCI Israel Capped Investable Market (NYSE: EIS), an exchange-traded fund, and First Israel Fund (AMEX: ISL), a closed-end fund.

Each of these funds offers broad exposure to the Israeli market, with both funds holding many of the same securities.

EIS % of Portfolio ISL % of Portfolio
Teva Pharmaceuticals 21.6 Harel Insurance 7.9
Israel Chemicals 9.9 Teva Pharmaceuticals 7.7
Check Point Software 8.2 Israeli Telecom 6.4
Bank Lumi 7.0 Bank Lumi 5.8
Bank Hapoalim 5.1 Bank Hapoalim 5.4
Israeli Telecom 5.0 Israel Chemicals 5.3
Nice Systems 3.6 Shikun & Binui 3.2
Partner Communications 3.1 Israel Corp. 2.7
Mizrahi Tefahot Bank 2.6 Perrigo 2.3
Elbit Systems 2.6 Israel Discount Bank 2.3

EIS is a bit top-heavy: Its top five holdings comprise more than 50% of the portfolio. ISL is more balanced: Its top five holdings make up 33% of the holdings. The fund trades at a -7% discount to net asset value, meaning investors get a dollar of assets for 93 cents. Considering that the TA-25 Index is trading at 34 times earnings and the TA-100 Index at 44 times earnings, cost-conscious investors may want to pick up ISL.