Bluestar Israel Equity Update Fourth Quarter 2012

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BlueStar Israel Equity Update Fourth Quarter 2012

Q3 2012 in Review & Year End Outlook

 Global equities continued to rise in Q3 2012. Global Israeli What’s equities rebounded in September after testing 52-week lows in Q1, Inside Q2 and again in Q3 2012.

During Q3 2012, the BlueStar Israel Global Index (BIGI) gained 5.46% while the S&P 500 gained 6.53%, MSCI EAFE gained 6.98%, 1. The BlueStar and the MSCI EM Index rose by 7.89%. Israel Global  Israel’s technology companies led the recovery in Israeli equities Index in 2012 higher, though financials, oil & gas companies, and basic materials YTD companies were relatively strong into the close of the quarter as the Euro-zone recession and debt debacle along with slower global 2-4. About the economic growth weighed on Israel’s technology exporters.

BlueStar Israel Volume on the TASE has been steadily declining throughout 2012. Global Index and Foreign investors’ appetite for locally listed shares picked up a bit in Risk/Return data July but fell sharply in August.

Major geopolitical risks seem to have been deferred after PM 5-6. Technical Netanyahu’s address to the UN general assembly, and economic Analysis policy management has been rewarded with credit-rating affirmations and stable outlooks granted by Moody’s and Standard & Poor’s. 7. Earnings Round-Up

8. Israeli Sector BIGI Performance Highlights (BlueStar Israel Global Index Jan 2010- September 2012)

9. Capital Markets

10. Israeli Economic Review

11. Geopolitical Environment

The BlueStar Israel Global Index (’BIGI’) provides a benchmark for investors to track the broadest and deepest universe of Israeli public companies. The index is constructed using BlueStar Indexes’ unique methodology and proprietary database of Israeli and Israel-linked companies. BIGI includes the largest and most liquid companies as well as mid and small cap companies that display sufficient liquidity for global investors. The index methodology allows for the inclusion of Israeli companies listed on the Tel Aviv Stock Exchange as well as other exchanges such as the London Stock Exchange, New York Stock Exchange, and NASDAQ. The BlueStar Israel Global Index has been created to provide investors with an investable product allowing them to quickly take advantage of both event-driven news and long-term economic trends as the economy and companies of Israel continue to evolve.

Comparative Sector Weights Comparative Risk

Source: BlueStar Global Investors LLC *Annualized Sept 28 2012 Inception Date: Dec. 1992 Source: BlueStar Global Investors LLC Sept 28 2012 Long- Term Returns Five Year Correlations

*Annualized Source: BlueStar Global Investors LLC Inception Date: Dec. 1992 Sept 28 2012 Source: BlueStar Global Investors LLC Sept 28 2012

Index Weight Index Weight as Company Name Ticker Exchange Company Name Ticker Exchange as of Sept 30 of Sept 30 2012 1 Teva Pharmaceutical Industries TEVA TASE 12.64%2012 48 Orbotech Ltd (US) ORBK NASDAQ 0.47% 2 Perrigo Co PRGO NASDAQ 9.10% 49 Delek Energy Systems Ltd DLEN TASE 0.47% 3 Check Point Software (US) CHKP NASDAQ 6.97% 50 Retalix Ltd RTLX TASE 0.47% 4 Amdocs Ltd DOX NYSE 5.09% 51 Syneron Medical Ltd ELOS NASDAQ 0.46% 5 Israel Chemical Corp ICL TASE 4.82% 52 Oil Refineries Ltd ORL TASE 0.45% 6 Bank Hapoalim BM Reg POLI TASE 3.39% 53 Cinema City International NV CCI WARSAW 0.45% 7 MELLANOX TECH MLNX NASDAQ 3.36% 54 Ceva Inc CEVA NASDAQ 0.44% 8 Bank Leumi Le-Israel BM LUMI TASE 3.29% 55 Given Imaging Ltd GIVN NASDAQ 0.43% 9 VeriFone Systems Inc PAY NYSE 2.79% 56 Clal Insurance Enterprises Hldgs CLIS TASE 0.42% 10 Israel Corp ILCO TASE 2.33% 57 PROLOR Biotech Inc. PBTH AMEX 0.41% 11 BEZEQ ISRAELI TELECOM CORP BEZQ TASE 2.11% 58 Ormat Industries ORMT TASE 0.41% 12 Nice Systems Ltd NICE TASE 2.01% 59 Babylon Ltd. BBYL TASE 0.40% 13 Comverse Technology, Inc. CMVT NASDAQ 1.36% 60 HOT Telecommunication HOT TASE 0.40% 14 Isramco Negev 2 LP ISRAp TASE 1.15% 61 Gilat Satellite Networks GILT TASE 0.39% 15 Mizrahi Tefahot Bank Ltd MZTF TASE 1.15% 62 AMOT Investment Ltd AMOT TASE 0.38% 16 Israel Discount Bank 0.1 DSCT TASE 1.07% 63 Clal Industries CII TASE 0.38% 17 LivePerson Inc LPSN NASDAQ 0.98% 64 MELISRON Ltd. MLSR TASE 0.38% 18 Ezchip Semiconduct EZCH TASE 0.95% 65 NITSBA Hldgs (1995) Ltd NTBA TASE 0.38% 19 Playtech PTEC LN 0.94% 66 Clicksoftware Technologies Ltd CKSW NASDAQ 0.37% 20 Avner Oil & Gas Ltd LP AVNRp TASE 0.94% 67 Rami Levi Chain Stores RMLI TASE 0.37% 21 Elbit Systems Ltd ESLT TASE 0.93% 68 Ituran Location & Control Ltd ITRN TASE 0.36% 22 Gazit Globe 1982 Ltd GLOB TASE 0.92% 69 Naphtha Israel Petroleum Corp NFTA TASE 0.35% 23 Electronics For Imaging EFII NASDAQ 0.91% 70 Caesar Stone Sdot Yam Ltd CSTE NASDAQ 0.34% 24 SodaStream International Ltd SODA NASDAQ 0.83% 71 Delek Automotive Systems Ltd DLEA TASE 0.34% 25 Azrieli Group AZRG TASE 0.83% 72 Menorah Insurance Co Ltd 1 MMHD TASE 0.33% 26 Delek Group Ltd DLEKG TASE 0.81% 73 Shufersal Ltd. SAE TASE 0.33% 27 VERINT SYSTEMS VRNT NASDAQ 0.73% 74 Space-Communication Ltd. SCC TASE 0.33% 28 First Intl Bank of Israel FTIN TASE 0.73% 75 Airport City Ltd ARPT TASE 0.32% 29 Delek Drilling LP DEDRp TASE 0.71% 76 Bayside LandCorp 1 BYSD TASE 0.32% 30 Cellcom Israel Ltd. CEL TASE 0.66% 77 Silicom Limited SILC NASDAQ 0.31% 31 Paz Oil Company Ltd PZOL TASE 0.66% 78 Matrix MTRX TASE 0.31% 32 Delek US Holdings DK NYSE 0.64% 79 Electra (Israel) ELTR TASE 0.30% 33 Radware Ltd RDWR NASDAQ 0.64% 80 Kamada KMDA TASE 0.30% 34 Partner Communications PTNR TASE 0.63% 81 Jerusalem Oil Exploration JOEL5 TASE 0.29% 35 Osem Investment OSEM TASE 0.61% 82 Avgol Industries 1953 Ltd AVGL TASE 0.29% 36 Imperva Inc IMPV NYSE 0.58% 83 Formula Systems (1985) Ltd FORT TASE 0.29% 37 Alon Usa Energy ALJ NYSE 0.55% 84 HADERA PAPER LTD HAP TASE 0.29% 38 Ratio Oil Exploration L.P. RATIp TASE 0.54% 85 Ceragon Networks [US Listing] CRNT NASDAQ 0.28% 39 Strauss Group STRS TASE 0.53% 86 Tower Semiconductor Ltd TSEM TASE 0.28% 40 Migdal Insurance Hdlgs MGDL TASE 0.51% 87 Israel Phoenix Assurance 1 PHOE1 TASE 0.27% 41 Ormat Technologies ORA NYSE 0.50% 88 Clal Biotechnology Industrie CBI TASE 0.26% 42 Frutarom FRUT TASE 0.50% 89 Africa Israel Properties AFPR TASE 0.25% 43 Aloni Hetz Properties ALHE TASE 0.49% 90 Koor Industries KOR TASE 0.24% 44 888 Holdings Plc 888 LN 0.48% 91 Givot Olam Oil Exploration L.P. GIVOp TASE 0.23% 45 Harel Insurance Inv Ltd 1 HARL TASE 0.48% 92 Discount Investment Corp DISI TASE 0.23% 46 Shikun & Binui Ltd. SKBN TASE 0.48% 93 Jerusalem Economic Corp (ECJ) ECJM TASE 0.23% 47 Protalix Biotherapeutics Inc PLX AMEX 0.47% 94 Africa-Israel Inv Ltd AFIL01 TASE 0.23%

BIGI Relative Performance Attribution BIGI vs TA-100 BIGI vs MSCI Israel Capped (MXIL)

Q3 2012 BIGI Q3 2012 BIGI BIGI Relative Weight (As BIGI Relative Weight (As Company Name Relative Weight Company Name Relative Weight of Sept 30 2012) of Sept 30 2012) Attribution Attribution

ILDC Energy -3.30% 2.55% Amdocs +5.09% 0.56%

Mellanox Technologies +2.57% 1.11% Alon USA Energy +0.55% 0.34%

Amdocs +5.09% 0.56% Delek US Holdings +0.64% 0.29%

Alon USA Energy +0.55% 0.34% 888 Holdings +0.48% 0.25%

Delek US Holdings +0.64% 0.29% Mellanox Technologies -4.25% (1.84%)

888 Holdings +0.48% 0.25% Israel Chemicals -5.91% (0.68%)

Israel Corp -1.51% (0.20%) Bank Hapoalim -3.77% (0.48%)

Verifone Systems +2.79% (0.44%) Verifone Systems +2.79% (0.44%)

Teva Pharm. -17.02% (0.65%) Teva Pharm. -8.93% (0.34%)

Israel Chemicals -7.24% (0.83%) Cellcom -0.85% (0.33%)

BIGI Internal Characteristics Attribution Currency Attribution Exchange-Related Attribution

Total Index Attribution of Local Currency Total Index Attribution of Category Domicile-Currency Weight Listed on Currency Performance vs Category Weight as of to BIGI Performance (Exchanges) Local Exchange(s) Performance to USD (Q3 2012) Sept 30 2012 (Q3 2012) as of Sept 30 2012 BIGI Performance Dual-Listed 34.71% 1.82% Israel – New Israeli Constituents Shekel 58.6% 0.67% 0.39% (TASE) Non-TASE 41.40% 2.50% Constituents US - US Dollar (NYSE, NASDAQ, 39.53% 0.00% 0.00% Non-TASE AMEX) Technology 25.43% 1.27% Constituents UK – GB Pound 1.42% 3.80% 0.05% (London)

Poland – Polish Zolty 0.46% 7.10% 0.03% (Warsaw)

Total Direct Effect of Currency Fluctuation - - 0.47% on BIGI Price Level

The tables above labeled “BIGI vs TA-100” and “BIGI vs MSCI Israel Capped” provide investors insight into precisely what factors cause BIGI, the global Israeli index, to outperform or underperform. We show the ten constituents which contributed most to BIGI’s outperformance or underperformance on an absolute return basis, along with BIGI’s relative weighting position, and the performance differential attributable to the rules resulting in a constituent’s inclusion or exclusion from BIGI or BIGI’s relative under or over weight position in these constituents. Some of the positive contributors in Q3 2012 were BIGI’s inclusion of Alon Energy USA and Delek US Holdings. Negative attribution derived from BIGI’s relatively lower weighting of TEVA and BIGI’s inclusion of VeriFone Systems (listed solely on the NYSE).

The tables under the “Currency Attribution” heading shows that the shekel appreciation through Q3, a reversal from the Shekel’s slide in recent quarters, contributed 39 bps to BIGI’s performance, and total currency fluctuations contributed 47 bps to BIGI’s Q3 performance. The table titled “Exchange Related Attribution” shows that the relatively large exposure to Israel’s global technology companies, which BIGI’s methodology allows for, contributed127 bps to BIGI’s Q3 2012 performance, and all non-TASE listed companies, which are excluded from the TA-100 and MSCI Israel by definition, contributed 250 bps to BIGI’s Q3 2012 performance.

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 the possibility of a break above the aforementioned one-year downtrend line (on the two-year performance chart below) a distinct possibility.

The longer-term outlook for Israeli equities could become bullish only if the Source: BlueStar Global Investors LLC (Jan 1 2010- September 30 2012) 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 Outlook, 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, has Source: BlueStar Global Investors LLC confirmed the support at this level. (January 1 2007- September 30 2012)

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 stop-loss 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 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.

PE (Sept 30 2012) Dividend Yield (Sept 30 2012)

BlueStar Israel Global Index 25.8 2.26%

5 Technical Analysis: BlueStar Israel Global Index Top Ten Holdings (& Weights)

TEVA- 12.64% Perrigo Co.- 9.10%

PE: 11.38 PE: 25.25 Yield: 2.34% Yield: 0.26%

Check Point Software- 6.97% Amdocs- 5.09%

PE: 17.39 PE: 15.06 Yield: n/a Yield: 0.39%

Israel Chemicals- 4.82% Mellanox Technologies- 3.36%

PE: 79.32 PE: 13.55 Yield: n/a Yield: 6.65%

Bank Hapoalim-3.39% Bank Leumi-3.29%

PE: 7.72 PE: 11.03 Yield: 1.65% Yield: n/a

Verifone Systems-2.79% Israel Corp- 2.33%

PE: 9.81 PE: 33.83 Yield: n/a Yield: 2.36%

6 Israeli Equity Q3 Earnings Season Round-Up Earnings Season Summary for top 75% of BIGI by Weight (reported between July and Sept 2012)

Revenue ($millions EPS ($ at Sept Price: Earnings YoY Revenue EPS Dividend at Sept 28 2012 28 exchange Ratio (Sept 28 Notes Growth Growth Yield exchange rates) rates) 2012) Teva 4,994.0 19% 0.99 52.30% 11.38 2.39% Perrigo 831.8 18% 1.14 25.27% 25.25 0.28% Check Point Software 328.6 9% 0.77 13% 17.39 n/a Expanded share repurchase program by $1 b Repurchased $122m of shares; approved Amdocs 809.0 0.90% 0.59 18% 15.06 0.39% $0.13 dividend/share/qrtr beginning in Oct 2012; 12-month backlog up by $35m to $2.67b

Higher sales in Brazil and China offset lower Israel Chemicals 1,964.6 2% 0.32 -4.46% 13.55 6.50% sales in Europe and North Amercia Deutsche Bank and Clal Finance have Mellanox 133.5 110% 0.74 1133% 79.32 n/a $140/share price target Bank Hapoalim 0.46 -14.81% 7.72 1.65% Bank Leumi 0.19 -50% 11.03 n/a Verifone 472.0 61.40% 0.75 53.06% 9.8 n/a Israel Corp 3,200.0 1.91% 13.52 -27.80% 33.83 2.36% BEZEQ 665.0 -10.30% 0.04 -31.80% 5.95 24.81% NICE Systems 212.1 8.50% 0.18 -25% 39.48 n/a Reduced net income loss by 100% on YoY Comverse Tech 383.7 1.77% -0.01 n/a n/a n/a basis; to be spun-off by parent copmany during Q3 2012 Isramco Negev 2 n/a n/a n/a n/a n/a n/a

Management says company on track to Mizrahi Tefahot Bank 307.0 5.26% 0.33 16.22% 7.1 n/a achieve 17% ROE by 2017; Israel's largest mortgage bank, volume up 10% in 1H 2012

Earnings negatively affected by provision for Israel Discount Bank n/a n/a 0.1 -18.75 6.58 n/a impairment of the Bank's investment in First Int'l Bank Israel. Live Person 38.5 21% 0 -100% 86% n/a

EZChip Semiconductor 15.8 -9% 0.29 -12.12% 40.27 n/a

Avner Oil & Gas (Q1 fin. 20.5 -16% 0.0001 -75% 38.31 n/a Data) Playtech (data for 1H 199.2 101% 0.27 40% 18.38 5.34% Strong start to Q2, traditionally a quieter period 2012)

Continued revenue growth in Latin America and Asia; 50% of revenues from regions with Elbit Systems 676.4 5.26% 1.14 -4.55% 14.04 3.61% growing defense budgets; back log fell to $5.47b from $5.53b

Gazit Globe 0.4 21% 0.434 -5.56% 7.31 3.72%

Electronics for Imaging 163.9 16% 0.15 114% 23.07 n/a

Azrieli Group 85.4 -26.67% 0.4 -50% 23.16 2.43% Delek Group 4,294.5 19.80% 1.58 -49% 3.02 5.38% Western Europe revenue increased 25%; SodaStream 103.0 49.10% 0.52 36.80% 21.1 n/a Americas revenue increased 109.2%; Asia- Pacific revenues increased 233.9%

First International Bank n/a n/a 1.42 42% 10.94 n/a Israel

Signed merger agreement with parent Verint Systems 215.0 10% 0.22 29.40% 23.66 n/a company, Comverse - closing in Feb 2013

Sector Financials Q3 2012 Q2 2012 Q1 2012 as defined by Financials as a whole have been rising on easing concerns Performance Performance Performance BlueStar Indexes over the stability of Israel’s financial system attributable to: Technology 1.40% -4.51% 3.77% positive developments regarding Israel’s sovereign debt rating stability, stable interest rate outlook, rising mortgage Basic Materials 0.93% -0.89% 0.58% and real estate markets, and reduced exposure to PIIGS Oil & Gas 0.76% -1.57% 0.30% (Portugal, Italy, Ireland, Greece, and Spain) debt. Regarding Financials 0.73% -2.66% 0.89% PIIGS sovereign debt, Israeli banks have the largest exposure Health Care 0.31% 0.13% 2.07% to Spain at NIS 714 million, followed by Italy and Ireland. They have less significant exposure to Greece and Portugal. Industrials 0.26% -0.79% 0.26%

Telecommunications 0.25% -2.12% -1.08% In August, the Bank of Israel, on recommendations of the Consumer Services 0.22% -0.40% 0.22% Committee on Concentration in the Economy, ordered banks Consumer Goods -0.03% -0.60% 0.05% to eliminate certain fees considered to be predatory or unfair to consumers. This will hurt banks’ profitability. An Utilities -0.07% -0.12% 0.06% 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. Energy Shares of companies in the Oil & Gas industry were up in Q3 2012 as the recommendations of the Tzemach Committee were revealed. It has been decided that gas partnerships will be allowed to export between 50% and 75% of gas reserves depending on the size of the reserve (this is still contingent on the actual amount of proven reserves to be found in Israel’s waters, reserves must first be sufficient for domestic Israeli use). A factor holding back Israeli Oil & Gas exploration shares throughout the first two quarters of the year 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.

The 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. Additionally, there have been some rumors floating around that Exxon Mobile and Chevron are interested too. It is unlikely that any company with significant operations in Arab countries would participate in Israel’s energy industry.

A new debate is heating up between the Leviathan partners as to what type of strategic partner they are seeking. If they are seeking the highest bidder then Gazprom would supposedly win. On the other hand Gazprom may be too politically entangled to make for a serious long-term and value producing partner. Other developments in Israel’s energy industry from Q3 2012 were: 1- No gas was found at the previously-promising Myra 1 well; 2- "’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 ); 3- Israel agreed to open talks with the Palestinian Authority to develop the marine natural gas fields offshore from Gaza; 4- Drilling at the Sarah license commenced and the target depth is supposed to be reached by early November. The Sarah well has an estimated 1.5 trillion cubic feet of natural gas with a 54% rate of success. Telecom Service Providers Israel’s telecommunications companies came under heavy pressure from the end of 2011 through Q2 2012. A changing regulatory environment and the recommendation of the committee on concentration in the economy have led to the entry of new competitors in this industry, Golan and HOT telecom. The new entrants are still in serious recruitment mode offering what many analysts feel are unsustainable pricing incentives to switch from Cellcom, Partner, or Bezeq. The three bigger players have been coming out with lower-rate and all-inclusive plans of their own.

The big three companies are also beginning to streamline operations to adjust to the new competitive environment, making investing in the telco's more appealing given recent stock price drops. Talk of mergers or acquisitions are right now centered around Partner but new regulations may open the sector up to more M&A activity. Given the aforementioned stock-price drops, investors seem to have put a floor under the sector, and the telecommunications sector rose in Q3 2012. 8 © 2012 BlueStar Global Investors, LLC These are not recommendations to buy or sell any security Developments in the Corporate Arena and Capital Markets

Corporate Structure

Israel’s economy has long been dominated by large corporate pyramids. Corporate pyramids are a type of holding structure which enable families or a few large investors to retain control of the subsidiaries of their core company, while keeping their exposure to the cash flows of these subsidiaries low. As the pyramid adds levels of subsidiaries and cross-holdings, the core investors’ exposure to cash flows is reduced at a faster and faster rate. This creates moral hazards in decision making and asymmetric information availability on those subsidiaries which are publicly traded. Additionally, the corporate pyramids have been able to take advantage of under-the-radar cash transfers between its holdings, funding one failing company with dividends or loans from the operating profits of another, in addition to creating barriers to entry for new competitors.

Israel ranks fourth in the world in percentage of public companies belonging to one of the ten largest holdings companies at 41%. Also, 88% of Israeli public companies have a controlling shareholder. In response to public protests in Israel that resulted from growing real inflation and a growing poverty rate despite unprecedented levels of GDP and corporate profits, Prime Minister Netanyahu established a Committee on Market Competitiveness. The Committee has taken several measures toward breaking up some of these large corporate holding structures. It has forced them to split financial and non-financial holdings, has made limitations on board members, and has prohibited majority shareholders from exerting decision-making influence on companies below certain layers of a corporate pyramid. This prohibition will also force institutional investors and portfolio managers to participate in shareholder voting proactively, giving voice to non-majority shareholders. The effects of such measures will be seen over the course of several quarters or years.

Other developments include effects of the Committee on Concentration in the economy. We have seen immediate positive effects on the Israeli consumer in the way of increased competition in the telecommunications market and the announcement that dairy imports will be allowed in the future, and we expect greater competition in most sectors of the Israeli economy.

Equity Market

The major hurdles for Israel’s equity market in continuing to develop and gain international attention are low liquidity and relatively low market capitalizations. However, as the corporate pyramids divest holdings, financial institutions and investors may become more interested in trading the common shares of the divested companies as their free-floated shares will increase.

Non-residents invested net $260 million in TASE-listed shares and net $280 million in foreign-listed Israeli shares in July but invested only a net $160 million in August and preliminary data for September shows this slide continuing. Israelis were net sellers of $120 million in foreign shares and Israel’s net foreign direct investment position was -$100 million. Debt Market

In July, business sector debt increased by 0.3% to NIS 791 billion and has increased a total Israel Non-Government Bond Index of 1.3% in 2012 year-to-date. Household debt increased by 0.8% in July to NIS 378 billion. (Jan 2010 – Sept 2012) The total volume of new mortgages granted in August was NIS 5.8 billion, a new record after NIS 4.9 billion in new mortgages was granted in July. Israeli banks continue writing down debt and reducing exposure to PIIGS sovereign debt. Some thawing in the “credit freeze” in Israel is beginning, though corporate and bank debt issues are still arising in isolated instances. For example: bank regulators ordered banks to classify IDB’s debt as problem debt with the highest risk in September.

Though the Bank of Israel policy interest rate is projected to remain stable at 2.25% through the end of 2013, the yield spread between 10 year Israeli and U.S. government bonds increased by 10 bps in Q3 2012 mostly as a result of increased inflation expectations in Israel and a new round of monetary easing in the U.S. 9 © 2012 BlueStar Global Investors, LLC These are not recommendations to buy or sell any security Israel Economic Review & Outlook

Historical GDP Growth Rates Israel’s GDP Growth Factors

During the third quarter of 2012 both the Bureau of Statistics and the Bank of Israel revised their 2012 GDP forecasts upwards while lowering 2013 GDP forecasts. The Bureau of Statistics predicts Israeli 2012 GDP growth to be 3.5% while the Bank of Israel is calling for a 3.2% growth rate based on better-than-expected export data. However, the Bank of Israel has lowered its expectations for 2013 GDP growth to just 3.0% based on the Euro-zone recession and Israeli government tax policies.

The two major risk factors to the Israeli economy from the Bank of Israel’s point of view are geopolitical uncertainties which could lead to a rise in the price of oil and/or a reduction in exports, and the prospect of the Euro zone breaking up. Looking forward to 2013, the largest declines in GDP growth are expected to come from private consumption and investment expenditures with government spending set to rise and net exports (roughly equal to the current account) set to return to a positive figure: The current account deficit for 2012 is estimated by the Bank of Israel to be $800 million while the bank expects a surplus of $1.5 billion in 2013. Projected GDP Growth Rates Fiscal Policy

Tax receipts are lower than the seasonal path in 2012 to date and the Bank of Israel is expecting a budget deficit of 3.5% – 4.0% of GDP in 2012. The government implemented several new taxes and policies in Q3 2012. The first of was the 1% rise in the VAT which is expected to contribute to inflation and bring NIS 1.2 billion in revenue for the government in 2012. 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.

Yields on government bonds increased in Q3, in line with worldwide trends and increased inflation expectations. The yield gap between 10 year Israeli and U.S. government bonds increased by 10 bps to 280 bps. Israel’s sovereign risk premium declined by 16 bps. The labor market in Israel continued to strengthen although at a slower rate. Employment growth continued in Q3 2012 and though the number of job vacancies declined by 4.5% in September, the number of vacancies filled increased Shekel/US Dollar over the past month.

Inflation and Monetary Policy

The CPI for August rose by 1% which was above expectations. Housing prices rose Strength 1.1%, transport prices (including gas) rose 1.8%, and fresh produce prices rose 7.9%. Inflation is expected to continue to rise due to: 1- increased VAT, import taxes, and income taxes; 2- continued rise in housing and energy prices; and 3- depreciation of Shekel the Shekel.

The Bank of Israel lowered interest rates twice in 2012 from 2.75% to 2.25%. The interest rate has remained at 2.25% throughout Q3 2012 and is expected to remain there through 2013. Shekel/Euro Rate New Israeli Shekel Performance

After substantial weakening through most of 2012 YTD, the NIS strengthened vs the

USD in September in line with global trends after the Fed announced QE3. The shekel, however, depreciated vs the Euro but the nominal effective exchange rate (measure of the NIS vs a basket of major currencies ignoring prices) appreciated by 1.5%. Currency appreciation is typically viewed as a negative development for an export-oriented Strength

economy, however it also represents economic strength and financial stability. Shekel Shekel

Though Israeli and U.S. equities gained in Q3 2012 and Israeli equities outpaced U.S. equities by over 200 bps in September, 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.

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. The continuing crisis in Syria is entangling Turkey and Russia and has enormous potential of spilling over into the broader Middle East region. These 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.

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