BlueStar Israel Equity Update November 2012 This monthly column discusses ideas and events related to Israeli equities traded worldwide. The relevant benchmark for this theme 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 stock investment opportunities that have contributed to global Israeli equities’ outperformance of U.S. equities by nearly 1,500% over the past two decades. “Building a Solid Foundation” In October, Israeli global equities continued to build on September’s rebound. Despite the slight lowering of 2013 GDP growth rate forecasts, investors should be encouraged by the resiliency of Israel’s economy and prudence of its economic leadership. Domestic-oriented companies once again led the Israeli Global equity market this month while the stock prices of Israel’s technology companies have reflected slower global economic growth. The major developments in October were a surprise interest rate cut alongside measures taken to cool the housing market; meetings between executives of global oil and gas majors and Israeli officials; and more visibility on the stability and security that the emerging energy industry will bring. Additionally, the developments of September and August (credit rating affirmations, confirmation of Israel’s financial system stability, and geopolitical developments) continued in October, and will continue into the foreseeable future, to provide solid support for Israel’s economy and global Israeli equities. A two-month rally in global Israeli equities is not insignificant, but there could be obstacles ahead due to: continued deterioration of the global economy and the European debt crisis; the looming US “fiscal cliff”; early Prime Ministerial elections; potentially lower- than-expected yield of gas and oil drilling; further and stronger intervention in the real estate and mortgage markets; socioeconomic-related unrest; and potential geopolitical instability. BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices Since 2010 Benchmark October 2012 Performance BIGI 2.83% TA-100 3.36% MSCI Israel 2.74% S&P 500 -1.98% MSCI EAFE 1.09% MSCI EM -0.44% Israeli equities, as measured by the BlueStar Israel Global Index (BLS:IND), gained 2.83% in October. Israeli equities outpaced developed and emerging market equities and global Israeli equities outperformed the S&P 500 by 4.81%. The divergence between Israeli and U.S. equities (with U.S. 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. 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. [See the chart at the end of the column on this subject]. We are not surprised to see Israeli equities playing catch-up based on strong economic fundamentals, a stable Shekel, and geopolitical risks pushed forward. 1 © 2012 BlueStar Global Investors, LLC These are not recommendations to buy or sell any security Israeli Sector Performance In October, the Financials sector led global Israeli equities higher, gaining 2.14%. Leadership within the Sector Financials was mixed between subsectors but Discount Investment Corp (84.08%), Harel Insurance and (As Defined by October 2012 Investments (25.02%), Clal Insurance Investments (24.12%), and Israel Discount Bank (18.14%) were BlueStar Indexes) among the top performers. The surge in Financials stocks was broad-based as half of the 21 Financials stocks within the BlueStar Israel Global Index had double digit gains and only three experienced stock Financials 2.14% price declines. This sector’s October performance is a continuation of last month’s rise, which came on the heels of Israel’s sovereign debt rating affirmation and stable outlook despite increased restrictions on Oil & Gas 0.90% fees charged to banks’ customers. There is also increased awareness among the investment community that some of the largest banks ought to be more profitable, and banks are planning to streamline their Basic Materials 0.43% operations in order to operate more efficiently. Bank Leumi has committed to reducing its workforce by Consumer Goods 0.22% 8% by 2014 and Bank Hapoalim is reducing its headquarters staff by 20-30%, which equates to 400-650 people. Industrials 0.18% Telecommunications 0.11% The major news for the industry and economy came towards the end of the month. The Bank of Israel surprised the market and cut its November policy interest rate by 25 bps to 2.00%, citing low inflationary Health Care 0.04% pressure and the need to support economic activity. On the other hand, the Bank is taking steps to cool down the housing market and prevent a real estate price bubble. [These topics will be discussed in the Utilities -0.01% Economic, Fiscal and Market Outlook section towards the end of the column.] It is apparent that at least some sort of housing market restrictions were baked into Financials’ stock prices as the sector held onto Consumer Services -0.03% October gains after the report. Mizrahi Tefahot Bank (the top mortgage bank in Israel), which has been Technology -1.15% one of the top performing companies in the sector over the last couple of months pulled back more sharply than other large banks on the news. Last month we wrote that we would hold an overweight position in the Financials sector. We expect the Financials to continue to gain moving into the last months of the year, perhaps at a slower pace. The operational adjustments discussed above and an undervalued domestic banking sector relative to international peers is encouraging. Basic Materials stocks were once again among the best performing stocks within the BlueStar Israel Global Index. All four components of the sector gained, led by Koor Industries (36.44%) and followed by Frutarom (9.40%), Israel Corp (7.03%), and Israel Chemicals (3.21%). Israel Corp owns a majority share of Israel Chemicals. It was announced late in the month that Potash, a Canadian company and the largest supplier of Potash in the world, is seeking a merger with Israel Chemicals, likely to gain greater exposure to Asian markets. Frutarom is a great global Israeli growth company that creates and markets high quality flavors and fine ingredients for customers in the food, beverage, fragrance, and pharmaceuticals industries. Frutarom 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. Like the Financials, shares of companies in the Oil & Gas industry continued to build on previous months’ gains, rising 0.9% in October. After the Tzemach Committee announced plans to allow companies to export between 50% and 75% of natural gas reserves, major license holders and global oil and gas majors began the process of deciding on the most suitable major to assist in developing Israel’s energy export market in terms of operational know-how and financial strength. Maybe Russia’s Gazprom was the initial front runner but Australia’s Woodside energy entered a competitive bid for 30% of the Leviathan Partners’ gas licenses. Woodside Energy’s CEO and top executives met with Prime Minister Netanyahu to discuss why Woodside would be the best fit for Israel’s partner on this, citing namely their ability to market to South East Asia where competition is less fierce than in Europe. Though the recommendation of the Tzemach Committee opened the gates to allow such talks, Israel’s ability to export natural gas is still contingent upon the continued finding of sufficient reserves. Last month, the partners involved with the Myra 1 well, once thought to be a potentially significant well, announced that there was no gas to be recovered there. Nonetheless, it has become abundantly clear that Israel’s energy market is well on its way to self-sufficiency. Several natural gas supply deals (highlighted below) to energy producers and major industrial corporations, are being announced as are pipeline and gas terminal plans. We expect that domestically produced natural gas will begin affecting Israel’s current account and CPI as early as the second quarter of 2013. The key developments and deals struck in October were: - Shishmom reservoir has a best estimate of natural gas at 0.55 trillion cubic feet -Tamar Partners stated: “The largest infrastructure project in Israeli history is moving ahead on schedule.” The Tamar field’s production platform is on its way to Israel and production is set to begin in March 2013 - Shikun and Binui is borrowing NIS 300 million to expand its Ashdod power station and convert it to natural gas - Noble energy raising its probability of success in finding oil at Leviathan