Helping ideas grow
Small companies are a risky profit for investors, which limits their ability to grow. Why and how the state should try to fix this market failure.
There are two jars. One contains nine white marbles and one red marble. The other contains 94 white marbles and six red marbles. If you pick out a red marble you win the game, but you have to choose only one jar to try your luck. Where are your chances best? In the jar with six red marbles but only 6% chance of drawing red, or in the jar with one red marble but a 10% chance?
When it’s a matter of marbles in jars, most people get it wrong.
Seventy-five percent choose the larger jar, which contains more red marbles but your chances of drawing one are smaller. How about when it’s a matter of choosing companies to invest in, not marbles from a jar?
As an investor, one normally looks for the place where your chances of achieving high returns are best, and your odds are probably better when it comes to the smaller jar − the Tel Aviv-25 Index − which aggregates the largest, most established companies. Almost every year, this index has included one of the Tel Aviv Stock Exchange’s star performers. This year it was Mellanox, last year it was Perrigo, and others, including Israel Chemicals, have held this title over the years. The jar with the remaining 500 or so publicly traded companies also had some stars, but your chances of hitting the jackpot there were probably much smaller.
Unlike marble hunters, most investors focus on the smaller jar − the large-cap index. Unfortunately this is not necessarily because they’ve calculated their probabilities correctly, but rather because they’re seeking out familiar brands and stocks with greater liquidity.
Regardless of why we make this choice and whether it’s the correct one from the investors’ standpoint, this tendency can have a negative impact on the economy. When most investors, including banks, favor large-caps, then small- and mid-caps have very limited access to funds, especially when the economy is slowing. Obviously that is an inherent market problem − if small- and mid-cap companies have no access to funds, they can’t grow and are unlikely to evolve into new, competitive, exciting big-caps.
Most of the developed world is grappling with this problem. We want a diverse market, we want competition, we want new and exciting game changers in every industry, but we have no efficient way of supporting small and medium-sized businesses. Israel is no different in that sense.
Three important industries evolved in Israel over the years: aerospace and defense, telecommunications and telecom-related IT, and biomed. Companies like Teva, Check Point and Amdocs became global leaders in their niche and still hold that position. For a moment, it seemed like we had the recipe for innovative growth. We probably still hold the world record for start-ups per capita, but we too have gotten stuck in the swamp, lacking the funds needed to let multiple companies grow from very small to self-sufficient.
Support for clean-tech
A few years ago the TASE tried to save the day. It opened its gates to a large group of very small biomed companies. Some 58 companies took advantage of this opening to raise money from the public.
One of them is Mazor Robotics, which developed a robot for back surgery. If you want to be cynical you might argue that this is no major breakthrough, as it improves surgery outcomes in only 9% of cases, but if you were to have a back injury and someone could promise you that your risk of a permanent spinal cord injury could be cut from 10% to less than 1%, you probably wouldn’t think twice.
Mazor has several other interesting developments up its sleeve, but as CEO Ori Hadomi told me a few weeks ago, his company probably wouldn’t have made it if the TASE had not allowed very small companies like it to raise money. Companies with no collateral or tangible assets, with only dreams and innovations, can’t raise money from the banking system. There is a size window when they are relevant to venture capital funds but if they are larger or smaller, then they have a very small chance of bringing a new device that improves back surgery, video streaming or traffic control to the market.
Dramatic increases in regulatory requirements, institutional investors’ loss of appetite for risk, and lower management fees that force institutionals to cut back on professional staff are some of the reasons the TASE is no longer a viable source of funds for Israel’s small- and mid-cap companies. There could be other sources if the government were to focus on supporting innovative small and medium-sized business.
One way to do so could be by offering incentives to encourage municipalities to beta test new clean-tech technologies. There are hundreds of new clean-tech companies in Israel in fields from water purification to recycling to clean energy. The computer and telecom industries enjoyed military budgets that let them develop and test many early-stage products. Clean-tech currently has no such support here, but that could easily change if we were to focus on putting the right incentives in place.
Take, for example, one of the largest infrastructure projects under way − the new military administrative center being built in the Negev at an estimated cost of NIS 25 billion. Could such a project incorporate new water technologies such as those developed by Tritech or Orad? Their technologies improve the water purification process and freshwater supply management, respectively. Local deployment and adoption are an important prerequisite for wide-scale global sales, but as the need for water is great, the world might not wait for the Israeli government to support local industry.
Last year, 200 Chinese representatives visited the annual Watech conference held in Tel Aviv. One of the visiting companies, Dowell, is establishing a 10-acre industrial park in Guangdong province where Israeli water companies can build plants and present their advancements to potential Chinese clients. In addition, Israeli water companies whose technology is incorporated into Chinese infrastructure projects are entitled to an annual $6 million grant each, an $18 million loan and access to private investments of up to $36 million. This means these small-cap technology companies could be looking at a one-year funding package of $60 million for focusing development efforts on the Chinese market. But is this good for Israel’s water industry?
Helping locals make the list
Forbes magazine recently published a list of the top 100 innovative companies. Israel had only one representative on this list − Israel Chemicals, which was ranked No. 60. The survey looked only at public companies with a market cap of $10 billion or more that invest at least 2.5% of revenue in R&D. There aren’t many Israeli companies in this category so it’s not really surprising that only one made the ranking.
Though a very well-managed and successful company, Israel Chemicals is trading at a P/E ratio below those of its peers in the agricultural fertilizer sphere. The main reason for this underperformance is the public pressure on the government to revoke ICL’s long-standing tax benefits. As the company has probably repaid its shareholders many times over for their original investment in ICL’s operational infrastructure, there probably is room for a public debate on its tax credits.
But an interesting alternative might be converting these benefits into R&D tax credits. What if the government were to give established big-cap companies tax credits for operating as beta sites for innovative early-stage companies? Not so they could buy them and swallow them live, not just for internal R&D efforts, but so that big companies would have incentives to give small- and mid-cap companies room to grow. Perhaps that would result in more than one Israeli large-cap company appearing on future Forbes lists.
The writer is the business development manager at IBI Investment House. This document is based on information published by the companies and evaluations that, due to the nature of things, may prove outdated, inaccurate or incomplete. Investment decisions should not be reached on the basis of this article alone: Its purpose is to provide information only, and it does not constitute counsel or invitation to purchase or sell the securities mentioned herein.
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