Bottom Shekel / Why Israel, Why Now?

One Saturday in early May 2006, billionaire investor Warren Buffett made the front pages in Israel's business press. Addressing roughly 23,000 cheering investors at the annual shareholders meeting of Berkshire Hathaway in Omaha, Nebraska, Buffett announced his company's first acquisition outside the United States. Berkshire Hathaway had acquired 80% of Iscar, a manufacturer of cutting-edge industrial blade technology, for $4 billion from the Wertheimer family.

Sellers and buyers alike won accolades, but they didn't have much time to enjoy them. Five days after the deal, on June 12, 2006, the Second Lebanon War broke out.

For five weeks the cities of northern Israel were peppered by missiles. The entire economy in the north shut down. Israel was roundly criticized in the international press, and Buffett's backers suddenly realized that the their money had been invested in one of the most volatile places in the Middle East.

Following the war, Israel underwent a series of political jolts, and Iscar itself went through a challenging period.

But Berkshire Hathaway's faithful evidently have not lost money on the deal.

Iscar is privately held, and its numbers are painstakingly veiled in Berkshire Hathaway's financial statements. Yet all indicators are that Iscar has been one of Buffett's best investments ever, maybe even the best. Buffett himself has often said it was a dream deal, and added that he had high expectations of Iscar - but the company surpassed them.

In the three years since Buffett's acquisition of Iscar, Israel has gone through two wars - the Second Lebanon War and then the war in the south, Operation Cast Lead. It has changed government and is now fighting off the global economic crisis. Israel's economy is more exposed than many others to the downturn, because of its heavy dependence on exports, high-tech and tourism. Yet just as Israel overcame both local wars with great speed, it has proven able to slog through the crisis with less damage than other, more developed economies.

Israel ended the first quarter of 2009 with economic contraction of 4%, in annualized terms, and unemployment hit 8%.

But relative to the United States and various European countries, the damage to the economy was minor. Israel's banks are standing firm. The government didn't have to nationalize any companies. There were layoffs but not en masse, and no major collapses ensued. The real estate market, which sent whole economies into spasms, was barely affected: If anything, home prices continued to amble upward (see the analysis by Arik Mirovsky on page 6).

Israel's mortgage market is competitive, yet the banks demonstrated responsibility and the tradition of negligible default rates was maintained, even at this hard time.

This year Israel celebrated its 61st independence day. During those 61 years, its population grew from 650,000 to 7 million. Israel has many reasons to feel proud of itself. One is that despite the perennial security threat, the standard of living (GDP per capita) has risen in tandem with that in other countries over the last 30 years.

During the last five years, Israel has made great strides in its culture of entertainment and consumption. Infrastructure has improved beyond recognition, and capital market reforms helped refine the financial system. The economy's vulnerability has been significantly reduced since the 2001-2002 crash, mainly because of consistent effort that reduced Israel's debt-to-GDP ratio below 100%. Credit rating agency Standard & Poor's has given Israel an A rating, partly because of its cautious, and clever, fiscal and monetary policies. Israel has managed to keep prices pretty much stable, and the proportion of household saving is high. One of the people piloting the good ship Israel's monetary policy is Stanley Fischer, governor of the Bank of Israel. Over and above his sage decisions, Fischer boasts an international reputation that has done Israel's image a great deal of good.

Iscar isn't the only representative of Israeli success on a global scale. Teva Pharmaceutical Industries has grown into the world's biggest manufacturer of generic drugs. Then there's Check Point Sofware Technologies, which developed the Firewall, not only a data security essential but now a generic name. And there's M Systems, which invented a technology that's become ubiquitous - the Disk-On-Key portable memory.

In high-tech, Israel has become a world leader. It is second only to the United States in terms of the number of companies listed on Nasdaq. National expenditure on civilian R&D is significantly higher than in the rest of the developed world.

Just this month, index compiler MSCI announced Israel's upgrade, effective May 2010, from emerging market to developed. From that time the MSCI Israel Index will be included in the MSCI World Index, which some believe could attract more foreign investment on the grounds that many vehicles confine themselves to developed countries.

Moreover, in recent years Israel has knuckled down in its fight on corruption. Ehud Olmert was shown the door as prime minister because of a series of allegations concerning himself and his deposed finance minister, Abraham Hirchson, who has since been convicted of fraud.

The upshot of wise economic policies and reforms has been that when the global economic crisis hit, Israel was in its best-ever condition. If we'd been exposed to something of this magnitude 10 or 20 years ago, our situation would have been much worse.

Yet that doesn't mean that nothing but roses are coming up in the Holy Land.

Israel faces serious problems and threats, which could worsen in the future. Social gaps haven't been narrowing for years, and the proportion of adults in the work force remains very low relative to the developed world, mainly because men in the ultra-Orthodox sector and women in the Arab sector typically eschew work.

Nor can we be sanguine when it comes to GDP per capita. It's true that the standard of living has risen smartly in the last three decades. But we have remained in roughly the same position relative to the rest of the world, in 19th or 20th place, despite the tremendous influx of immigrants from the former Soviet bloc, our competitive advantage in technological innovation, aid from the United States and donations from the Diaspora.

Israel also suffers from almost impossible political structures. Its form of coalition government generates instability. One after another, governments rise only to fall well before their scheduled demise, which results in a tremendous waste of resources. A new low was recorded this year with the inauguration of the biggest cabinet in Israeli history: The new prime minister, Benjamin Netanyahu, conducts an orchestra with no less than 37 ministers and deputy ministers.

Israel's system of governance impairs the proper administration of the state. One result is that the government is forced to capitulate to pressure groups. Crucial reforms are stymied and destroyed, in education, in eradicating the monopolies, in the management of the local authorities.

Nor did Israel ever manage to resolve the blood-soaked conflict raging for the last hundred years with most of the Arab nations, and mainly, with the Palestinian people in the nation's east - in Judea and Samaria. Israel is therefore forced to maintain a vast, and expensive, army funded by a commensurately vast, and expensive, defense budget. The public debate on security and policy commands so much attention that advance on other important issues is held back.

Concern that the Iranian threat will materialize has intensified. Aside from its existential aspect, the rise of the Iranian nuke could trigger emigration, mainly among the wealthy, and hinder foreign investment. That renders Israel heavily dependent on the goodwill of the American government, and also heavily reliant on the help of America's Jewry.

Israel has much to offer investors: a healthy, robust economy with reasonable (not necessarily low) prices, many excellent people with keen hunger to succeed, serial entrepreneurs who think outside the box, and world-leading research people. Israel has all these things, under the shadow of complex structural problems and unresolved security issues.

Should you invest in Israel? No. You should invest in businesses that are excellently managed.

Are there businesses like that in Israel? Yes. Just ask Mr. Warren Buffett of Omaha.