MSCI Barra will classify Israel as a developed market, which could give some stocks a boost. By Thomas M. Anderson, Contributing Editor July 20, 2009 Israel is surrounded by unfriendly neighbors. Three years ago, it fought a war against Hezbollah in Lebanon. It finished a shooting war with Palestinians in the Gaza Strip last January. And the country regularly endures threats from Iran. Despite all this, Israel will soon join a group of the most stable countries in the world. Israel, which has a population of 7.4 million and is about the size of New Jersey, is losing its label as an emerging market. Index compiler MSCI Barra will promote Israel to developed-market status next May (the FTSE Group, a rival keeper of indexes, classified Israel as a developed nation in June 2008). The upgrade raises the profile of Israeli stocks. Most funds that invest in emerging-markets stocks, including those that track MSCI emerging-markets indexes, will sell shares of Israeli companies. Some diversified international funds that focus on developed-market companies may buy Israeli stocks. The move could be a mixed bag. "Israel will represent a much smaller percentage of the MSCI World index than it did previously of the MSCI Emerging Markets index, meaning the sellers will likely outnumber the buyers" says Michael Johnston, an analyst with research firm ETF Database. Advertisement Dan Harverd, a Deutsche Bank analyst, surveyed institutional investors about the upgrade to developed-market status. The result: 78% replied that the move would be negative for the Israeli market, and 22% said it would be neutral. No one thought it was a positive sign. However, a majority said the MSCI reclassification would benefit the shares of Teva Pharmaceutical Industries (symbol TEVA). Teva is the world’s biggest maker of generic drugs and Israel’s largest publicly traded company, with a market value of $42 billion. The surveyed investors also thought the move would hurt the stocks of banks, telecommunications firms and other companies that focus on Israeli consumers. Harverd disagrees with the crowd. He thinks stocks of Israeli banks and telcos will look attractive when compared with similar stocks from small, developed European countries. Emerging-markets funds are already light on stocks of Israeli banks and telcos, he says, so he doesn’t anticipate a massive selloff. Harverd expects sector funds to show interest in Israeli companies that dominate their industries. He sees defense contractor Elbit Systems (ESLT), pesticides manufacturer Makhteshim Agan Industries and real estate developer Gazit-Globe as prime targets for such investors (neither Makhteshim nor Gazit trades in the U.S.). Political risk could prevent Israel from reaping the rewards of its new place in the economic pecking order. Stocks in developed markets tend to trade at higher price-earnings ratios than shares of similar companies in emerging markets. Why? Because historically, investors valued the stability and liquidity of developed economies. However, given Middle East tensions, the Israeli stock market may not experience such a lift. Aaron Katsman, editor of the Israel Opportunity Investor newsletter, thinks those concerns are overblown. "Israel's major companies are all big exporters, and political risk doesn’t affect their bottom lines very much," he says. The Israeli stock market has taken investors on a wild ride, though no wilder than those of most of the world’s other stock markets the past two years. The Tel Aviv 100-stock index fell 51% from its October 31, 2007, peak to its November 23, 2008 trough. From the bottom through July 16, the index advanced 47%. Over the past five years, the Tel Aviv 100 returned 7% annualized, while Standard & Poor’s 500-stock index lost 1% and the MSCI EAFE index, a measure of developed foreign markets, gained 3% a year. Advertisement Consider an exchange-traded fund if you don’t want to pick individual Israeli stocks. Johnston recommends iShares MSCI Israel Capped Investable Market Index (EIS). The fund holds a diversified portfolio of Israeli stocks, although Teva accounts for one-fourth of its assets. The fund’s expense ratio is 0.63%. With its well-educated population, which includes many scientists and engineers from the former Soviet Union, Israel is a leader in technology. But don’t overload your portfolio with Israeli stocks. The Jewish state ranks 42nd in the world by gross domestic product, according to the International Monetary Fund.