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Since the nation's establishment in 1948, Israel has existed in a perpetual state of conflict. There is little doubt that these conflicts have had a negative impact on the country's stability and relations. The BBC World Service Country Poll states that 49% of the more than 28,000 interviewed held a negative view on Israel's influence in the world.

This small nation has, however, experienced astonishing economic growth. Israel is the 40th largest economy in the world, with a GDP of around US$245 billion (putting it ahead of Portugal and Ireland, and just behind Malaysia and Singapore). This is a nation second only to the United States in terms of venture capital funds, with the highest rate of start-up businesses per capita and also the highest ratio of university degrees to population anywhere in the world.

To learn more about the opportunities in Israel, I spoke to Michael Freedman, Executive Director of Asquith Israel Merchant Bank.

Q: What is the current state of the Israeli Economy?

[Michael Freedman] It's really very robust. Last year, while the rest of the world was back-pedalling or stagnating, Israel's economy grew by 4.7%. Even this year, while many countries are worrying about a double-dip recession, Israel may still achieve over 2% growth.

Israel is really an export economy but somehow… even though the countries we are selling to are experiencing recession, they continue to want to buy the goods and services that are made here. Israel also has a lot of room for internal growth, and we are now trying to find ways to exploit that.

There's every reason to be optimistic… Banks here are not over-leveraged and while we have experienced a sharp increase in house prices, it's not built on the back of individuals borrowing too heavily, it's on the back of a lot of foreigners and Israelis returning with lumps of cash and coming into the market. It's for the genuine reasons that prices go up rather than because of inherently an urge to leverage. To a degree we also experience a lot of people buying second homes here and even engaging in buy-to-let aimed (often) at the student market.

Fundamentally the economy is strong, and there's no real reason to panic!

Q: What is the health of the capital markets infrastructure?

[Michael Freedman] There are a handful of families that own a very substantial degree of the economy including several companies on the stock exchange. This has a couple of effects. The positive effect is through stabilizing- it's very difficult for speculators to short stock here or to play tricks on the exchanges. There are simply not enough shares in free float to do that. The negative is that shares trade at a discount for much the same reasons (lower volumes). If, for example, you are a small buyer- it's a stable and liquid market. If you are a large buyer, you will have to negotiate with a big group. The government has started to take steps to address this and open this part of the economy. Our stock market is very robust and issues of conflict are gradually being dealt with in a way that is sensitive to avoid sudden changes.

Q: Can you give us some examples of key innovations or companies which have emerged from the Israeli economy?

[Michael Freedman] There are a handful of Israeli companies who have made it onto the world stage. You have here companies like Comverse (NASDAQ:CMVT) in the tech space and companies like Teva Pharmaceuticals (NYSE:TEVA) who have become a giant in pharmaceuticals. [Teva is now the 2nd largest generics manufacturer in the world and has a very substantial IP bank of its own.]

We are also known for a huge variety of start-ups. Israel is not called 'the start-up nation' for nothing. We have great statistics to show the number of start-ups per capita, the number of PhD's per capita, V/C Dollars per capita, Patents per capita and more. Israel creates a huge amount of innovative start-ups which are often bought out before they are even revenue-producing!

All of the really serious players in the tech-space have really critical R&D facilities here. Bill Gates of Microsoft (NASDAQ:MSFT) is on-record as saying, "…Microsoft would not function as a company in the way that it does without operations in Israel."

Intel (NASDAQ:INTC) also has a number of substantial R&D facilities here, and even some of its manufacturing. Most Intel chips have two names. The first name, which the consumer knows, is the marketing name… so you have things like 'Centrino' and so forth…. All the chips also have Hebrew biblical names which are the original names of the chips as they are developed in laboratories here in Israel.

Google (NASDAQ:GOOG) has also now opened a major office in Israel not just for R&D but as a base to make substantial acquisitions.

Motorola (NYSE:MMI) has been here for many years, and a lot of the key innovations in the mobile industry came out of the businesses within this cluster. For example, it was Motorola engineers in Israel that first built SMS into mobile handsets as part of its research into how mobile phones communicate with each other. ICQ, the first Internet chat program, was also an Israeli innovation. It began with three people working out of their garage and sold out for a few hundred million in the late 90's… a classic Israeli start-up! The ICQ story is particularly interesting as the father of one of the boys, Yossi Vardi, later became regarded as one of the fathers of the venture capital industry.

Q: Does the Israeli security situation impact risk levels within the economy?

[Michael Freedman] You have the same economic factors which exist in any economy. That goes without saying…

What's remarkable about Israel's economy is that in the last few years we have situations which, in any other country, would have been totally disruptive. In the last couple of months alone we have seen literally hundreds of missiles and mortars fired at us from one of our neighbors. There is the permanent threat of having the same thing from our northern neighbors, Hezbollah in Lebanon. And we live under the constant threat of Iran going nuclear, and what that may mean for us. The incredible thing is that none of these threats have a measurable impact on our economy! The defense precautions and infrastructure we have allows most of our nation's citizens to lead pretty-much normal lives most of the time. It's a sad thing that a country needs to become so resilient.

For sure… if we were at total peace with our neighbors and we could afford to not spend double-digit percentage of our GDP on defense, then yes of course we could deploy that money elsewhere. Even in this sense, we can assess the economic benefits. A lot of the money spent on defense is spent with Israeli businesses, and from the military scientific units we are launching many start-ups! In many ways it's not necessarily money down the drain, but money that does create a feedback loop.

I can give you a great example of how we deal with the threat. Warren Buffett has only bought one business outside the U.S.A. and that's in Israel. He bought a company called ISCAR from the Wertheimer family. He spent US$4 billion making this acquisition which is not small even by his standards. He was in the middle of the due-diligence process when the second Lebanon War broke out with Hezbollah. During the due-diligence process, Hezbollah landed rockets in the car park of the main factory he was buying. Literally all the workers were in bomb shelters and very soon after they cleaned the shrapnel in the car park and got back to work. The factory owners said to Buffett that they would totally understand if he wanted to postpone the due-diligence if he perceives a risk and he said, "…as far as I'm concerned any business that's up and running within an hour of having mortars land in their car park is a pretty resilient company…"

Every Israeli business has built into itself the flexibility to cope with problems such as physical security threats and the fact that everybody is a reservist and could be called upon at any time to serve in the military.

Many of the costs and risks in this regard are offset by the fact that in any given group of people you will have exceptional leaders and people trained in a verity of key skills ranging from first-aid to emergency response, team-work and more.

The risks of doing business in Israel are offset by our experience in dealing with those risks, and that's pretty unique.

Q: How is Israel's entrepreneurial landscape and where are the investment opportunities?

[Michael Freedman] In terms of being an entrepreneur, it's fantastic here. This is a country geared toward you, should you wish to start a company. Barriers to entry are pretty low and we have a great base of intellectual property, private incubators, city incubators, not for profit incubators and more. You name it… If you have a good idea, there are many ways of accessing capital to get your idea to the market.

The last couple of years have seen VC's have less money to play with and so many are moving further up the food-chain. Angel investors, who are happy to take on that level of risk and take a punt on start-ups, are filling the gap the VC's left. Israel is second only to Silicon Valley in terms of the power of that funding network. The government is also working hard to attract non-Jewish entrepreneurs to come here and be a part of that story.

A really telling measure of how good we are in this regard is the fact that the U.K. embassy has set-up a technology hub. This is the first time it has done this anywhere and as far as we know, this is the first time any embassy has built such a feature within its own walls. It has a team entirely dedicated to looking at technology transfer between the U.K. and Israel. The view that this hub is taking is that Israel is great at inventing but it then needs Britain's engineering and manufacturing capacity together with market-scale to be the natural environment to roll these investments out.

To use the parlance this group has created, they wish to link Silicon Roundabout to Silicon Boulevard!

From an investment perspective… If you are a VC or into angel investing, you can come here and literally just set up a stand in a coffee shop with a sign saying 'looking for start-ups' and you would have a string of people coming in all day long… you could literally sit in that coffee shop from now until next year and you wouldn't get close to touching the sides in terms of people who want to spend an hour talking to you. The level of innovation here is simply staggering. If you are a more conservative investor, there is a gap in the market… Most companies here tend to sell-out before they grow particularly far or fast. Something that more mature entrepreneurs struggle within Israel is that once they have already started-up and instead of exiting… if they want to continue running their business? It's harder to get capital.

Israeli banks are notoriously difficult lenders (which also means they are not at risk in the current crisis). The nuanced private equity that we see elsewhere simply doesn't exist here. It's either the heavyweight transactions or small. The middle ground, which is very attractive in terms of risk and return, is very underfunded. That presents an opportunity to investors who wish to come in. That is the rationale behind our setting up… to service that need and become a platform for investors to participate, by either putting a stake directly in our fund or by investing with us in these deals. We've already had discussions with major banks here such as Bank Hapoalim (OTC:BKHPF) who is, at least at this stage, interested in investing behind us- using our infrastructure for due diligence.

It's now been 20 years since the Yozma program [was instituted], where the Israeli government pumped a huge amount of money into matching funders 1:1 should they wish to come to Israel to start operations. Over that period, the entrepreneurial community has grown up too. You still have the smart young kids coming out of special forces and intelligence units in the Israeli army and setting up start-ups… but you are also seeing mature serial entrepreneurs who are saying, "you know what? I don't want to be in a position of build it and sell it fast, I'd actually rather build an Israeli company!"

What does this mean for investors and risk managers?

Israel suffers from the fact that humans have an availability bias (meaning that we use the ease with which examples come to mind as a guide of their importance). For Israel, this manifests with the fact that people find it incredibly hard to separate politics with economics as when they think of the nation, their mind is instantly filled with news about conflict and military exchanges. This is perhaps, the fault of the Israeli marketing machine which has failed to promote enough 'good news' about the nation globally. There is no doubt that there are real problems concerning security and how the nation deals with religious conflict- but these are not specifically Israeli problems… countries like India and China have experienced the same with their neighbors and, like Israel, have built processes into their economy to cope.

Disclosure: None

Source: Finding Alpha In Israel's Market