iShares MSCI Israel Capped ETF (EIS): Strong Returns And Further Upside On Valuation

iShares MSCI Israel ETF (NYSEARCA:EIS) is an exchange-traded fund that provides investors with exposure to Israeli equities. The fund carries an expense ratio of 0.58%, and it was launched on March 26, 2008. The fund remains relatively unpopular, with net assets under management of $158.3 million as of January 25, 2023. That follows negative net fund flows of -$6.57 million over the past year or so.

Israel is not an obvious place to invest. However, the fund does have significant exposure to technology (about 30%), and the country is relatively advanced. The country ranks 20 out of 127 for economic complexity.

Unfortunately, earnings are forecast to fall over the next twelve months. This is based on the fund’s benchmark index’s most recent factsheet as of December 30, 2022. The factsheet for the MSCI Israel IMI Capped Index reveals trailing and forward price/earnings ratios of 9.18x and 9.61x, respectively, with a price/book ratio of 1.52x and a trailing dividend yield of 3.59%. This is important: Morningstar also offer a three- to five-year average earnings growth (consensus estimate) of 7.23%. With our first year seeing a fall in earnings, I am tentative about assuming the fund will “make up for it” in later years. Instead, I am going to work with a base case of meager growth, with an average of just under 2%, factoring in the first year.

Using the past as a guide for most other factors, and also assuming a constant forward earnings multiple, we arrive at a headline IRR of potentially 12% per annum over the next five years (see below).

The underlying equity risk premium in this case is very strong, at over 7%, which is after adjusting for the local 10-year yield (as a risk-free rate proxy) of 3.35% and a country risk premium of 1.22% per Professor Damodaran‘s work. A fair ERP would be 4.2-5.5% generally speaking, and so this suggests under-valuation. EIS is also lower-beta at 0.94x; this makes the country risk premium approach more relevant, as less liquid markets do tend to move in a less volatile fashion owing to lesser liquidity/trading volumes. I would argue a fair IRR would be more like circa 9%, suggesting upside potential of over 30% on valuation alone.

The underlying return on equity for EIS’s portfolio is decent, at over 15% on a forward basis.

On a separate matter, the Israeli shekel is probably fairly valued per The Economist’s GDP-per-capita adjusted PPP model. Meanwhile the local current account (see below), which has surged, indicates potential under-valuation.

Therefore, there are no important FX headwinds, and the EIS portfolio appears inexpensive. I like the fact that the headline IRR is both higher than global equity funds I have covered, and also suggests under-valuation on a relative valuation basis.

Given falling global equities through 2022 and recessionary fears, it makes sense that funds like EIS might be undervalued, as EIS’ portfolio is more exposed to cyclical and sensitive sectors (as depicted in the earlier table from Morningstar). Into the next business cycle, EIS stands to benefit from greater-than-average upside beta (potentially), driven possibly also by both equity valuation and FX valuation tailwinds.

I would take a bullish view on EIS. The only reason why I would not be very bullish is because the underlying portfolio return on equity is lower than can be found in some of the more technologically advanced countries and equity funds, and the Israeli equity market is also likely to be a riskier hold in the long run (than say the United States). Still, I expect EIS shareholders to do well over the long term.