I’ll confess. I’m not a huge fan of exchange-traded funds (ETFs). I can fully appreciate what they offer, but there’s just not enough upside with them most of the time.

See, though diversification is usually the goal, more often than not, ETFs are so diversified that mediocre, watered-down returns are about all you can get. More than that, if you ever take a closer look at the comparative performance of most ETFs, then you may be surprised to find that most of them show a strong correlation to the market‘s overall performance.

#-ad_banner-#In other words, what’s the point? Why not just buy an S&P 500 index fund and forget about it?

Every now and then, however, a real opportunity arises with an ETF.

Let me explain…

The ETF I’m talking about is the iShares MSCI Israel Capped Index Fund (NYSE: EIS).

Resilient
A little background on Israel, its market and its economy may be in order to fully appreciate the brewing upside. The iShares MSCI Israel Capped Index Fund — along with the country’s stock market — lost 25% of its value in the span of six weeks by the middle of 2011. It was fueled by a combination of the debt crisis in the Unites States and protests in Israel about the skyrocketing cost of living.

 
Located in an unfriendly neighborhood
This was a blow the country certainly didn’t need, given its troublesome geopolitical situation. Israel is surrounded by political and military enemies, and missile and mortar attacks aren’t uncommon sights for those who live there. So if there was ever a reason for a population to hole up and live every aspect of their lives defensively, Israel’s inhabitants have one.

But Israel has done the exact opposite with its economy. The country is second only to the United States in its number of venture capital funds, and its economy still grew by 4.7% in 2011 while other nations were struggling to create any growth at all.

And despite the terrorist attacks that troubled the country in August of last year, the country’s publicly-traded companies never actually hit any earnings wall. It’s just that their stocks slumped as a result the instability in the region.

And with the average price-to-earnings (P/E) ratio for the stocks in the fund now at a stunningly-low 5.0, that’s exactly where the opportunity lies.

Chock full of undervalued winners
Of course, a compelling economy is one thing, but a country-based ETF is only as attractive as its constituent stocks. In that regard, though, EIS doesn’t disappoint.

One of its bigger holdings is the world’s largest generic drug maker, Teva Pharmaceuticals (Nasdaq: TEVA). The company posted nearly $18 billion in revenue in 2011, its fourth straight year of revenue gains. While earnings per share (EPS) were off a tad at $3.09 from $3.67 in 2010 , the company is still profitable, and the stock’s still priced attractively at less than 15 times earnings.

Another major constituent of the fund is semiconductor maker Mellanox Technologies (Nasdaq: MLNX). Although earnings have been shrinking since 2007, the tide is expected to turn this year, and even more so next year — by a lot. This is because the company is well positioned to reap the benefits of the fast-growing cloud-computing and storage-device markets. Forecasters see earnings nearly doubling this year to $2.12 per share and to $2.48 per share in 2013.

The real attraction to the ETF, however, is its exposure to stocks that are not available to U.S. investors.

Take fertilizer and chemical manufacturer Israel Chemicals Ltd. for instance, which only trades on the Tel Aviv Stock Exchange. With customers all over the world, it ranks as the world’s top supplier for many chemical products. More important, the company grew sales by 24% last year and pumped up its operating profits by 43%. Throw in its dividend yield of nearly 6%, and what you have is a stock that leaves domestic investors wondering why there aren’t any opportunities like this in the United States.

Then there’s Mizrahi Tefahot Bank Ltd., a small-cap Israeli bank that increased its profit by a whopping 30% last year compared with 2010. To put it in perspective, two of my favorite small-cap bank stocks in the United States, West Bancorp. (NYSE: WTBA) and Community Bank System (NYSE: CBU), increased profits by about half that last year — at 16% and 15.5%, respectively.

EIS is loaded with similarly-successful undervalued stocks that are thriving in the unique entrepreneurial environment the country has created for itself. The ETF’s average price/sales ratio is a mere 0.87, compared to the U.S. average of 2.4. The fund’s stocks also trade at an average of only 1.2 times their book value, which is almost unheard of for U.S. stocks.

Risks to Consider: It almost goes without saying the biggest risk investors could face with these stocks or an Israeli ETF has nothing to do with its economy. Social and political unrest could throw a curve ball at any time. 

Action to Take –> A position in iShares MSCI Israel Capped Index Fund offers twofold benefits. Not only is the fund undervalued, but if the “Sell in May and go away” phenomenon strikes U.S. stocks again this summer, then the best way to avoid taking the hit is by removing yourself from the U.S market as much as possible. Going halfway around the world to Israel could do nicely.