In their recent book, Start-Up Nation, Dan Senor and Saul Singer argue that one of the main reasons Israel has had such success in starting up new companies lies in the fact that all Israelis go through military service, where they learn such qualities as leadership, responsibility and decision-making.

Indeed, the largest number of foreign companies to list on American stock markets are Israeli. Over the past two decades, Nasdaq has seen some 200 IPOs by Israeli firms, of which some 125 are still traded.

But this is only the tip of an iceberg. Israel has 4,000 or so start-ups, the most of any country in the world except for the United States. Given its small population, in per capita terms Israel leads the world in entrepreneurial activity by a wide margin. George Gilder’s The Israel Test, another new book on this hot topic, tells a similar tale.

A Military Secret

Israeli firms have had a hand in developing a disproportionate number of new technologies and high-tech gadgets. More than any other country — including India and China — the Jewish state has partnered with Silicon Valley to lead the information technology revolution. Not surprisingly, the list of high tech giants buying Israeli companies and investing in Israel reads like a Who’s Who of the “new economy.” It includes General Electric, Microsoft, IBM, Johnson and Johnson, Intel, eBay, Kodak, Cisco, Alcatel, Broadcom, Verifone, Sierra and others.

Before the advent of the economic crisis, Hewlett-Packard bought Mercury Interactive for $4.5 billion — the biggest deal involving an Israeli firm to date — while SanDisk spent $1.6 billion on M-Systems, another Israeli company. Overall, direct foreign investment in Israel rocketed in recent years and even the global crisis is unlikely to reverse this trend.

Israel has been such an eye-popping success in developing new technologies and starting and growing entrepreneurial companies that some sort of an explanation is certainly in order.

Understanding what makes Israel hum is not a mere intellectual exercise, but has a bearing on determining whether it makes sense for individual investors to invest in Israeli companies.

While it is true that everybody in Israel does his (and her) military service, it is debatable that it helps develop technological acumen or a knack for starting businesses. Few other countries where military service is compulsory have seen a similar efflorescence of entrepreneurship. While the Israeli Defense Force relies more than most armies on personal initiative, the modern military is more about discipline and following orders, not creative thinking. The United States has been able to innovate without putting its entrepreneurs through boot camp. Other countries which innovate successfully — notably the Nordic nations — have done very little fighting for centuries. Successful modern entrepreneurs, while certainly disciplined and committed, tend to be mold-breakers who are able to think outside the box. It is not the kind of virtue one associates with soldiering, even with the less conventional citizen-soldiers that exist in Israel.

Innovate or Perish

Nevertheless, in Israel, as in the United States, the high tech sector is closely linked to the defense establishment. Historically, Silicon Valley was supported by the Pentagon and the development of such technologies as computers, mobile telephony and the Internet has been in a large measure financed by the U.S. military. It may be a coincidence that both Boeing prior to its move to Chicago and Microsoft were headquartered in Seattle, but it is indicative of a symbiotic relationship between defense dollars and technological revolution.

Israel has been fighting for its survival ever since it came into existence. In the early years of the conflict, personal courage, commitment and training played a key role in the new state’s success on the battlefield. But after the 1973 Yom Kippur war, the Israeli military realized that Israel’s key advantage from then on would have to be technological. Modern weapons were becoming too destructive. In order keep winning regional wars without suffering prohibitive casualties Israel would need overwhelming technological superiority. Since technology was becoming portable and easily transferable, the only way to keep ahead of the game was to innovate independently.

For Israel, therefore, keeping a technological edge has been a question of life and death. This is why Israel’s success has been largely in the high-tech area. Israeli scientists and engineers have taken out nearly 8,000 patents in the United States — an astonishing number for such a tiny nation.

Even though Israel has no formal alliance with the United States the way NATO members in Europe do, the Pentagon works more closely with the Israeli military than any other armed force in the world. The cooperation between the two is very much a two-way street. The technological sophistication of the Israeli military has cemented the cooperation with the Pentagon and increased Israel’s value as an ally. Defense contractors from the two countries also work together on developing new weapons systems.

International Outlook

Israel resembles the United States in another area as well. The United States, a nation of immigrants, has been built by the skills, hard work and ambition of its newcomers. It is not surprising, perhaps, that the U.S. economy stagnated when the proportion of foreign-born Americans declined to historic lows in the 1970s. The revival of U.S. economic fortunes has gone hand in hand with the renewed rise in immigration since the early 1980s.

Israel, another new nation, has been the homeland of the Jews since its inception, and, by its very nature, it is a country of immigrants. It assimilated a mass of educated new citizens from the former Soviet Union in the early 1990s, and has had inflows from Iran, France, Argentina and South Africa in recent decades. There is a small but steady stream of American Jews choosing to live in Israel.

New immigrants bring with them education, skills and, in some cases, money. More important, they have the knowledge of the outside world and are at home in two countries and their cultures. In a highly globalized world the ability to forge links across borders has been a valuable asset. Globalization has penalized insular cultures and favored those nations that have large, diversified immigrant communities on their soil or far-flung diasporas abroad. Uniquely, Israel has both.

Fear Means Undervaluation

By the time widely discussed books about an investment opportunity come out, the investment opportunity is typically gone. Under normal circumstances, it would be the case in Israel, too. Israel should have been a darling of international investors — especially since they have plenty of ways of tapping into the Israeli success story. There are U.S.-traded Israeli companies — from start-ups to well-established ones such as Teva Pharmaceuticals. There is a variety of ETFs and open- and closed-end funds dedicated to Israel.

However, political concerns have kept Israeli shares undervalued. After all, Israel is still at war with many of its neighbors as well as non-government players, such as Hezbollah and Hamas. It is living under a potential threat from Iran’s nuclear weapons. Its geographic region has been characterized by instability and hostility toward the West in general and Israel in particular. This is not the kind of political climate that makes investors comfortable.

The intrinsic undervaluation of Israeli shares plays into the hands of those who seek longer-term gains. Israel has demonstrated its ability to survive and defend itself, and while investors may undervalue Israeli shares, recent wars in Lebanon and in Gaza triggered no substantive mark-down of the Tel Aviv market.

In 2006, legendary U.S. investor Warren Buffett spent $4.4 billion to buy a majority stake in Iscar Metalworking Cos., an Israeli engineering firm. Many analysts declared at the time that Buffett put Israel on the investment map. After all, Buffett’s reputation rests on his ability to spot undervalued investment opportunities. He has become one of the world’s richest men by betting that hidden value will eventually out.