The amorphous sector challenge

The big book Charles Scott picks up from behind his desk "is a very important piece of research because the internet represents a new era for all businesses". Scott, director of European equity research at Morgan Stanley Dean Witter, is talking in his office on London's Canary Wharf, overlooking the Thames. The book, released in June by Scott's firm under the title The European Internet Report, is a 360-page analysis of the impact the internet will have on the European business world.

The report analyzes the growth potential of three groups of corporates in terms of the opportunities that the net offers them. The first group, which includes stocks such as Dutch telecom operator KPN and Finland's telecoms equipment firm Nokia, comprises 11 large companies from technology-related industries such as telecommunications, software and media. The second, featuring some of Europe's best-known companies such as German airline Lufthansa, UK bank Barclays and UK supermarket chain Tesco, comprises 29 stocks from a wide variety of sectors that could boost their profit further through the internet. The third includes a large number of European .com companies that could replicate on the old continent the astonishing boom posted by their American counterparts in the US.

Spanning the sectors

It's more the way the work has been organized than the huge quantity of information and forecasts involved that Scott regards as the main achievement of the research. "The European Internet Report represents a flagship piece of cross-sectoral research, involving complex interaction between 10 different teams of sector analysis," he says. "We believe demand from our clients for research which spans different sectors will only increase in the future, especially in the technology/telecoms/media space".

Arjen Los, research product director at Merrill Lynch's European headquarters in London, shares Scott's view of the future of equity research. "It is getting increasingly difficult to understand which sector some companies belong to. If you take, for example, Alcatel or Siemens, you don't always know how to classify them," he says. "We can always use the old rule: define them as they define themselves. But you increasingly need cross-sector analysis and different skills and types of knowledge to provide a good product."

Gone are the days when the debate between sector and country research dominated the European equity market. With the single currency looming, all the major powerhouses shifted towards the sector approach over the past decade. Morgan Stanley claims to have been the first, in 1991, to organize itself on a pan-European basis along sector lines, while country heads disappeared at Merrill Lynch only during the fourth quarter of last year and now sector heads run the whole European business from their London offices.

And even the biggest European banks, some present in every country with an extensive coverage, are now organized on a matrix basis. At Deutsche Bank the dividing line is size: large-cap companies are followed along sector lines, small and mid caps by country.

At ABN Amro the approach depends on the sector. Twelve industries - autos, chemicals, energy, forest products, IT, technology, media, mining, pharmaceuticals, telecoms, telecom equipment and utilities - are researched along sector lines. The remaining ones, such as banks, insurance, food-retailers and luxury products, are still followed on a country basis, with analysts reporting mainly to the country head and only in a second phase to the sector head. "We think that having analysts based in the country markets adds insight in certain sectors," argues Nigel Hugh-Smith, head of global research at ABN Amro in London. "And you've got a clear example of that right now, with [Italian insurer] Generali bidding for INA. It helps to have someone in Italy that speaks the language, understands the financial structure, regulatory environment and the implications for the Italian financial system to produce the local insight that our clients need.

Not yet a global stock market

The increasing number of intercontinental deals and the emergence of the internet are already pushing the big brokers to the next step: going global. That, in some cases, is already a necessity. "For example, as an European auto analyst, how can you analyze Renault without coverage of Nissan in Tokyo, or DaimlerChrysler if you don't work closely with your counterpart in the United States," wonders John Mueller III, co-director of European equity research at Morgan Stanley headquarters in London.

Merrill Lynch's Los is a bit more cautious and doesn't gloss over the difficulties of the process. "It is undeniably true that global research is the direction for the future, but it will take time," he says. "It doesn't simply mean carrying out different analyses from different parts of the world and compiling them. It is a team-building process that involves making analysts from different countries, with different corporate cultures, meet together, spend some time together and develop a common background. In a few words, we need to do at a higher level what we are doing in Europe."

The delay that's likely before this is achieved is almost welcomed by Los. "If you seriously ask yourselves how many real global investors do actually exist, you would find that they are probably no more than a single-digit number," he says. "And you've got time before global research will become the norm of the market. You want to be slightly ahead of the clients, but not years ahead, because, in the meantime, we are in the business to make some money."

Fund managers, he forecasts, will continue to invest mostly in their home continents for at least five to 10 years before it will be possible to talk about real globalization. In this period, the world will be divided into four macro-areas - Europe, the US, Asia excluding Japan and Japan - where the vast majority of investments will still be domestic.

The several domestic-oriented securities firms that still are at the top of most of our poll's rankings are the more likely victims of this trend.