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The 2001 All-Europe Research Team

As an American-style equity culture takes greater hold in Europe, so do concerns about the integrity of investment research.

As an American-style equity culture takes greater hold in Europe, so do concerns about the integrity of investment research.

By Justin Schack
February 2001
Institutional Investor Magazine

As an American-style equity culture takes greater hold in Europe, so do concerns about the integrity of investment research.

On December 5, Orange, the wireless subsidiary of France Telecom, hosted more than 100 securities analysts from investment banks all over Europe at a briefing on its highly anticipated initial stock offering. At first the event looked to be a landmark for Continental investor relations. Equity analysts commonly write preoffering research in Europe, but those from firms that aren,t underwriters are typically excluded from such gatherings. This time Orange invited just about everyone with a passing interest in the IPO, slated for this month.

The London meeting quickly became a flash point of controversy. Orange demanded that attending analysts sign waivers giving its lead bankers the right to vet any research based on information disclosed during the meeting and, according to one person who saw the document, "to amend or correct anything with which they disagree." Orange and its joint global coordinators , Dresdner Kleinwort Wasserstein, Morgan Stanley Dean Witter and SG Securities , say they only wanted to avoid potential lawsuits should the IPO flop and stock buyers charge that the company had helped prepare misleading research.

But investors and securities firms throughout Europe were outraged. Their view: Orange just wanted to censor any negative comments that might hinder the success of the offering, which is expected to raise between E7 billion and E10 billion.

"Our members were very concerned about analysts being put into the position of having to choose between receiving information with restrictions placed on what they could do with it and not receiving any information at all," says Peter Montagnon, head of investment affairs for the Association of British Insurers, which has more than 400 members managing a combined £1.1 trillion ($1.62 trillion) in assets. "There is a great deal of anxiety about the relationship between the company, the syndicate and the lawyers, and concern generally about the independence of research. Somewhere across the line someone's gotten a bit too zealous."

The Orange brouhaha hardly marked the first time an issuer demanded the right to review and alter research reports. France Telecom insisted on similar rules for its own IPO in 1997 and for that of its Internet service provider, Wanadoo, last July. Analysts say that Interbrew, a Belgian beverages concern, asked researchers to sign a similar pact when it was preparing for its December offering. And about one year ago, several analysts reportedly stormed out of a pre-IPO presentation by Stepstone, a Norwegian online employment agency, claiming the company wanted to censor their comments.

Analysts in Europe and in the U.S., where pre-IPO research reports are avoided, have routinely run their numbers and projections by company management to ensure their accuracy. That practice, however, is ending in the U.S. following the introduction of new fair-disclosure rules, known as Regulation FD, which require that material information about public companies be made available to all investors at the same time.

But the Orange incident struck a raw nerve with investors because of the stark way it underscored a growing concern about the all-too-cozy relationship between research analysts and their firms, banking clients. That concern was only heightened during last year's wretched markets, when many, if not most, analyst recommendations misfired even as investment banks hustled to bring new clients, especially technology companies, to market.

Research practices in Europe have changed dramatically over the past few years, spurred by the advent of a single currency, which has created a pan-European investing climate, as well as the Continentwide movement toward pension reform, which has helped undergird a nascent equity culture. Most of the changes, which parallel those in U.S. markets in recent years, are decidedly for the better. Companies, eager to gain greater access to equity capital, are disclosing more material information to investors. Money management firms are building their own research staffs, paying greater attention to execution costs and demanding more customized, value-added analysis from the sell side.

But just as in the U.S., investors in Europe are increasingly worried that the independence of sell-side analysts is becoming compromised by their firms, investment banking relationships with the companies they cover. Balancing such conflicts is tricky. With deal flow and interest in equities rising, Europe,s analysts have more constituencies to please than ever , institutional and corporate clients, retail investors and comment-hungry media outlets among them , and precious little time or leeway to conduct the independent research investors want.

To be sure, Europeans are not yet as jaded as their American counterparts. When this magazine asked U.S. institutions last year to rate the overall quality of sell-side research, they responded with resounding criticism (Institutional Investor, October 2000): Forty-four percent said that the quality of sell-side research had declined in the previous 12 months, compared with only 6 percent who said it had improved. Half believed it stayed the same. On a scale of 1 to 10, investors said brokerage firm research rated a 5.9. We asked the same questions of European investors as part of the process of compiling the 2001 All-Europe Research Team. The result? More Europeans (27 percent) thought the quality of research had improved during the past 12 months than thought it had declined (24 percent), and the work of the sell side received a 6.5 rating.

Still, European investors do have serious concerns. Forty percent say they use research boutiques or other sources of investment analysis as alternatives to brokerage firms. Sixty percent have increased the size of their in-house research departments during the past 12 months. When asked to rate on a scale of 1 to 10 the extent to which corporate finance work creates a conflict of interest for sell-side analysts, investors gave an average response of 7.7, a strong degree of skepticism about researchers, objectivity.

Who can blame the investors for a little sour grapes? Last year saw one IPO after another emerge highly touted by analysts working for the underwriting firms, only to plunge when the Internet bubble burst. There is a horror story associated with just about every underwriter. Credit Suisse First Boston took U.K. online auctioneer public in October 1999 at 65 pence per share and three months later initiated coverage with a "buy" rating and 12-month price target of 567p, only to see the shares fall to their recent price of about 15p. Morgan Stanley's analysts touted shares of British e-tailer and IPO client, which have fallen from their March 14 offering price of 380p to about 80p. Goldman Sachs International researchers still smart from their fiasco with Internet portal World Online International, which the firm took public last March. The shares, issued at E43, within weeks plummeted to the low teens after reports that its then-chairwoman was found to have sold most of her stake in the company before the IPO.

"A lot of the Internet deals have been almost scandalous, really," says Simon Fraser, chief investment officer for Fidelity Investments in London. "If an investment bank is doing a deal for a company, it creates certain conflicts in terms of their view on a stock price. We,ve been at this long enough to know we,ve got to do the work ourselves."

Admonishes Ewen Cameron Watt, head of investment strategy and research for Merrill Lynch Investment Managers in London: "If a buy-side professional relies solely on the recommendations of a sell-side analyst, he or she deserves exactly what they get."

Clearly, the beating taken by investors in European stock markets last year left a bitter taste. The benchmark FTSE 100 index of U.K. shares was down 7 percent. The pan-European Dow Jones Stoxx 50 index declined by a more modest 2 percent, but the once white-hot technology, media and telecommunications sectors flamed out. Germany's Neuer Markt closed the year off a stunning 41 percent, and London's techMARK plummeted 30 percent. When hot IPOs helped boost funds, performance records during the late 1990s, buyers were most concerned with getting the biggest piece possible of each deal. Now the new-issues market bedevils investors, some of whom made their initial forays into pan-European stocks during the past few years.

"It's not too hard to understand why people are frustrated with sell-side research," says John Mueller, director of European research for Morgan Stanley in London. "In 1999 stocks soared, recommendations were working, and performance was good. Last year reflected an inflection point, and the collective question is how we all could have missed it."

Nonetheless, as the following pages reveal, investors still believe that much good work is being done by individual analysts and by research teams. The most noteworthy aspect of the 2001 results is the stunning resurgence of European firms, led by Credit Suisse First Boston, which vaults to first from fourth in 2000. Aided by an extensive restructuring of its research department (which is run out of New York), CSFB nosed out , by one team member , Merrill Lynch, which had held the No. 1 spot since 1999. Deutsche Bank, improving its number of ranked analysts by more than half, jumps from fifth place to round out the top three. UBS Warburg, with five fewer ranked teams than last year, falls from third to fourth place. In another notable move, newly merged Schroder Salomon Smith Barney rises from a distant seventh to sixth place , just one ranked team member behind fifth-place Morgan Stanley.

Perhaps not so coincidentally, two of the firms that declined in the rankings, Morgan Stanley (which falls from second to fifth) and Goldman Sachs International (which falls from sixth to seventh), are among the most frequently criticized by both investors and competitors , fairly or not , for their heavy focus on investment banking relationships.

REGARDLESS OF WHERE THEY are headquartered or how well they fare in the rankings, all research departments are grappling with how to balance the interests of the two major constituencies that fund their existence , institutional investors and corporate issuers.

The conflict is less pronounced in Europe than it has become in the U.S., where sell recommendations have all but disappeared. Indeed, on January 9, six of the 11 stocks discussed by analysts during the morning call at Schroder Salomon were assigned ratings of 3 or worse on a 1 to 5 scale, with 1 representing the most favorable rating. Schroder Salomon research co-heads Richard Dale and Michael Crawshaw say that 10 to 15 percent of their coverage list at any given time is rated 4 or 5. This percentage, of course, varies from firm to firm, but is generally higher in Europe than in the U.S.

Schroder Salomon mining analyst Fiona Perrott-Humphrey even initiated coverage in September with a neutral recommendation on U.K. mining concern Billiton, although her firm was one of three banks coordinating a £1 billion secondary equity offering for the company. "Fiona was uncomfortable about the assets being acquired by Billiton and with the company's level of gearing [debt versus equity]," recalls Crawshaw. "We said, ,What do we do?, It was a very hectic two or three days. We told Billiton about Fiona,s reservations, and they weren,t really happy at first, but we went ahead with our honest view of the positives and negatives. We wound up outselling other members of the syndicate, and Billiton in the end thought we did a great job."

Senior bankers and research managers at Schroder Salomon have just completed an extensive review of their client and coverage lists, with the aim of identifying opportunities for bankers to go after fees without analysts feeling pressure to change established negative views on a company. "This way, if research is on record as negative over the long term for a company, the corporate finance guys have no basis for trying to push out an analyst or get him to change his opinion so that they can get business from a company," says Crawshaw.

Similarly, CSFB recently began holding regular sector review meetings so that analysts can tell investment bankers where they stand on various companies and let them know ahead of time about downgrades or initiations of coverage with neutral or sell ratings. Analysts also have the power to veto deals they think would be bad for institutional clients. Still, managing the relationships isn,t easy. "Analysts will get a lot of pressure from the bankers. And getting it right this year has been particularly hard, especially in technology, where it's more difficult to understand the industries, value fast-growing companies and resist the banking pressures," says David Mathers, head of European research. But CSFB says it has turned down seven deals in the past year on the advice of its analysts.

Other firms say that having a large retail distribution network or a strong institutional sales and trading business can act as a check on analysts selling out to bankers. Charles Lambert, co-head of global equity research at Merrill, notes that his firm's secondary markets business in Europe is bigger than that in the U.S. "If an analyst puts a valuation on a stock that he doesn,t believe in just to appease the investment bankers, it will catch up with him," he says. "His credibility will be damaged permanently."

For all the concern, a number of changes may soon force even the most deal-crazed stock picker to spend more time kicking tires than pitching deals. Sell-side officials and investors alike agree that regulations encouraging wide, full disclosure of company information to investors , much like Regulation FD in the U.S. , eventually will be implemented across the Continent.

Already the Commission des Operations de Bourse, the agency that oversees securities regulation in France, has condemned Orange for releasing important financial information about its IPO to a select group of analysts rather than to the public at large, even though Orange invited a broader group than usual to its pre-IPO briefing. And some firms, mindful of the public relations damage inflicted by the Orange incident, are encouraging their clients not to repeat the same mistake. "We have clients coming to us and saying, ,How do we avoid this kind of mess when we go public?," says CSFB's Mathers. "And our answer is simple. We just say, ,Don,t do what they did.,"

The move to a Reg FD,like environment throughout Europe (strong selective-disclosure rules have been in place since 1997 in the U.K., but regulation on the Continent generally is less strict) will put the onus on analysts to delve behind the numbers provided by management. Analysts will have to judge a company,s prospects by talking to its suppliers, competitors, customers and line managers, rather than relying solely on the official company spin. This type of regulatory environment, combined with a return to sanity in the new-issues market now that the technology bubble is out of air, may go a long way toward easing investor concerns about the integrity of research.

In the meantime, to be sure, some argue that working closely on corporate finance business gives analysts an information advantage in assessing a company,s prospects. "I,ve been in this business for 15 years, and I never once apologized to a client for being one of the top underwriters," says Morgan Stanley,s Mueller, who served as an institutional sales executive in the U.S. before moving to London in the fall of 1999.

Institutional investors aren,t waiting for the sell side to reform. Fidelity, Merrill, Franklin Templeton Group and the Capital Group continue to build their own research departments. Research at these firms is now seen as a career path rather than as a stepping-stone to a portfolio management job. And the job of valuing stocks and making a buy or sell decision increasingly is being handled internally.

Some investment managers have turned to the growing number of stand-alone research outfits that are unaffiliated with brokerage or banking arms. Most of these specialize in macroeconomic analysis. An exception is Arete Research, a technology research firm founded one year ago by Richard Kramer, who from 1997 to 2000 was the top telecommunications equipment analyst in this magazine's poll. Kramer left Goldman Sachs with two colleagues because, he says, marketing to institutional clients and helping bankers with deals took too much of his time away from fundamental research. Kramer predicts that more sell-side researchers will follow his lead.

"There is such a huge demand for research, but analysts at investment banks are too busy doing other things to provide it," says Kramer. "Over time there will be a constellation of independent research firms like ours doing the kind of research that is largely absent from traditional investment banking environments. Sell-side research will be folded into the investment banking departments, which will dispense once and for all with the pretense of objectivity."

One way or another, the role of sell-side research is changing. Bigger buy-side departments mean more, not less, work for investment bank researchers. Even if they are doing more of the valuations and recommendations on their own, buy-side analysts will still rely on their sell-side counterparts for in-depth looks at a particular industry sector or extensive data screening and scenario projections involving changes in commodity prices or interest rates.

Such customized, or "bespoke," research is on the rise in Europe , and globally. These special assignments run the gamut from lending out financial models and raw data that a sell-side firm doesn,t publish to spending, say, a week producing a report on the state of e-commerce in a given industry. The brokerage provides a client with information and broad-based conclusions but does not issue or change existing recommendations or price targets. Deutsche Bank, for instance, recently prepared a report for an institutional client on the pay packages of CEOs at major companies across Europe, highlighting whether compensation was weighted toward cash or options. "Increasingly, it's that kind of information that helps a fund manager make up his mind about buying, selling or holding a particular stock," says Nimrod Schwarzmann, head of European research at Deutsche Bank. "Bespoke research is critical for us and our client base."

Also forcing change is the spread of global investing. Not too long ago, many institutions for the first time began to put their money in pan-European stocks instead of domestic equities or debt instruments. Now that trend is being eclipsed by a movement toward investing in equities according to global industry sectors. The biggest institutions have been aligning their businesses this way for several years. And many smaller investors in continental Europe are moving to a global model, skipping the pan-European stage altogether.

For sell-side firms, this means that the pan-European product they spent years developing must be fit into a global framework. Teaming up not only with other European analysts, but also with researchers following the same sector in other parts of the world, has become critical. "The biggest issue for us during the past 12 months has been globalization," says Jeremy Allen, deputy head of European research at Dresdner Kleinwort Wasserstein in London. "More and more of our clients are now investing on a global basis. Even those that aren,t still want global research, because a company in Europe or Asia may be greatly affected by developments in America or elsewhere."

Contending with these changes means that European analysts and their bosses are now increasingly confronted by an issue that long has faced their U.S. counterparts: burnout. Exhaustion leads to poor-quality work and to turnover, as sell-side veterans change careers in search of less stress and more autonomy. Not that defectors are devoting their lives to charity. "At the end of the day," says Merrill's Lambert, "the people leaving the sell side are looking at their cash flow, and they haven,t gone on to be nuns, priests and teachers. They,ve tended to trade down to second-rate brokers, where there isn,t so much deal activity."

Most European research directors, fresh from year-end employee reviews and feedback sessions, now speak of burnout and lifestyle issues as foremost among their analysts, concerns. And they are responding with a bevy of programs and perks to keep overburdened researchers happy. Merrill, for instance, last year hired a full-time trainer to teach young analysts skills such as headline writing and oral presentations. And all firms are placing a greater emphasis on teamwork, more evenly dividing the labor of covering a pan-European sector , such as calling institutional clients with updates , among all members of the team.

Then there are little perks to boost morale. After analysts complained at an off-site retreat that they were wasting hours in traffic when traveling to Heathrow, CSFB enlisted the services of a motorcycle livery company that gets researchers from the firm,s Canary Wharf offices to the airport in a remarkable 35 minutes. Schroder Salomon, borrowing from Silicon Valley workplace culture, installed a foosball (they call it "table football" in London) table on its research floor. More than 100 teams now compete in an intramural league. "It's nice when you,re waiting around at 9:00 at night for curry to have a way to wind down a bit," says research co-head Dale. Last year the firm went as far as to enroll an analyst who complained of job-related exhaustion (officials decline to specify who) in a course on how to balance work and one,s personal life.

A better market wouldn,t hurt, either.

The 2001 All-Europe Research Team ranking results are now available in the Research & Rankings section of this site.