Kevin Parke of MFS examines the success of the group's research driven process and predicts its spread to Europe

At a time when global economic and political turmoil seems to be taking most of the world's stock markets down with it, investors are looking even harder for companies that they think can sustain the earnings momentum they need to carry them through hard times. To help them do this, many investors rely on highly complex systems that measure such factors as price-to-earnings or price-to-book ratios. Or they use computer-generated programs that they hope will tell them the best time to buy or sell a particular stock, or even when to get out of the market altogether. Other investors use 'top-down' systems that start by trying to predict which way the economy and interest rates will move. Then they attempt to select the industries that they think will do well if their economic scenarios play out.

However, we believe that a more fundamental method of selecting stocks gives investors a better chance to find those companies that have the products, management, and financial strength to be market leaders during - and beyond - market downturns. While this 'research-driven' process has already proved its value in US markets, we think it may be even more important in international markets.

In fact, as markets in Europe become more closely linked under a single currency, and as European companies become more and more competitive, fundamental research will become even more valuable in helping to separate the winners from the losers.

Industry fundamentals: In undertaking fundamental research, an investor, analyst, or portfolio manager has to look at all of the forces that can determine the success or failure of companies operating in a particular industry. These fundamentals include:

* The competitive environment: The market may be dominated by a few major players, or the field can be crowded with many companies, all of which are struggling for market share.

* Pricing trends: In some industries, some of the companies have fairly strong 'pricing power,' that is, they can charge what the market will bear and enjoy high profits. In other industries, the buyers have much more control, forcing companies to hold down prices and limit their profit margins.

* The industry's long-term growth prospects: Some companies are fortunate to find themselves operating in new, untapped markets that have the potential for dramatic growth, while others are in mature industries where the market for their products is saturated. For many of these companies, the only way to grow is to take market share from competitors.

* The regulatory environment: In some industries and countries, growth and expansion are limited by government regulation. In other cases, industries are free from excessive regulation and can grow with their markets. The global telecommunications industry is one example of this environment and, in some countries, the electric utility industry is rapidly becoming another example.

Understanding these industry fundamental can help investors overcome much of the conventional wisdom about factors such as the overall economy and how it might affect certain industries. For example, banks and other financial services companies have traditionally performed better when interest rates were falling and did not do so well when rates were rising. This is the approach many top-down investors have used to decide when to get in and out of financial services stocks. But in 1996, something unexpected happened: Interest rates moved up and the financial services stocks outperformed many other sectors. A couple of developments that top-down investors often miss contributed to this phenomenon. First, the banking industry had done a much better job of getting its costs under control and, second, the banks had adjusted their business mix to focus more on consumer loans and less on less-profitable and potentially riskier commercial loans. This helped them avoid many of the problems that higher interest rates can cause.

Company fundamentals: While industry fundamentals are important, company fundamentals also play a significant role in the research process. These fundamentals include:

* The company's market share: This includes current market share, but so are any changes in that share - and the reasons for those changes.

* The quality of the company's products: Again, any changes in product quality must be closely monitored.

* The quality and experience of the company's management team.

* The position of the company's products in the marketplace: It can make a big difference if the company is the leader in its market or if it is the third, fourth, or even fifth player in the group.

* The company's financial condition: The strength of the company's balance sheet, or the amount of debt in relation to its equity, should be examined closely. Also, some companies do a much better job of generating 'free cash', that is, the cash they have at their disposal after meeting all other expenditures such as building new facilities and paying shareholder dividends. Companies that have substantial amounts of free cash have more options to increase value for shareholders. They can, for example, invest more money in their businesses, make acquisitions that add to returns, or buy back outstanding shares.

Getting the information: There are a number of ways for investors to get the information they need on industry and company trends. One of the most common is to subscribe to and read reports from outside securities analysts. These reports, prepared by major brokerages and investment banks, can be thorough and, often, quite useful. However, we believe in the value of doing our own research. This means, first of all, constantly meeting with companies, either in our offices or at their plants and facilities wherever they may be around the world. When they're not meeting with company officials, our analysts are on the phone, keeping in touch with their contacts in those companies, but also talking to their competitors, suppliers, distributors, and, if their products are sold to the public, the retailers who watch those products move - or not move - off their shelves.

One-on-one meetings with company managers are not only the best way to learn what's going on in a company, it's also the best way for an analyst to become an expert in his or her industry. If a pharmaceutical analyst spends almost all of his or her time talking to drug companies and their customers, for example, they are more likely to quickly become experts in that industry and to be able to understand the possible impact a new drug might have on the industry and the company introducing the drug.

Personal meetings with executives can also help an analyst spot potential trouble. For instance, if a CEO gives an answer to a question in one meeting, but gives a different answer to the same question a few months later, it may be a sign that the company doesn't have a clear focus for the future or the executive is trying to hide something. In any case, it raises a red flag for the analyst.

Translating research globally: In an ideal investment world, all of these techniques could be applied in any country, in any market. But that isn't possible. For one thing, many non-US companies simply do not release nearly as much information as their US counterparts, and the information they do give out may be released weeks, if not months, after the end of the reporting period. And, if a company is a conglomerate made up of several divisions, the company may not break out operating results for each division but, rather, only provide data for the entire company. There are, of course, some historic reasons for the reticence of many non-U.S. companies to bare their financial souls to the world. In some other markets around the world, companies have not had to rely on the equity markets as a source of funding. They have tended to rely more on banks. So, companies are often hesitant to share what they view as confidential or important information because they feel if they share it with a broker or an analyst or someone else, that their competitors may quickly get that information and use it to the company's disadvantage. However, more companies are learning that if analysts or money managers do have more information, they may be less likely to sell the stock during a period of market volatility, if they know that individual company's overall financial situation is sound.

This situation is rapidly improving, particularly with many of the European-based pharmaceutical and consumer-products companies that compete globally for customers and investors. In the future, it can be expected to improve even more as many European countries with pay-as-you go pension systems look for way to achieve higher investment returns, and as individuals are encouraged to do more saving and investing for their own retirements. As this scenario unfolds, more and more people can be expected to become investors, rather than savers, and to seek more information from publicly listed companies.

Even with these improvements, it would seem that the only way to cover all the global markets is to have an analyst for each industry in each country. But that isn't necessary. In many industries, such as automobiles, pharmaceuticals, oil and gas, chemicals, and steel, almost all the major companies are international competitors within their respective industries. So an analyst who follows the US auto industry, for example, must be familiar with the products and management of all the world's major car companies, not those auto companies in the US. An auto analyst based in Boston, New York, or Detroit can probably keep up with developments in that industry as well as one in London, Paris, Frankfurt or Tokyo.

Analysts needed 'On the ground' Other industries, however, are more locally oriented and require analysts 'on the ground' in or near the countries in which they operate. In these cases, stocks are much more impacted by what is happening in the local market, including such factors as consumer confidence, interest rates, and the overall economic situation. For this reason, MFS has offices in London, Singapore, and Tokyo to help provide coverage of businesses like retailing or financial services.

No matter where they are based, the current lack of timely information from many overseas companies requires some extra work by every analyst. Because many companies do not break out operating results for their separate divisions or subsidiaries, for example, a research analyst must develop his or her own contacts within each of those subsidiaries and, to the extent company policy allows it, find out the subsidiaries' goals for themselves and try to see if those goals are being met. The analyst must also keep in touch with each subsidiaries' competitors, suppliers, and customers in an attempt to pick up any additional insights. This can give an analyst some idea as to whether a particular division is picking up or losing market share, or whether they're being aggressive in satisfying the customers' needs.

While this is very similar to the research process in the United States, its importance is magnified in those countries where there is a paucity of good and timely information from the companies themselves. In fact, for investment companies such as MFS, this fundamental, bottom-up research process can be a great advantage in these markets because it provides the most complete, up-to-date information, and often provides it before other investors have access to it.

This does not mean that MFS analysts totally ignore what's happening in countries or broad industries. However, it does mean that an analyst can pay more attention to the industry than to the country in which it is based. In the past, for example, an investor considering a bank in Europe not only had to understand the risk of investing in that bank, but also the potential currency risks that could affect returns. But with the movement toward a single European currency, the currency risk is greatly diminished. Now, an investor who wants to have a certain amount invested in banks can just look for the best banks, irrespective of their location in Euroland. This also gives an advantage to investors who follow a bottom-up, research-driven discipline that looks for good companies in strong industries, rather than trying to predict which markets may or may not be attractive at any given time.

The common currency will also make comparisons among similar companies across Europe much easier. We believe the euro will make those companies much more efficient in how they operate and force them to be more competitive than they may have been in the past. Eventually, they will no longer have many of the tariffs and other barriers to entry that kept companies from other countries at bay. This should lead to more consolidation and a drive towards more efficiency. Also, as companies realise that certain parts of their businesses are underperforming or are not competitive, some of those divisions may be sold or reduced in scope. This will let the companies concentrate on those core business in which they are most competitive on a worldwide basis.

Here again, it will be fundamental research that will help investors find those companies doing the best job of restructuring and creating long-term value for shareholders.

Kevin Parke is an executive vice president, chief equity officer, and director of equity research of MFS Investment Management

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