August 27, 2013 / 2:57 PM / in 4 years

Investors must dig deep for Europe stock bargains

* Stocks rally makes finding “hidden gems” more difficult

* SG only sees 26 deep-value stocks versus 145 in May 2012

* Scarcity of bargains seen as negative signal for market

By Blaise Robinson

PARIS, Aug 27 (Reuters) - Investors hunting for stock bargains as the euro zone emerges from recession have few to choose from after a 15-month rally that has yet to be backed up by a recovery in profitability.

Improving economic data and central banks’ massive liquidity have mostly driven that rally, but earnings in Europe have yet to justify the gains, leaving them far from secure.

The STOXX Europe 600 has surged 30 percent since May 2012, while the euro zone blue-chip index has jumped 38 percent over the same period.

The broad-based rally does not mean there are no valuation bargains, or “deep-value” stocks left - some shares in the energy and basic resources sectors remain cheap on concern over Chinese growth - but the pool of available targets has shrunk, analysts said.

“Easy picking has disappeared,” Societe Generale global quantitative strategist Andrew Lapthorne said. “Normally, at the start of a cyclically oriented rally, you would have quite a lot of ‘value’ opportunities. We don’t have that at the moment.”

“Deep-value stocks” trade at a significant discount to their intrinsic value, for instance below their book value or at a negative enterprise value with a cash position greater than the market value.

The lack of such shares suggests equity markets have got ahead of themselves this time in pricing in economic recovery, partly because an abundance of liquidity from central bank stimulus has encouraged investment in stocks.

Lapthorne said that raises concern about equities’ prospects in the coming months given that analysts are still trimming their earnings forecasts.

“These are not valuation levels you typically see in a cycle trough, so people should be cautious about the market at this point,” said David Thebault, head of quantitative sales trading at Global Equities.

“We need to see real improvement in companies’ balance sheets first to really confirm the economic recovery.”

At the height of the euro zone debt crisis in mid-2011, there were “hundreds” of deep-value stocks in the MSCI World index, and even in May 2012 there were 145, according to SocGen’s quantitative analysis team.

It now sees only 26 deep-value stocks in the MSCI World index, of which seven are in the euro zone, including oil firm OMV, potash miner K+S and chemicals group BASF. Oil major Royal Dutch Shell is also on SocGen’s list.

The number of deep value opportunities in Europe might soon shrink even further. BNP Paribas analysts say flow data shows investors have been scooping up shares in telecom and basic resources companies over the past few weeks.

Filtering stock picks for deep value is a strategy widely employed by quantitative funds and desks at investment banks. Other metrics used in assessing such value include dividend yields and price-to-earnings ratios.

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Earnings momentum: link.reuters.com/xuv52v

Price-to-book ratios: link.reuters.com/qyv52v

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“Expectations are that the global economic healing is starting to happen, which indeed has reduced the number of deep-value opportunities,” said Steve Dean, director of strategy and analysis at AXA Rosenberg, a unit of AXA Investment Managers which specialises in quantitative analysis.

Most European companies posted in-line or better-than-expected second-quarter earnings. However, in absolute terms, or when compared with previous earnings, profits at STOXX Europe 600 companies are down 6.6 percent from the second-quarter of 2012, and down 2.7 percent versus the first quarter of this year, Thomson Reuters Datastream data shows.

And equity analysts continue to cut their forecasts, with the STOXX Europe 600’s earnings momentum - analyst upgrades minus downgrades as a percentage of the total - at minus 3.

“What we see now is that a lot of the potential economic recovery has been priced in already, and I don’t really think you’re going to make a ludicrous amount of difference to your profitability if the economy delivers real GDP growth of 1 percent instead of 0.5 percent,” SocGen’s Lapthorne said. (Additional reporting by Alexandre Boksenbaum-Granier, graphics by Blaise Robinson; Editing by Nigel Stephenson and Susan Fenton)

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