Morgan Stanley Europe analysts Matthew Garman, Graham Secker, Krupa Patel and Hanyi Lim take a shine to the neglected and oversold Energy and Mining sectors in their March 31, 2014 research note on European equity strategy.

“While macro fundamentals in EM remain largely bearish, the low valuations and depressed sentiment mean the outlook for related sectors is now more attractive than it has been for some time,” say the analysts, referring to commodity sectors such as energy and materials.

European commodity plays may benefit from improvement in EM fortunes

They point out that earnings disappointments and valuation de-ratings have driven sector valuations to 25 year lows, and that there is little scope for further devaluation. These sectors, which are EM-related plays, may now benefit from positive news out of EM such as slowing outflows, and the recent appreciation in EM FX despite the rise in US yields.

1-em-exposed stocks valuations European Mining

The analysts point out that the EM account for 50% of revenues of European Energy and Materials sectors, resulting in the close correlation between the underperformance in these sectors and the EM growth environment.

“The sheer consistency of the downward trend has been remarkable,” say the analysts, referring to the 23% underperformance of the energy and materials sectors opposite the wider market. “The commodity sectors combined have not seen a single 5% relative counter-trend rally at any point in that period.”

2-commodity – underperformance European Mining

Deteriorating fundamentals

The sectors have suffered negative earnings reports as well as falling ROEs (currently at 10-year lows). The market has not hesitated in de-rating sector valuations, more so as even dividends are not covered by current levels of free cash flow.

But de-rating may be done for now

“Although there is a risk of further underperformance from the commodity sectors due to additional downward pressure on earnings, we see little scope for further de-rating from current levels,” observe the analysts.

The analysts point out that Europe’s energy and mining sectors rule at 25 year relative lows on P/BV, and that the energy sector has been cheaper relative to the market only 17% of the time historically when assessed on a range of metrics.

3-mining – oil – historical Pbv lows European Mining

Mining stocks in the limelight

Last week, mining stocks in Europe were in the limelight on expectations that the Chinese central bank may launch stimulus measures following weak economic data. Comments from an ECB governing Council member also ignited hopes for a stimulus program in the Euro zone.

Earlier today, BHP Billiton Limited (ADR) (NYSE:BHP) announced that it was weighing a number of options to restructure its business, saying that “the simplification of our portfolio is a priority and is something we have pursued for several years… We continue to actively study the next phase of simplification, including structural options, but will only pursue options that maximise value for BHP Billiton shareholders.” The news lifted mining stocks and the FTSE today.

Oil and mining fundamentals changing

“Although it is not clear that the relative profitability of the commodity sectors has yet troughed, there is evidence of key incremental improvements for both the miners (where FCF is likely to turn positive in 2014) and integrated oil (where there is increasing evidence of management starting to address the pressures on both cash flows and returns on capital),” says the Morgan Stanley research note.

Upgrades

In their European model portfolio, Morgan Stanley elevates the rating of the Energy sector to Overweight and that of Mining to Equal Weight.