Morgan Stanley (NYSE:MS) analysts believe European large cap stocks offer the best risk-reward and now is the time to enhance exposure to these stocks.

Graham Secker and team at Morgan Stanley (NYSE:MS) in their recent report dated May 6, 2014 on “European Strategy” point out large-caps are a significant consensus underweight across both long-only investors and hedge funds.

30-year relative valuation low on P/BV

The Morgan Stanley analysts point out going forward, Euro large-caps offer the most attractive risk-reward across the market thanks to (a) very low relative valuation, (b) a consensus underweight position across long-only and hedge funds investors and (c) potential catalysts in terms of an upturn in large-cap corporate activity and an inflection point in monetary policy.

Looking from the most basic / fundamental valuation metric of P/BV, the analysts point out European large-caps trade at a record low to mid-caps and are only marginally expensive against small-caps. This can be evidenced from the following graph:

30Y low on PBV European Large-caps

European large-caps: Cheap from DY basis too

Graham Secker and team point out European large-caps also look relatively undervalued to other areas of the market on dividend yield, particularly relative to small-caps. Citing an example, the analysts point out large-caps currently yield 0.6% more than mid-caps and 1.1% more than small-caps. The following graph elucidates the analysts’ view:

European Large-caps on DY basis

By computing relative normalized P/E for the various size indices, the analysts observed that large-caps again trade at record valuation lows against both mid- and small-caps. The analysts note on relative normalized P/E, large-caps are as cheap now as they were expensive at their secular peak in 2000. The following graph illustrates large-caps’ record relative low valuation:

Large caps on PE basis

Relative low ROE premium

The Morgan Stanley analysts note as is normal in the early stages of an economic recovery, the use of normalized valuation metrics is also common at this time. Though ROE is currently higher for large-caps than mid- or small-caps, this has been a structural trend in the market over the last 25 years. As highlighted in the following graph, the relative ROE of large-caps is actually very low when compared to that for mid- and particularly small-caps:

European Large-caps Relative low ROE premium

The analysts have also screened for large-cap stocks that offer the most attractive valuations, the best growth outlook and have the most potential to unlock value through more shareholder-friendly activity. The following table depicts the 50 large-cap names meeting these criteria that have the lowest normalized P/E:

European Large-caps with lowest normalized PE