If Barclays Bank is correct, a relative value trader’s dream could be setting up between European and US mid-cap stocks.

European Mid-Caps Barclays Aug 2014 relative value

European mid-caps under-performed similar US stocks

In a research note today, the bank noted that performance of European mid-caps (minus UK stocks) has significantly under-performed similar US stocks. In fact the gap in value between the two is the largest since January of 1995.

European Mid-Caps vs UK US

The reason for this divergence of value is due to earnings of European companies.  “The reason for the under-performance of mid-caps in Europe appears to be clear,” the report says. “While UK mid-cap stocks have delivered strong earnings growth over the past few years, European mid-caps saw earnings collapse between 2011 and 2013.”

European Mid-Caps

The question for traders is can European mid-cap stocks play catch up. Barclays speculates the answer is “yes.”

While “valuations look full” and forthcoming earnings growth “might not be sufficient to generate out-performance, the under-performance of mid-caps is starting to end and recent growth has been stronger,” the report noted.

European Mid-Caps Barclays Aug 2014 actual stock picks

European mid-caps recommendation

Barclays makes specific stock recommendations based on the assumption that earnings for European mid-caps recovers.  At a macro level, on a valuation basis the firm recommends materials and financial sectors where an earnings recovery could deliver the largest potential upside.  Among their picks across all sectors are Alcatel Lucent SA (ADR) (NYSE:ALU) (EPA:ALU), Gjensidige Forsikring ASA (FRA:XGJ) (OTCMKTS:GJNSY), KUKA AG (FRA:KU2) (OTCMKTS:KUKAY), Ryanair Holdings plc (ADR) (NASDAQ:RYAAY) (LON:RYA) and Technip (EPA:TEC) (OTCMKTS:TKPPY).

“Earnings appear to have reached a bottom in 2013 and have shown strong signs of improvement this year,” the letter noted.

European Mid-caps Barclays Aug 2014 mid vs big cap

European mid-caps’ relative valuations are nearing the lows of 2007 and 2011

Despite the weak performance of European mid-caps, the report points out weak fundamentals’ mean relative valuations are nearing the lows of 2007 and 2011. “Looking at the implications of dividend yields for future returns in European mid-caps, current levels of relative dividend yields have, in the past, led to mid-caps performing in line with large caps.”

European Mid-caps Barclays Aug 2014 location

European Mid-Caps earnings 2011

While the outlook took a bullish tone, it was not all rosy.  Certain numbers have Barclays analysts Joao Toniato, Ian Scott, Dennis Jose and Jason Hart on Barclays London equities desk concerned. “Eurozone industrial production numbers have in the past been a good indicator of earnings growth for European mid-caps,” they write. “And after a recovery in late 2013 and early 2014 industrial production growth has stalled. To have greater confidence that the mid-cap earnings recovery will materialize we would need to see eurozone industrial production returning to growth in the second half of the year.”

European Mid-Caps industrials