It seems like every financial adviser in the country is advocating for investors to buy equities, which they expect to grow strongly in both the U.S. and Europe, but picking stocks can be difficult. Morgan Stanley (NYSE:MS)’s European equity strategy team headed by Graham Secker has been bullish on stocks since May, and they’ve identified sectors where valuations are more spread out so it should still be possible to find good deals.
“Value is still depressed versus Growth (in terms of long-run performance and valuation),” writes Secker. Cheap stocks have been outperforming expensive stocks for most of the year and low growth has been outperforming high growth stocks since summer.
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Valuation Dispersion: Value propositions in Europe
Morgan Stanley (NYSE:MS) also points out that value’s ROE is rising and that macro trends support value propositions in Europe next year. “However, as we have argued in several recent notes, current levels of valuation in the market increasingly discount the coming EPS recovery,” writes Secker. “We find median valuations to be quite elevated at this point. That complicates the search for stock ideas to play the value theme.”
Looking at valuation dispersion can help in the search for value stocks, since it implies that some stocks may still be under bought. Of course you still have to make sure that the company is financially sound and that it isn’t being avoided because it is poorly positioned or poorly run.
The materials sector is particularly interesting in this regard because it is has the highest valuation dispersion in Europe, and its spread is wider than the historical average. It’s also second highest when looking at dispersion on an industry-by-industry basis. Even if the best quality stocks have already seen their stock prices go up, stocks with lower valuations will gain ground if dispersion returns to the mean.
Similarly, the energy sector appears to have unusually high dispersion, both when stocks are broken down by sector or by industry, and is high relative to history.
Retail, consumer staples, health care, and pharma are some of the other industries or sectors with high valuation dispersion, while the financial sector has the least. That doesn’t mean these sectors are going to grow faster than the rest of the market, but it could be a good place to start for someone interested in stock picking.