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by Mani

Morgan Stanley says European markets still remain attractive on a normalized valuation basis, given MSCI Europe's normalized PE is trading at a discount

Europe is set to experience a continued focus on the self-help/restructuring theme for several reasons, including momentum in the pace of corporate activity, notes a Morgan Stanley report.

Krupa Patel and colleagues at Morgan Stanley in their research report dated August 4, 2014, note corporate profitability in Europe appears to be stabilizing which should provide a further boost to management confidence.

Factors aiding self-help theme

According to the Morgan Stanley analysts, there are four reasons coming together to create the continued trend of companies announcing self-help initiatives. For instance, corporate activity in Europe has gathered pace this year, as balance sheets remain strong and cash balances high. Moreover, M&A deal value has also spiked sharply this year, as can be seen in the following graph:

Europe Pick up in M&A activity

The MS analysts also note corporate profitability in Europe appears to be gathering steam and should provide a further boost to corporate management confidence. As set forth in the following graph, the second quarter earnings season has been encouraging so far with most companies returning to positive earnings growth.

Encouraging 2Q

Furthermore, margins too appear to be troughing out. As captured in the following graph, consensus margin expectations are still lagging and hence corporations have some margin headroom to aim for:

Troughing margin

Europe remains attractive

The Morgan Stanley analysts point out that despite Europe's 12-month forward PE being near its 10-year highs, the market still looks attractive on a normalized valuation basis. As can be interpreted from the following graph, MSCI Europe's normalized PE trades at 22% discount to MSCI World, which is also below its historical average:

MSCI Europe looks attractive

The report also highlights that in an environment where corporate management teams are looking to restructure business and enhance efficiency, the areas of the market that offer the greatest potential of unlocked value for shareholders are those where current valuations and/or returns are most depressed.

The Morgan Stanley analysts point out that market has underappreciated self help over the last year, as economic recovery in the euro area gained momentum. They note only 44% of stocks in their list of self help candidates outperformed since they last published their report in September, with less than half the stocks witnessing an increase in their 2014 EPS estimates as against the wider market.

The MS research report provides an updated full list of self-help candidates, based on their definition of self-help as cost cutting, balance sheet repair, portfolio optimization measures, cash flow improvements and changes in management and/or organization structure:

(click to enlarge)

A few of the overweight-rated companies where self-help initiatives are least 'priced in' include Accor SA [EPA:AC] (OTCPK:ACRFY), Delhaize Group (ADR) (NYSE:DEG) [EBR:DELB], Danone SA (ADR) (OTCQX:DANOY) [EPS:BN], Bankia SA [BME:BKIA] (OTCPK:BNKXF), AEGON N.V. (ADR) (NYSE:AEG) [AMS:AGN] and IAG.

In addition, the report highlights the sectors most likely to engage in self-help include Financials, Energy, Telcos, Utilities and Materials.

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Source: European M&A Surges Amid Cheap Valuations