* "Value" recovery comes after 5 years' underperformance
* Value funds back in vogue, still at half pre-crisis levels
* Value vs growth gap second-largest of past decade
By Toni Vorobyova
LONDON, Oct 2 (Reuters) - Europe's cheapest stocks arejoining the equity rally, a move that traditionally marks thebull market's final stage, although the scale of their recentunderperformance means their recovery could take time.
Typically, stock market rallies start with investorssnapping up the most stable, "quality" companies, before movinginto stocks with the best earnings growth prospects. When that trade becomes crowded, they pour into whatever is still cheap,before ceasing to buy altogether.
That final phase has now started: for the past three months,value funds invested in Europe's cheapest large caps haveattracted more money than those buying firms for their growthpotential, according to Morningstar.
After lagging for four of the past five years, value stocks- now touted by JPMorgan, Societe Generale, Nomura and Natixis,among others - have a lot of catching up to do.
On a stock price to earnings basis, the gap between valuestocks and growth shares is among the widest seen in the pastdecade, according to Thomson Reuters Datastream.
"Finally, you have some areas of the market that arebecoming investable again - banks, peripherals. They havemassively underperformed for three or four years because ofeconomic activity in Europe, political uncertainty, etc. Thecatch-up could take a few years," said Emmanuel Cau, equitystrategist at JPMorgan.
Top weights in the MSCI Europe Value Index include bank HSBC, and energy giants BP, Royal Dutch Shell and Total.
While the STOXX Europe 600 trades at 12.6 times next year'sexpected earnings, according to StarMine, HSBC trades at 10.4times, BP at 7.7 times, with Shell and Total both at 8.2 times.
The amount of money invested in European large-cap valueequities was 24 billion euros ($32.49 billion) by the end ofAugust, half as much as five years ago, Morningstar data shows.
"The common theme is catch-up by lagging assets. That's alate-cycle theme," said Christopher Potts, head of economics andstrategy at Cheuvreux. "We're not going to do it in six months.If you're talking about the recovery of value in Europe, it's afive-year idea. It took five years to kill that view and it'sgoing to take years for it to come back."
In 2011, the only other time in the past decade when theprice/earnings gap between growth and value was as wide as it isnow, the broad market retreat started around three months afterthat gap began to close.
That could be an indicator of when the broader market rallymay run out of steam this time although not necessarily. In 2000the gap between growth and value stocks was narrow yet theoverall market downturn did not begin until around five monthsafter the gap began to close.
In the past five years the MSCI Europe Value Index has underperformed growth bynearly a quarter, in the run-up to the 2000 market peak, the gapbetween the two was less than 5 percentage points.
In the current market rally - European stocks rose in 14 ofthe last 16 months and the STOXX Europe 600 index is up byaround a third in that time, trading near five-year highs - thepool of obviously cheap, "deep value" stocks for investors tochoose from has already contracted.
The number of STOXX Europe 600 companies tradingbelow their 10-year average price/earnings ratio has halved toaround 270 over the past two years.
On the flip side, investors' aversion to companies exposedto the economic cycle during recent years has left manywell-established companies with healthy balance sheets tradingat lower valuations than the overall market.
In these cases, the distinction between value and qualitystocks has been blurred.
"The opportunity is not so much in deep value but inrelative valuation within the European equity space, where youhave a lot of cheap cyclicals that you can invest in and benefitfrom the cyclical upturn," said Manu Vandenbulck, seniorinvestment manager at ING Investment Management.
On a sector basis, energy and financials -the biggest weights within the MSCI Europe Value index - lookthe cheapest, followed by utilities and consumer discretionaryshares.
Investors, though, are using additional criteria to filterstocks that are cheap for good reason from those that may beunjustly discounted. ING Investment Management looks atsustainability of dividend payments, for example, while JPMorganprefers firms well placed to ride Europe's economic recovery.
"That is banks, obviously, autos, part of construction, partof consumer cyclicals. So this is what we think has to be played- cheapness but cheapness which is linked to the improvingactivity," said JPMorgan's Cau.
"We don't want to buy value which has no catalyst, becausevalue traps will remain value traps."
- Investment & Company Information