* "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 are joining the equity rally, a move that traditionally marks the bull market's final stage, although the scale of their recent underperformance means their recovery could take time.
Typically, stock market rallies start with investors snapping up the most stable, "quality" companies, before moving into 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 have attracted more money than those buying firms for their growth potential, 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 value stocks and growth shares is among the widest seen in the past decade, according to Thomson Reuters Datastream.
"Finally, you have some areas of the market that are becoming investable again - banks, peripherals. They have massively underperformed for three or four years because of economic activity in Europe, political uncertainty, etc. The catch-up could take a few years," said Emmanuel Cau, equity strategist 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's expected earnings, according to StarMine, HSBC trades at 10.4 times, BP at 7.7 times, with Shell and Total both at 8.2 times.
The amount of money invested in European large-cap value equities was 24 billion euros ($32.49 billion) by the end of August, half as much as five years ago, Morningstar data shows.
"The common theme is catch-up by lagging assets. That's a late-cycle theme," said Christopher Potts, head of economics and strategy 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 a five-year idea. It took five years to kill that view and it's going to take years for it to come back."
In 2011, the only other time in the past decade when the price/earnings gap between growth and value was as wide as it is now, the broad market retreat started around three months after that gap began to close.
That could be an indicator of when the broader market rally may run out of steam this time although not necessarily. In 2000 the gap between growth and value stocks was narrow yet the overall market downturn did not begin until around five months after the gap began to close.
In the past five years the MSCI Europe Value Index has underperformed growth by nearly a quarter, in the run-up to the 2000 market peak, the gap between the two was less than 5 percentage points.
In the current market rally - European stocks rose in 14 of the last 16 months and the STOXX Europe 600 index is up by around a third in that time, trading near five-year highs - the pool of obviously cheap, "deep value" stocks for investors to choose from has already contracted.
The number of STOXX Europe 600 companies trading below their 10-year average price/earnings ratio has halved to around 270 over the past two years.
On the flip side, investors' aversion to companies exposed to the economic cycle during recent years has left many well-established companies with healthy balance sheets trading at lower valuations than the overall market.
In these cases, the distinction between value and quality stocks has been blurred.
"The opportunity is not so much in deep value but in relative valuation within the European equity space, where you have a lot of cheap cyclicals that you can invest in and benefit from the cyclical upturn," said Manu Vandenbulck, senior investment manager at ING Investment Management.
On a sector basis, energy and financials - the biggest weights within the MSCI Europe Value index - look the cheapest, followed by utilities and consumer discretionary shares.
Investors, though, are using additional criteria to filter stocks that are cheap for good reason from those that may be unjustly discounted. ING Investment Management looks at sustainability of dividend payments, for example, while JPMorgan prefers firms well placed to ride Europe's economic recovery.
"That is banks, obviously, autos, part of construction, part of consumer cyclicals. So this is what we think has to be played - cheapness but cheapness which is linked to the improving activity," said JPMorgan's Cau.
"We don't want to buy value which has no catalyst, because value traps will remain value traps."