LONDON European equities look fairly priced but only because average values are being kept in check by a handful of sectors with poor outlooks, meaning a good deal could be hard to find.
The pan-European benchmark index, the STOXX Europe 600 .STOXX is up a quarter since last June and trading at 12.7 times its companies' expected earnings over the coming year. That is just above the average of the past decade and around three-year highs.
If the low-performing energy, utilities and telecoms sectors are excluded, stocks start to look expensive.
"Europe is not as cheap as the headline numbers suggest," said Mark Hargraves, manager of the AXA Framlington European Fund. "There are two or three sectors where they are materially trading below (historical averages) and quite a number of stocks and sectors are trading considerably above."
Utilities .SX6P face regulatory hurdles and political barriers to raising prices, energy companies .SXEP are battling higher production costs and are at the mercy of global prices and demand for oil. Telecoms, meanwhile, face tough competition, especially in the move to mobile networks .SXKP.
These three sectors have the lowest earnings growth expectations for 2014 among STOXX Europe 600 sectors, according to Thomson Reuters StarMine SmartEstimates, at between 2.7 and 5.9 percent, compared with the index average of 13 percent.
"When I look at those three sectors I am very cautious," Hargraves said. "They are all trading at what superficially looks like ... cheaper multiples, but the challenge there is that you've got a mixture of potential value traps (cheap stocks that may fall further) and earnings uncertainty."
The need to dig deep for bargains is even more acute at the stock level, with 240 of the companies in the STOXX Europe 600 trading above their 10-year average price-earnings ratio, twice as many as a year ago.
Graphic of Europe's P/E: link.reuters.com/hav28s
Sector valuations: link.reuters.com/fub34s
Dividends vs Bund yields: link.reuters.com/xez67t
Expensive blue chips: link.reuters.com/qab78t
Europe's ratios vs history: link.reuters.com/pab78t
The valuation of the market as a whole, meanwhile, reveals that investors are most willing to pay for strong cash flow.
Comparing prices to cash flows - a tangible measure of corporate health in economic dips - suggests the market is slightly expensive against the 10-year average.
By contrast, European equities are cheapest on book value, the price companies put on their assets, which is vulnerable to writedowns. This is especially true of banks .SX7P, where loan books have been hit by borrowers' declining financial health.
The average valuations also mask the fact that the last time the market was at such price ratios, the euro zone economy was in much better shape, posting steady growth rather than shrinking as it did at the start of this year.
"From here, I can't see the multiples expanding too much in a hurry - now it's a case that we need to get profit growth coming through to drive prices higher," said Kevin Lilley, European equities fund manager at Old Mutual AM.
Information technology, industrials and materials have the highest prospects for earnings growth next year, based on StarMine SmartEstimates, which weigh forecasts based on timeliness and on the analysts' accuracy.
However, those sectors offer below-average dividends, potentially missing the criteria of those investors who are turning to equities as an alternative to low bond yields.
Compared with bonds, stocks still offer value. The gap between the STOXX 600 dividend yield and German government bond yields has narrowed slightly in recent months, but at 1.6 percentage points in favour of stocks, shows equities close to their most attractive levels of the past 15 years.
"When you start comparing to where else you could put your money, then equities start to look very attractive," said Lars Kreckel, global equity strategist at Legal & General Investment Management.
(Editing by Simon Jessop, Nigel Stephenson and Anna Willard)