The next stage of the rally in European equities will be far more selective than the last, with many defensive and growth companies better placed to outperform than industrial cyclical stocks, according to Ignis Asset Management.

Head of European equities Adrian Darley believes that many industrial cyclical stocks rose ‘too far too fast' in the recent rally, leaving many valuations stretched against most economic recovery scenarios.

He argues that defensive stocks now offer better prospects for outperformance, with the Ignis European Growth Fund moving from heavily overweight industrial cyclicals to significantly underweight.

The freed-up assets have largely been redeployed into defensive and growth stocks in the pharmaceutical, technology and telecoms sectors.

He says, ‘Not all defensives will outperform but the next stage in the rally will be much more selective. It will not just be about buying the stocks which have fallen furthest.

‘Most industrial cyclical stocks were up 50 to 60 per cent in a short space of time. This was predictable due to very cheap valuations, but the air is now getting thin and with the exception of several mid cap stocks, such as Finmeccanica, Tognum and Scania, there are now better opportunities elsewhere.’

Darley believes pharmaceutical/healthcare companies offer particularly good value in the current climate, with firms such as Fresenius and Roche trading on historically low valuations - 10/11 times 2010 earnings - despite strong long-term growth prospects.

The telecoms sector is another significant overweight for the team, with Darley saying its seven per cent yield and historically high cash flow more than compensates for its negligible growth potential.

Indeed, he suggests that European dividends will continue to support markets and does not believe that shareholder payouts will be cut as extensively as they have been in the UK.

‘European equities are yielding around five per cent and that is very attractive. The yield may come down if markets rally hard again but investors should not be concerned about payouts falling by much,’ he adds.

‘Bear in mind that the market has a high yield despite the fact that European banks, which account for 16 per cent of the market overall, are hardly paying anything at all at present. When you consider that most are likely to resume paying dividends in the next year or two, it's obvious that shareholder payouts are likely to continue to support markets in the years ahead.’

As part of its repositioning, the team has also recently lowered its exposure to banks, in which Darley says the bad loan risk remains high, and raised its exposure to insurance companies where the managers see better valuations and opportunities for upside. The team is also selectively overweight utilities, although Darley says skewing funds towards defensives is not a sign that the team is bearish on markets.

He concludes, ‘Our current positioning reflects the view that many defensives are likely to outperform in the months ahead and there are still great opportunities to add value as long as investors ignore the noise. In fact, to a certain extent, investors should now ignore the negative economic data. At turning points in past market cycles the news flow has rarely been a good indicator of performance, for example, 2003 saw excellent returns for investors who bought equities in March despite the fact that many were selling in response to weak economic news flow.’

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