Cazenove European Equity manager Chris Rice thinks that despite a sharp rally in European equities since the summer, the market still looks ‘crazily cheap’ compared to the US.

Rice also tips large cap value stocks to continue their run as the best performing sector in the market for a while longer, but thinks a modest correction of between five and 10% is due in the near future.

‘Despite what has happened in Europe recently, you can hardly see the rally and it is still too early to start buying into growth stocks,' Rice told Citywire Selection. 'We expect large cap value to be the best performer in the next setback.’

He added: ‘A pause is overdue. We expect value to stay ahead of security if Europe continues to outperform the US in 2013. If corporate profitability continues to hold and volatility remains low, Europe’s second half rally should continue.’

Recycling into defensive 'stodge'

Rice has been taking profits on his cyclical winners of the past six months and is gradually moving back into what he terms as more defensive large cap ‘stodge’.

The move has seen him go from an underweight in oil to an overweight, with French oil giant Total and Italian peer ENI representing key holdings. Deutsche Telekom now represents the largest overweight position in the fund.

‘We have not gone long on defensives yet but are starting to move back towards things that have been relatively derated and we are keeping beta just above 1.’

With a keen focus on where stocks are in the business cycle, Rice is looking to stick with companies that are trading at below 20x earnings and took the portfolio overweight on cyclicals last August with a number of selective quality growth stocks increased.

In the top 10 positions, quality growth stocks include third largest holding and long-term favourite Campari, French media giant Publicis and chemicals and cosmetics group Henkel.

Rice likes Henkel as it is ‘not as aggressively priced as L’Oréal’ and he stresses that despite strong runs, many of his other core quality growth holdings are still not too expensive, despite strong reratings in the second half of 2012.

‘BIC was at 12x earnings and it is now at 16x and SAP is trading at 18x earnings.’

Luxury goods group LVMH was added to the portfolio recently. Despite concerns over a marked decline in the consumption of luxury goods across much of Asia, Rice is not too concerned about the stock, which is trading at around 17x earnings.

‘There is no doubt that demand for luxury has gone down. Goods such as cars and luxury products are classic “wall of worry” stocks that people often fear can’t keep going.

‘The price to earnings ratios of [fund holdings] VW and BMW have got down to four, but these companies are still seeing 25%-30% annual growth in Chinese sales.’

Nevertheless, Rice has been slowly taking profits on both stocks, and has been adding to tyre stocks Pirelli, Michelin and Continental, which he believes have fallen to inexpensive valuations.

‘I don’t think value is finished yet so I don’t want to get out too early.’

Rice admits that returns from European equities are unlikely to be as exciting in 2013 as the previous year, as the business cycle enters what he sees as its mid to late stage.

‘We should get back to more normalised stock returns as we are set up for mid to late cycle reratings and we are looking for companies where we expect to see strong positive earnings per share revisions. We would buy the opposite of growth when the cycle ends.’

The largest stock in the European index Nestle remains a key underweight in the fund, at just 1.4% compared to the benchmark’s 4%. After a continued steady run, Rice thinks it may be vulnerable in the next sell-off.

Over five years to the end of December, the fund has returned 6.4% compared to -3% by the FTSE World Europe ex UK index.