Investors need to look harder for value opportunities as there are no obvious parts of the market that are wholesale out of favour, according to SYZ Asset Management fund manager Mike Clements.
But when looking down the market cap spectrum people should focus more on earnings momentum than valuations, added Andrew Paisley, who manages the Standard Life Investments European Smaller Companies fund.
The European market has been the top performer so far this year, after many years of being a laggard, meaning valuations have been pushed higher.
Indeed, the MSCI Europe ex UK index has returned 13.68 per cent year-to-date compared to the 7.16 per cent return of the wider MSCI All Countries World, as the below shows.
Performance of indices YTD
Source: FE Analytics
Clements, who runs the top performing Oyster Continental European Selection fund, said there were no longer obvious opportunities that existed previously.
“I am a contrarian investor so our way of approaching the market is pretty simple which is to buy low and sell high and buying low is hard,” Clements said.
“I need people to be nervous or upset about something either sector or a country or a situation.”
“There are not many of those at the moment. If we went back 12 months ago I would have been talking about energy,” the manager added.
“If you went back two years ago we would have been looking at a lot of emerging market plays because at that time China’s economy was slowing down and people were very nervous about the ramifications.
“Roll forward to 2017 there is not those obvious parts of the market that are wholesale out of favour so we [value managers] have to look a bit harder.”
Below, FE Trustnet explores the two areas of the market where Clements has found value in Europe as well as how European fund manager peer Andrew Paisley is approaching the small-cap space.
The first area Clements is unearthing new ideas is in Italy and particularly the banking sector as the country continues to struggle though a financial crisis.
He said: “If you look around the stock market over the last 12 months then banks have been under a lot of pressure and within that the Italian banks have been a disaster for all the reasons [that are already out there].
Indeed, as the below shows, the Italian banks sector remains 53.53 per cent down over the last decade and has struggled to regain much ground since its lows in 2011.
Performance of index over 10yrs
Source: FE Analytics
“They are pretty much bankrupt a lot of them – or let me be kinder – they have some balance sheet issues which need to be resolved,” Clements said.
But while banks such as Monte Dei Paschi and UniCredit continue to struggle, the manager noted there are opportunities in the sector.
“If you look up and down that value chain the people that are benefiting from that crisis are not the banks but the people on the other side of the transaction who are buying these distressed loans at very good prices,” he said.
“These are mostly hedge funds and private equity vehicles who are buying these non-performing loans off the banks’ balance sheets at say 20 cents on the euro.”
“If you’re going to look for a place to make money it is better to be on that side of the transaction than on the selling side because you are selling in a distressed way.” 
The manager said that there are different ways to play the sector but his preferred stock is Eurocastle, which despite being Dutch-listed is Italy’s largest third-party servicing company for non-performing loans. In essence, hedge funds that have bought these non-performing loans have to collect the money that is owed to them and so outsource this task to a third party.
“There are €200bn of non-performing loans in banks’ balance sheets in Italy, which is why it has a financial crisis, and Eurocastle services €86bn of them,” Clements (pictured) said.
“They don’t own the loans so it’s not like they put their own balance sheet at risk, they just collect money and pass it on to the owner and take a cut.
“So it is a low-risk way of playing the financial crisis in Italy but it’s cheap because the banks are under a lot of pressure and the financial sector in Italy is cheap.”
The second theme he is playing is volatility, which is nearing all-time lows in Europe despite the high number of political events and the overhanging Brexit negotiations.
“If you look around and ask yourself what is hitting all-time lows there is not a lot but there is one thing and that is volatility,” the manager said.
“Now if I was a multi-asset investor I could buy options on the V stocks or something cool like that but I can’t because I am a long only equity investor. So, I have got to find stock market ways to play an increase in volatility over time.”
Instead, he has bought Dutch company Flow Traders, which is Europe’s largest market maker for ETFs.
Clements said: “If you buy Flow Traders you get two things. For a long-term investor like us you get the structural growth in ETFs and passive vehicles.
“Unfortunately for us the world is only going to go more and more passive so there is going to be more of these products traded.
He added: “The second and probably more interesting part at the moment is it’s a pure way to play volatility in that what happens when markets go crazy – think around the Brexit vote – the way that you change your asset allocation position tactically in the short term is you just buy and sell ETFs.
“So what happens when volatility picks up and the markets go a bit crazy is that people’s buying and selling volumes of ETFs pick up and Flow Traders are just sitting in the middle taking a spread.
“Their revenue is directly linked to the spread they make which is 4 basis points, times by volume so when the volume goes up they make a lot more money.
“This is a great time to buy this because no one wants it so we are trying to play volatility picking up from incredibly low levels and Flow Traders is probably one of the best ways to play this.”
In the smaller companies sector, Standard Life’s Paisley said value is not necessarily the key driver, with his Standard Life Investments European Smaller Companies focusing on quality, growth and particularly momentum.
“We are believers that earnings momentum in particular is a key driver to share price performance in small caps. These are companies where their earnings potential is being underappreciated by the market,” the manager said.
“Where this tends to be most prevalent is more in terms of market cap rather than actual sectors. What we see is that companies worth around €1bn and below are poorly covered by the sell side.
“In fact on average there is only four analysts covering each of our companies so not a huge number at all.
“What it does mean is that there is a fighting chance that these analysts haven’t covered everything into their numbers and there is a reasonable possibility of having a non-consensus view.”
His example of this is Fevertree, which has been on an incredibly strong run since its launch in 23014, up 952.62 per cent since inception.
Performance of stock since IPO
Source: FE Analytics
Paisley said: “When it first started there were only two analysts covering the stock and therefore estimates were really quite conservative by our reckoning when we looked at what the company had been doing historically.
“And that’s what we’ve seen – consistent upgrades to numbers for the last two or three years.”
Yet he noted that Fevertree has “optically always looked expensive since it first floated,” meaning valuations are not as important as earnings momentum in the smaller companies space.
“When it floated the P/E [price-to-earnings] was around the mid-twenties which put off many people from investing. But what they were missing was that the EPS [earnings per share] was clearly being massively misstated and therefore the proper P/E was much lower.
“That’s the real opportunity in small caps, to find these great growth companies that are growing much faster than expected and can grow much faster for longer.”