* DAX second best performer in Q3 in Europe
* Favoured by more cautious investors returning to euro zone
* Cyclical weightings to benefit from global improvement
* Euro zone collapse, or crisis resolution pose risk
By Toni Vorobyova
LONDON, Oct 10 (Reuters) - German equities are proving to be more than just a bolthole from the euro zone's debt storm and muted company valuations and a cheap euro mean it should do well unless the crisis deteriorates markedly or is fully resolved.
Exporters with a global reach, an economy that has stayed out of recession, and an abundance of solid household names made Germany a top pick for those who wanted to - or had to - invest in euro zone equities when the currency union's future looked in question earlier this year.
But the same characteristics are now attracting the more cautious investors who had stayed away from the region until July, when European Central Bank President Mario Draghi said he would do whatever it took to preserve the euro.
That helped Germany's DAX equity index gain 12.5 percent in the third quarter - the second best showing in Europe after volatile and risk-sensitive Greece . Comparative valuations suggest that rise may have further to run.
"Clearly Germany is in better shape than everybody else. If you want to buy a country that is not risky and is relatively cheap, Germany fits the bill," said Fabio Di Giansante, senior portfolio manager for Pioneer Investments in Dublin, who manages around 800 million euros and whose top picks in Germany include Adidas and Continental .
Germany was also one of the places chosen by ABN Amro Private Banking, which manages 146 billion euros, when it turned overweight on European equities last month for the first time since 2010, cheered by the ECB's policy actions.
The appeal of German equities is highlighted by Lipper data, which shows European-based funds with over $100 million in assets have on average raised their allocation to Germany to 17.4 percent this year from 16.8 percent in 2011, while decreasing holdings of France, Greece, Portugal and Spain.
Germany's financial markets have benefitted almost across the board from investors' need for a safe haven from the euro zone storm and a sagging global growth outlook that classically drives players out of stocks and into bonds and cash.
In such times, Germany is underpinned by solid state finances and a relatively stable economy.
But its equity market also benefits from any sign the world economy is improving since cyclical consumer goods and services, industrials and materials account for around 45 percent of the index.
By comparison, the volatile financial sector has the biggest weight in the EuroSTOXX 50 .
"I am overweight Germany because valuation on the German market is pretty low and it will be probably the main beneficiary in Europe if you get global growth projections starting to rise," said Kevin Lilley, European equities fund manager at Old Mutual Asset Managers.
The DAX still looks cheap on some measures. For example, the index, which is around 7,250 points, is trading at 10.4 times the earnings of its component companies, below the ratio's 10-year average of 11.8 times, Thomson Reuters Datastream shows.
"By historical comparison, that is not an especially ambitious valuation, so further price gains are quite possible in coming months," M.M. Warburg & Co said in a strategy note.
"Even reaching and surpassing old DAX levels just above 8,000 points cannot be ruled out from a valuation standpoint."
Germany's valuation looks particularly attractive if solid earnings expectations are taken into account.
Corporate profits are expected to grow 7.3 percent this year according to Starmine SmartEstimates. By contrast, Spanish earnings are seen slumping by 45 percent but Spain's IBEX
has a higher price-to-earning ratio, of 11.1.
Meanwhile, a retreat in the euro, which has lost 4.5 percent on a trade-weighted basis from February peaks , has made German exports cheaper for foreign buyers. It is a trend that is expected to continue, according to a Reuters poll.
Exchange rates are one reason BNP Paribas strategists picked Germany as their preferred investment region. They recommend long bets on the DAX with short positions on the Russell index of U.S. small caps or Japan's Nikkei .
RISKS ON BOTH SIDES
The DAX's strong export focus comes with a price, as was seen in August 2011, when weak U.S. data sparked a slide that saw the index shed a fifth of its value in its worst monthly showing in nearly a decade.
Then, its safe haven appeal soon reasserted itself, and it outperformed EuroSTOXX 50 in 10 of the subsequent 13 months.
But the global backdrop, in particular any sharp slowdown in China, remains a risk, albeit one that could be partly offset by strength in Germany's domestic economy.
There are also risks from euro zone developments.
A resolution of the immediate crisis that is sufficient to at least make investments in the likes of Spain or Italy more palatable, could draw some of the most cautious investors, such as foreign mutual funds, to pull some funds out of Germany.
"I wouldn't be surprised that as soon as they've taken up their weighting (in euro zone), that they will then take their weighting out of Germany more in to the rest," said Andy Ash, head of sales at Monument Securities.
Conversely, despite its safe haven status, Germany cannot avoid being tainted if the euro zone crisis deteriorates markedly and concerns resurface about the future of the union.
It is Berlin who is largely funding the hundreds of billions of euros already handed out in bailouts and if officials ultimately fail to rescue the euro, or later that could come home to roost.
"I still see (Germany) as one of the more secure places in Europe but the main reason why people have been worried about (it) is that they are one of the few countries that are able to help out if problems develop in southern Europe," said Per Kongsgaard, portfolio manager at Jyske Invest.
(Additional Reporting by Joel Dimmock, Editing by Swaha Pattanaik and xxxx)
Keywords: EUROPE MARKETS STOCKS/GERMANY