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Forget about 'quality' when investing in Europe

After a woeful third quarter, investors looking to position themselves for the final three months of the year claim equity markets in Europe are in full "rotation" mode in favor of cyclical stocks, as commodity prices and sentiment around China have started to pick up.

European stocks saw their best week since January last week, led by miners and commodity-exposed companies as oil prices briefly rose by the most in over six years on Friday.

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Investors are now looking to boost their exposure to cyclical stocks, or companies that are the most sensitive to ups and downs in the overall economy such as banks and firms with commodity exposure.

"If you look at the performance of the cyclicals against the defensives in Europe, we are back below where we were in March 2009 and that is even if you take out the banks, so it is not just the banks," head of European equity strategy at UBS, Nick Nelson told CNBC.

"So if we get any belief that there is better economic going into 2016, these stocks will rally. Cyclicals are an area where we could see a bounce," he said.

Banking on a return

European banks in particular which have been much slower to reform than their U.S. counterparts are attractive from both an earnings growth and valuation point of view, Nelson added.

Looking at valuations of stocks across Europe, data from Barclays suggests that European investors are paying a substantial 35 percent premium for "quality" stocks, in line with some of the worst points seen during the sovereign debt crisis and above the peak premium during the global financial crisis.

"Quality" stocks, such as consumer staples, healthcare and tobacco stocks tend to be more resilient to economic downturns, and given the sharp turbulence seen in global financial markets over the summer, investors have stocked up on defensive companies, pushing prices higher.

But since the end of last month, quality firms have underperformed their cyclical peers and a "safety first" approach is no longer sitting well with the recovery in earnings and economic in Europe, European equity strategist at Barclays Ian Scott said.

"The market is in full "rotation" mode: commodity producers have been in the vanguard with the oil sector beating the market by 10.5 percent since 29 September, as crude prices have similarly jumped by 10 percent," he said.

"While, at the other end of the spectrum, the European healthcare sector has underperformed by 5.5 percent, telecoms by 4.5 percent and consumer staples by 1.2 percent. We think the pro-cyclical rotation has a good deal further to run," Scott said.

Commodity focus

On this view, Barclays added commodities and shipping business A.P. Moller Maersk while removing budget airline Ryanair from its European recommended portfolio, as well recommending a "heavy underweight" to healthcare and consumer staples and "overweight" to cyclical and value sectors.

European firms with commodity and emerging market exposure are also the pick of Morgan Stanley chief European equity strategist, Graham Secker, as sentiment surrounding the slowdown in China and commodity prices has improved, which should give cyclical European equities a lift in the fourth quarter.

Secker said that the less bearish outlook for emerging markets (EM), as U.S. interest rates are expected to stay lower for longer, should lead to selling of defensive stocks and an increase in demand for commodity names.

"We recommend investors raise their exposure to EM/commodities given the combination of very low sentiment, attractive relative valuations and a likely inflection in macro sentiment," Secker said in a note to clients.

Morgan Stanley also tweaked their European model portfolio recommendation, and like Barclays suggested an "overweight" to commodity sectors.

"Against a backdrop of extreme underperformance and very low valuation we upgrade mining and materials from underweight to overweight and reiterate our overweight position in energy. We downgrade healthcare to maximum underweight," Secker added.