Morgan Stanley analysts have identified what they say are five highly-profitable stocks in Europe with downside risk to their share prices ahead of first-quarter earnings results. The Wall Street bank believes stock markets have broadly priced in a potential "over-earning" and a "solid" first quarter, thanks to the 10% rally in the Stoxx Europe 600 index this year. The "over-earning" refers to a situation in which companies or sectors have been generating higher-than-average profits compared to their historical performance. Over-earning can be temporary during periods of strong economic growth or other favorable market conditions. However, it can also be a warning sign that a company or sector is at risk of a mean reversion, which is the tendency for profitability levels to return to their historical averages. "1Q results should be solid but the recent rally in equity markets suggests that this positive outcome is already in the price," said Morgan Stanley's strategists, led by Graham Secker, in a note to clients on Apr. 21. "Ongoing earnings resilience is testing the patience of the bears, however we still see a very plausible path to an [earnings per share] downgrade cycle consistent with a 10% fall in European earnings this year." The below table lists the five stocks "that may be over-earning," according to Morgan Stanley: Morgan Stanley's research suggests that the sectors most at risk of over-earning include transport, semiconductors, construction materials, energy, and autos. The investment bank analyzed these sectors across various profitability metrics and compared them to their 10-year historical averages, highlighting the potential risk of mean reversion. Factors contributing to this potential decline in earnings per share include slower GDP growth in the United States and Europe, decreasing margins, and foreign exchange headwinds. The bank advised clients to take an underweight position in the energy sector due to peak profitability, downside risk to consensus EPS, elevated investor positioning, and the impact of lower inflation on relative performance. It took a similar underweight view of the autos sector, as growing pricing pressures and higher credit costs are expected to undermine margins going forward. Conversely, the bank suggested an overweight position in the medical technology sector, which according to Morgan Stanley, is one of the few long-duration sectors where profitability and valuation are both low compared to historical levels. Last week, the bank named the five stocks to buy where its analysts have a "high conviction" in the stock's performance ahead of earnings. — CNBC's Michael Bloom contributed to this report.
