* High yield stocks have underperformed in the rally
* Low yield environment puts payout at a premium
* Telecoms, pharmas, energy stocks set to outperform
By Simon Falush
LONDON, Sept 15 (Reuters) - High yield European equities, neglected during a recent rally in favour of growth companies, should return to favour as the recovery matures, boosted by investor demand for bigger payouts.
The European equity market has surged 53 percent since March , but high yield stocks, which are typically seen as more defensive plays, have gained just 36 percent, according to data from Exane BNP Paribas.
After growth stocks fuelled the sprint higher from the March trough, however, more conservative high-yield stocks should pick up the baton and take the rally to its next stage.
"Cyclicals have run very fast in a very short time, almost faster than any previous cycle... which means there is less and less value to be had there," said Ad van Tiggelen, senior strategist at ING Investment Management, in the Hague.
This moves the spotlight onto stocks that can deliver a yield at a time of rock-bottom interest rates.
"Into 2010 we would expect (high yield equities) to outperform the wider market as interest rates remain low and the search for yield continues," van Tiggelen said.
ENERGY, PHARMAS
Stocks with high dividends include energy sector giant BP, which pays a one-year forward yield of 6.2 percent, compared with an average yield in the DJ Stoxx 600 of 3.62 percent.
Meanwhile, Barclays, which has rocketed by 679 percent since March, has a forward yield of just 0.8 percent.
As well as energy stocks, Tineke Frikkee, manager of the 2.5 billion pound ($4.2 billion) Newton Higher Income fund, also pointed to tobacco and defence stocks as having potential to outperform.
"British American Tobacco doesn't get a lot of credit for its growth, and some of the aerospace and defence companies have been left behind," Frikkee said.
British American Tobacco whose forward yield is 5 percent has gained 30 percent since March, compared with the FTSE 100's 43.7 percent gain for the same period.
"BAE Systems and Smiths Group are companies that haven't moved up with the smaller engineers. These are stocks that have got interesting earnings and cashflow powers and haven't really performed very well," Frikkee said.
ING's van Tiggelen cites high yielding telecoms and pharmaceuticals as sectors which are particularly likely to benefit from a move into high yield stocks.
ROTATION
Also helping high yielders will be the rotation back into equities from asset managers that got left behind in the sharp rally since March.
"Many investors are still underweight equities, have too much cash, leading to flows into equities as long as news flow remains positive," Lars Kreckel, European Equity Strategist Exane BNP Paribas said.
Reuters data shows that, for August, global investors had 57.1 percent of their assets in equities, less than the 59.3 percent average of the last five years.
A move back to the average would see hundreds of billions of dollars injected into equities from cash and bonds.
"These asset allocation flows into equities are broad and, if anything, favour more conservative stocks and laggards ... like high yield," Kreckel said.
With growth likely to be much more anaemic in the year ahead compared with the period prior to the crash, and with interest rates creeping back up only slowly, income will be at a premium.
Euro overnight index swaps, a measure of market expectations on euro zone interest rates, indicate the European Central Bank's key interest rate will likely be on hold at 1 percent for the next year.
"Dividends have historically contributed the majority of real long-term returns for equity investors," Kreckel said.
"But with less earnings growth and with capital appreciation more difficult to come by, dividends will play an even more important role than normal. So investors should pay a higher premium for them ... which is not yet the case."
Certainly the rally so far has seen companies which are the most focused on rapid growth, and the least concerned with the health of their balance sheets, rebound the fastest.
"The companies with the worst balance sheets, with the highest gearing, with the lowest dividend payments, with the smallest size, have outperformed anything large, high dividend, in itself a normal phenomenon in a rally. But this time it's been very extreme," said van Tiggelen at ING.
Britain's small-cap index has surged 52.1 percent since the start of the year, compared with a 13.2 percent rally in its large cap counterpart. (Additional reporting by Jamie McGeever; editing by Simon Jessop)