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INVESTMENT FOCUS-'Sweet spot' in European M&A puts floor under valuations

* European M&A and index valuations: reut.rs/2nrVMW6

* Europe Inc vs USA Inc profits: reut.rs/2mx3Wrm

* MSCI Europe earnings estimates reut.rs/2553txN

* Unilever bid shocks markets, resets assumptions

* Corporate confidence returning, environment for M&A in "sweet spot"": Goldman

* UK industrials sector on radar as weak sterling tempts foreign buyers

By Helen Reid and Vikram Subhedar

LONDON, March 17 A boom in European deal-making activity -- a sign better growth prospects are boosting confidence in European corporate boardrooms -- is helping support stock market valuations which, on some measures, appear stretched.

A brighter outlook for the global and regional economy, buoyant stock markets and low borrowing costs have underpinned merger and acquisition (M&A) activity in Europe, which is enjoying its best three-month period since 2007, Reuters calculations show.

Moreover, rising share prices of both acquirer and target companies when deals are announced suggest shareholders are willing to back mergers, a shift from recent years when they preferred dividends and cautious spending.

"Doing deals in the peak of a market is also unwise as you could end up paying more – so what you want is the sweet spot where companies aren't trading on very expensive multiples," said Sharon Bell, a strategist at Goldman Sachs.

"We are at that sweet spot now."

European equities trade at just under 15 times forward earnings, slightly above the long-term average of about 14 times. But they are well below peaks seen over the past 15 years, and underpinned by the best earnings outlook for regional companies since 2010. reut.rs/2nrVMW6

The broad sweep of sectors involved in M&A, from global food and personal goods giants to UK industrials and oil services firms, is also seen as a healthy sign and is spurring a rethink of valuations.

"There was nothing for a few years, so all the activity that was bottled up is bubbling up now," said Goldman Sachs's Bell.

The surprise $143 billion takeover bid by Warren Buffett-backed Kraft Heinz for Unilever, while rejected, has reset some assumptions about stocks, market participants say.

"The size of the proposed transaction was a wake-up call for corporations all over the world - and their investors," star UK fund manager Nick Train wrote in his latest letter to investors.

Shares of large consumer staples companies have lagged the recent stock market rally as investors preferred faster growing sectors in the markets.

"Towards the end of last year there was a lot of bearish talk about rich valuations in consumer staples like Unilever," said Mark Martin, a fund manager at Neptune Investment Management, who manages a portfolio of mid-sized UK companies.

"Now you've got sensible investors including Buffett still finding as much as 20 percent upside for Unilever," he said.

BRICK BY BRICK

While the earnings outlook in Europe has brightened significantly from the lacklustre growth seen since 2010, both corporate profits and margins remain well below prior peaks and have significantly lagged those in the United States. reut.rs/2553txN

Total annual profits for European firms, of about $616 billion, are about half what they were in 2008, according to Thomson Reuters data. reut.rs/2mx3Wrm

"While management waits for European earnings to catch up with the U.S., in a much more wholesale growth environment, M&A is likely," said Dylan Ball, a portfolio manager Templeton Global Equity Group.

Meanwhile, weaker currencies, particularly sterling, have made acquisitions in Europe more tempting for offshore buyers.

"U.S. companies with large offshore cash balances and maxed-out stock buy-back programmes are looking to take advantage of the U.S. dollar strength," Ball added.

One group of companies on the radar for investors is UK industrials, on which a combination of Brexit-related worries and exposure to beaten-down oil and mining had dented sentiment.

Neptune's Martin, whose fund has comfortably beaten peers' performance on a three- and five-year basis, had nearly half his fund in UK industrials at the end of February.

Martin, whose fund owns shares in oil services firm Amec Foster Wheeler, which recently agreed to be bought by peer Wood Group, said he would back companies buying others in a bid to grow market share.

"A lot of companies are doing it (M&A) to drive down costs. So there isn't the same euphoric growth-at-all-costs mentality we saw in 2007," Martin said, playing down concerns over whether a flurry of deal-making is a harbinger of market tops.

Instead, investors see the uptick in mergers as a sign of a long-awaited revival of corporate confidence in Europe, which has been hamstrung by worries including sovereign debt crises, sluggish growth and, more recently, political risks.

After four years of underperforming developed market peers, European stocks are catching up, with M&A one more prop to valuations and investor interest.

"The wall of worry is being taken down brick by brick," said Neptune's Martin.

(Reporting by Vikram Subhedar and Helen Reid; Editing by Toby Chopra)

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