Strong corporate balance sheets allied with pockets of optimism about European economic policies are likely to help revive merger activity in Europe, argues the CIO of Edmond de Rothschild Asset Management. That spells opportunity for investors amid the continent's economic woes.

“There are a lot of companies with a lot of cash on their balance sheets,” said Philippe Uzan during a trip to Asia last week. “Valuations [of target companies are also] attractive, so we expect M&A deals to pick up, and this will be a strong factor in the re-rating of the market.”

The global financial crisis made European corporates wary of investing, leading to a 30% increase in cash on their balance sheets from 2008 to 2011. But economic confidence has been boosted since September’s pledge by the European Central Bank to buy potentially unlimited sums of short-term debt. The Euro Stoxx 50 index has since gained around 10% to 2,617 as of February 12.

And with companies having focused more on paying off debt since the financial crisis, thereby reducing leverage, corporates' operating margins are now relatively high.

For example, the UK saw its gross private debt-to-GDP ratio fall from its 2008 peak of 70% by nearly 10 percentage points last year. Similarly, Spain saw its ratio drop to 110% in 2012 from its 2007 peak of 120%, according to BlackRock.

But as further deleveraging has pushed down return-on-equity (RoE), companies are increasingly incentivised to grow via acquisition, says Paris-based Uzan.

Hence, while global M&A by value fell by 2.5% in 2012, the fourth quarter saw a 40% spike in activity compared to the previous quarter, with a 95% jump in European M&A activity, notes law firm Clifford Chance. And 44% of $505 billion cross-border M&A activity involving emerging markets originated from buyers in Europe.

Such activity can offer opportunities to investors looking to bet on a rise in the share price of the target company.

Moreover, European corporates are now more cash-rich than before 2008, says Uzan, meaning they have plenty of scope to increase dividend payouts. Dividend yield in Europe is higher than in other markets, he notes, with some companies likely to increase their payout and others to invest into other corporates.

Shareholders of Euro Stoxx 50 names are expected to receive an average dividend payout yield of 4.3% this year, nearly double the 2.2% expected from the S&P 500 index. (But this is a significant drop from a 6.3% dividend yield from eurozone companies in September 2011, according to Bloomberg.)

Meanwhile, there has been a recent upturn in the forecast for corporate earnings following consistent downward revisions of corporate earnings growth for the past two years, especially for companies exposed to external markets.

In 2013, the earnings revision ratio – which measures the proportion of upgrades to downgrades – has risen to 36% upgrades (versus 64% downgrades), up from 30:70 in October, according to Reuters.

Europe has certainly seen strong fund flows in recent months, with a net 15% of global portfolio managers saying they are overweight European equities – the highest reading in five years – in last month’s Bank of America Merrill Lynch fund manager survey.

And a net 11% of global portfolio managers said they would like to increase their allocation to Europe – the highest reading since September 2007. (The net percentage figures refer to the total amount of those answering in the positive minus those answering in the negative.)

Asked about the slush fund scandal engulfing Spanish president Mariano Rajoy, Uzan said there is a low chance of a leadership change as a result of an early election. Rajoy's Popular Party has a strong majority, so it's unlikely that an early election will be called, he notes, but the government having little public support in “such a dramatic situation is not very comfortable”.

“It’s a pity,” he says, because there has been significant improvement on several fronts, such as a growing current-account surplus; with competitiveness improving and exports rising. However, unemployment remains very high, he points out, meaning there is growing risk of social unrest.