Market correction an opportunity to capitalise on the unloved & undervalued

Increasing volatility in equities markets – spurred by an erratic US policymaking machine and an overegging of staple stocks in 2024 – is unearthing ‘diamonds in the rough’ companies, presenting a big opportunity for investors to buy up quality businesses at attractive prices, says DNR Capital CIO Jamie Nicol.

“We embrace the volatility,” Nicol wrote in a recent analysis, “because it allows us to buy good companies at better prices.”

Sclerotic growth in bank and insurance stocks has challenged equities investors of late, adding that companies with strong structural growth have been trading at significant premiums.

“Those companies needed to perform exceptionally well to justify their share prices,” Nicol said. In many cases, this has not come to pass.

Instead, he noted, stocks that did perform well were an “eclectic group of companies that surprised to the upside”.

“The market is struggling to find its setting, and this is undermining business confidence,” he wrote.

“We’ve seen a reduction in bond yields and the potential for interest rate cuts to emerge again. This uncertainty is playing into the market’s volatility, just as we have seen several times over the past year.”

‘Like twins, but opposites’

While many tried and true stocks are underperforming, the early 2025 market ructions are exposing quality undervalued opportunities.

Referencing DNR Capital’s portfolio positioning, Nicol contrasted the firm’s biggest overweight against its most underweight stock: Commonwealth Bank of Australia (CBA) and CSL Limited (CSL), respectively.

He noted that while CBA has bounced back strongly over the last five years, since the beginning of the Covid crisis, CSL, a biotechnology researcher and developer, has lagged.

CSL is currently trading at just over $255, not far off its five-year low of around $233.00.

“CBA is trading at a record multiple, whereas CSL is at its lowest multiple in 15 years.”

However, while CBA remains a standout of Australia’s big four banks “with a solid competitive advantage in deposit accounts”, competition remains tight, with the bank “earning slightly above its cost of capital, with growth expected to be just 3-4% per annum,” he said.

At its current valuation of 26-27 times earnings, Nicol believes CBA is significantly overvalued.

“Historically, CBA’s average multiple is about 16 times earnings. Even if we assume zero bad debts next year, our valuation suggests the stock is 30% overvalued. At that price, investors are unlikely to see strong returns.”

By contrast, he argues, CSL presents a compelling investment opportunity, with strong prospects for growth – despite some hiccups surrounding the Vifor acquisition.

He notes that, historically, CSL has traded at an average multiple of 35 times earnings, but estimates that, at its current valuation, the stock is at least 30% undervalued.

“In an expensive market, CSL looks attractive. It’s defensive, and demand for its life-saving drugs should persist regardless of macroeconomic trends,” he said.

With a market correction more than overdue after an 18-month bull run – and optimism around the Trump Bump, now a Trump Dump, and Magnificent Seven stocks beginning to fade – Nicol sees opportunities for a range of quality undervalued stocks.

“This is a healthy correction and could present opportunities,” he said.

He adds that DNR Capital is taking an interest in companies that may benefit from a Fed rate cut, particularly those in the US housing market.