How buying undervalued ASX stocks can deliver great returns

One of the enduring themes of US investment is a strategy known as buying the “dogs of the Dow”.

The idea is that companies that have had a really bad year but still pay a dividend often surprise on the upside later on, either due to mean reversion, managerial change or a combination of both.

Some good local examples from 2024 include the turnarounds of Downer EDI (ASX: DOW) which enjoyed a rise of more than 20% during 2024 and Insignia Financial (ASX: IFL) with a rise of more than 40%.

Both of these companies went through a management shake-up and refocussed on their core businesses to achieve an overdue good result for investors.

Plenty of dogs to choose from

Unfortunately, there is no shortage of companies that meet the “dogs of the ASX’’ label and which have to some extent entered into a rebuild phase.

The difficulty comes in sifting through these dogs to find which one might be moving to a more fancy kennel as they have reached a point in their turnaround in which shareholders start to get some of the valuation benefits of an improving bottom line.

Some of the companies that really disappointed and landed in the bottom 20 performers include casino company Star Entertainment (ASX: SGR), Lifestyle Communities (ASX: LIC), Mineral Resources (ASX: MIN), Domino’s (ASX: DMP), IGO (ASX: IGO), Fletcher (ASX: FBU), Nine Entertainment (ASX: NEC), Ramsay Health Care (ASX: RHC) and Tabcorp (ASX: TAH).

All are potential “dogs” investments – the problem is picking those that are more advanced in their turnaround strategies than others.

ASX 200 performing well but very patchy

Interestingly the need to adopt something like the “dogs of the ASX” strategy is also shown by the decidedly patchy performance of the ASX 200 during 2024.

While a cursory examination shows that the Australian market had a nice, solid year, a deeper look shows that the 7.5% rise on the ASX 200 – 12.5% if dividends are reinvested – was not as easy to earn as it looked.

Sure, a simple ASX 200 ETF would have got there but those who select their own stocks – including the shrinking cadre of active managers – would have found it very difficult to beat that performance without picking out some really strong outliers such as Insignia and Downer EDI.

The reason is that the patchy performance within the ASX 200 meant that it relied too heavily on the efforts of a few really strong performers.

A few pivotal stocks

Commonwealth Bank (ASX: CBA) is obviously one of those arguably overvalued but pivotal stocks behind the good performance and with a 37% rise by the biggest company on the bourse was by far the biggest influence on the ASX 200 result.

Some of the other smaller top performers included faster growing companies such as Financier Zip Co (ASX: ZIP) social media app Life360 (ASX: 360), medical imaging software group Pro Medicus (ASX: PME), Chemist Warehouse merger partner Sigma Healthcare (ASX: SIG) and diagnostics developer Telix Pharmaceuticals (ASX: TLX).

In terms of large companies, the biggest contributions behind Commonwealth included Westpac (ASX: WBC), National Australia Bank (ASX: NAB), Bunnings owner Wesfarmers (ASX: WES), Goodman (ASX: GMG), Aristocrat (ASX: ALL), Macquarie (ASX: MQG) and ANZ (ASX: ANZ).

If you didn’t hold most if not all of these names, it would have been really difficult to outperform the ASX 200 unless you had some of those previously referred to small top performing growth stocks or the best turnaround dogs from 2023.

Difficult to outperform

What this shows is not just the benefits of index investing but the need for active managers to cull their portfolios of duds and also include some of the stocks such as Commonwealth that might not meet their normal hurdles for profit growth, value or overall growth.

The sheer weight of superannuation and other passive and index aware investment cash flowing into the ASX means that the weight of money has been overwhelming more traditional measures of value.

That might reverse at some stage but for the moment, the patchy performance of the ASX 200 means that outperformance must include all sorts of strategies, including the best of the “dogs of the ASX” approach and also buying some arguably over-valued stocks such as Commonwealth just to keep up with the pack.