Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 211

Value investing from an Australian perspective

While the long-term returns from 'value investing' are strong and well documented, the technique has struggled over the past decade prompting many investors to question its merits.

This article discusses value investing from an Australian perspective. The traditional classifications of ‘value’ include earnings, book value and dividends, but value investing by ‘free cash flow’ (FCF) has performed well through market cycles. FCF value investing has also displayed lower levels of volatility when compared to traditional classifications.

These conclusions support our investment philosophy, which is built around the notion that companies undervalued by FCF and franking will outperform over time.

A long-term perspective

The chart below highlights the performance of value investing in an Australian context using more than four decades of data provided by Professor Kenneth French.

Returns of ‘value’ portfolios relative to ‘glamour’ portfolios (December 1974 to December 2016)

Source: Professor Kenneth French. Portfolios are formed using four valuation ratios: book-to-market (B/M); earnings-price (E/P); cash earnings to price (CE/P); and dividend yield (D/P). The raw data is from Morgan Stanley Capital International for 1975 to 2006 and from Bloomberg for 2007 to 2016.

The ‘value’ portfolios contain firms in the top third of a ratio and the 'glamour’ portfolios contain firms in the bottom third. Portfolios are formed at the end of December each year by sorting on the four ratios and then computing value-weighted returns for the following 12 months.

Over the 42-year period for which data is available, value portfolios outperformed glamour portfolios by between 5% and 9% per annum depending on the way ‘value’ is defined.

15 years of poor performance

The data presented below shows returns to value investors in more recent periods have been less than stellar, prompting some commentators to question its merits.

Average annual returns of ‘value’ portfolios relative to ‘glamour’ portfolios (December 1974 to December 2016)

Source: Professor Kenneth French. The raw data for Australia is from Morgan Stanley Capital International from 1975 to 2006 and from Bloomberg from 2007 to 2013. US data is from CRSP. The chart represents the average of four portfolios.

Traditional ‘value’ has become a crowded trade

Anecdotally, there has been more institutional asset allocation towards value strategies in recent years, focusing on the traditional classifications listed above. In addition, many commonly deployed ‘risk models’ use the mainstream classifications to measure the extent of a portfolio’s value exposure.

The focus of institutional asset allocation towards simple strategies concentrating on the four classifications may have reduced the excess returns available from pursuing such strategies. The growth of ‘smart beta’ strategies, which are usually focused around simple and observable value classifications, accentuates this situation.

Traditional classifications of value are more often based on accounting earnings and management’s manipulation of dividends. The recent ramp up in dividend payout ratios and the growing divergence between statutory and ‘underlying’ earnings are examples of this. Of course, this unsustainable situation can lead investors to mistakenly classifying stocks as ‘cheap’ at particular points in time leading to poor investment outcomes.

This situation will be helped by classifying stocks based on their capacity to generate cash flow above that needed to sustain and grow their businesses (‘FCF’). The use of FCF rather than accounting earnings or dividends is important because management can less readily manipulate the measure.

Returns of ‘value’ portfolios relative to ‘glamour’ portfolios (March 2004 to June 2017)

Source: Merlon Capital Partners. Portfolios are formed using four valuation ratios: FCF-to-price (F/P); enterprise-FCF-to-enterprise-value (EF/EV); earnings-to-price (E/P) and book value-to-market (B/M). Monthly portfolio returns are calculated by equally-weighting all sample companies and sorting from top to bottom by each valuation ratio. The ‘value’ portfolios contain firms in the top one third of a ratio and the ‘glamour’ portfolios contain firms in the bottom third. The analysis is based on S&P/ASX200 constituents, and the raw data is from Bloomberg.

The performance of a value strategy that classifies stocks based on FCF has performed well with lower risk compared with traditional accounting-based alternatives. This finding supports our investment philosophy built around the notion that companies undervalued by FCF and franking will outperform over time.

Why do cash flow-based value strategies outperform?

We do not believe that value stocks outperform simply because they are ‘cheap’ but rather because there are misperceptions in the market about their risk profiles and their growth outlooks. A good investment requires market concerns to be priced in or deemed invalid. We incorporate these aspects with a ‘conviction score’ that feeds into our portfolio construction framework.

In a second paper to be released next quarter, we will explore why value strategies based on FCF outperform the broader market. We will present findings that dismiss the notion that value investing is 'riskier' than passive alternatives and support the presence of persistent behavioural biases in investor expectations.

 

Hamish Carlisle is an Analyst and Portfolio Manager at Merlon Capital Partners, an Australian-based boutique fund manager specialising in equity income strategies. This article is general information and does not consider the circumstances of any investor.

 

  •   20 July 2017
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

Have value investors been hindered by this quirk of accounting?

After 30 years of investing, I prefer to skip this party

Call that disruption? Investors are forgetting

banner

Most viewed in recent weeks

Why have Australian living standards 'fallen' and how do we fix it?

For the last few years there has been much talk of a 'cost-of-living' crisis in Australia and of 'falling living standards'. Lately this has flared up again with the pickup in inflation resulting in a renewed fall in real wages.

Will you run out of money in retirement?

Fear of running out has become a defining retirement anxiety. Why do some retirees die with substantial wealth while others deplete their nest egg? Evidence suggests the answer is more complicated than we think. 

Four options for an income investor’s next dollar

What if Australia’s golden age of dividends is ending? Rather than overhaul your portfolio, it may be worth considering where new capital can work harder. I discuss four income strategies and the trade-offs behind each.

The investment that sidesteps the new tax traps

Tax rules have changed, but many investors are still using yesterday’s strategies. Insurance bonds may offer advantages for those seeking greater control, tax efficiency and certainty about their wealth.

Welcome to Firstlinks Edition 674 with weekend update

What begins as appetite, grows into excess and ultimately ends in spectacle. Millions of investors just discovered this the hard way.

  • 6 August 2026

Testamentary trusts have secured the CGT exemption

Treasury’s latest CGT reform draft delivers a win for testamentary trusts and deceased estates, exempting estate-derived gains from the 30% floor. However, questions on death and divorce rollovers remain unresolved.

Latest Updates

Retirement

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

SMSF strategies

Who really loses from the SMSF borrowing ban?

The ban on borrowing to buy residential property inside a self-managed super fund was framed as closing a loophole for the wealthy. Yet ATO data suggests its effects may be felt more heavily on members with moderate balances.

Investment strategies

The investing rule that explains the next market crash

What if investment success depends less on picking the right assets and more on understanding the decisions of other investors? A principle borrowed from game theory offers a different perspective on markets.

Investment strategies

Gold: should you own the metal or the miners?

Gold is back in the headlines but investors may be asking the wrong question. Before deciding where prices are headed next, it's worth considering whether the investment you choose will deliver the outcome you're actually seeking.

Fixed interest

Global bonds markets are hiccupping

For decades, investors looked the other way as government debt ballooned. But a reckoning may be beginning. Bond markets are stirring and the consequences could reach far beyond markets into everyday life.

Property

Why investors are looking beyond traditional property sectors

A little-known corner of the property market may be quietly benefiting from powerful demographic and healthcare trends. Could this specialised sector offer investors something increasingly difficult to find: enduring demand?

Retirement

Retirement in reality - 6 months in

Is retirement really an identity crisis, or is something else at play? New insights challenge conventional thinking and reveal why some retirees struggle to fully embrace life after work.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.