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

2 billion reasons to fix retirement income

A proposal to address Australia's 'stranded balances' in retirement by requiring super funds to transition members to pension phase at 65, boosting retirement income and reframing super as a source of income.

The ultimate superannuation EOFY checklist 2026

Here is a checklist of 28 important issues you should address before June 30 to ensure your SMSF or other super fund is in order and that you are making the most of the strategies available.

Noel Whittaker’s take on the budget

Marketed as a fix for inequality and housing affordability, the latest budget instead delivers a tangle of tax changes that leave everyday Australians worse off.

Welcome to Firstlinks Edition 662 with weekend update

The debate over the budget is increasingly shaped by frustration and perceptions of unfairness, rather than clear-eyed assessment of policy outcomes.

Two months into retirement

A retirement researcher's take on retirement and her focus on each of her six resource buckets to stay engaged during the transition and beyond.

Australia has no death duties. Technically.

Australia may not levy formal death duties, but a growing web of tax measures is quietly shaping what wealth passes between generations. Now, the 2026 budget adds another layer.

Latest Updates

Investing

Markets without a margin for error

From US fiscal pressure to China’s shifting growth model and Australia’s structural constraints, markets are yet to reflect a less forgiving global investment landscape.

Investment strategies

The investment mistake killing your returns

Retail investors face an increasingly complex product environment, but simplicity may be the most overlooked advantage in building a portfolio you can actually live with.

The ticking clock on oil reserves

A sustained disruption through the Strait of Hormuz is forcing a rapid drawdown of global inventories. Without a resolution, the arithmetic points to a supply shock by early August and a sharp surge in the oil price.

Infrastructure

Managing the impact of the Middle East conflict on listed infrastructure

The outbreak of conflict in the Middle East in February 2026 marks an historic shock for oil and gas markets, with major implications for inflation, interest rates and ultimately for listed infrastructure companies.

Economy

Rent inflation and the missing policy

The government plans to remove negative gearing to help renters buy homes. For those who remain renters, the wrong levers are being pulled to try and increase rental unit supply.

Investment strategies

The Risk-Wealth Paradox: Why more money means you should take less risk

As wealth grows, so does the assumption that risk should too. But in reality, the opposite may be true: once you understand how the value of money changes over time, the case for taking less risk becomes far more compelling.

SMSF strategies

SMSF estate planning: Eight things to consider

As super balances grow, SMSFs are becoming central to retirement outcomes. Without proper planning for “Armageddon” scenarios, even well-structured funds can unravel when it matters most.

Sponsors

Alliances

© 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.