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

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

Latest Updates

Taxation

13 ways to save money on your tax - legally

Thoughtful tax planning is a cornerstone of successful investing. This highlights 13 legal ways that you can reduce tax, preserve capital, and enhance long-term wealth across super, property, and shares.

Taxation

Taking from the young, giving to the old

Despite soaring retiree wealth, public spending on older Australians continues to rise. The result: retirees now out-earn the young, exposing structural flaws in the tax system and challenges for fiscal sustainability.

Investment strategies

An obsessive focus on costs may be costing investors

As a relentless fee war grips Australia’s ETF market, investors may be missing the real battleground. Beyond basis points, index design itself - not cost - may be the most powerful driver of returns.

Taxation

Clearing up confusion on how franking credits work

It seems the mere mention of franking credits generates a lot of heat but not much light. Here's a guide to how franking credits work, and the impact they have on both companies and shareholders.

Investment strategies

Are the good times about to end?

As the bull market revs up, some investors worry about a possible correction. History shows the real question isn’t timing the top, but whether you have the time and liquidity to ride out inevitable downturns.

Superannuation

Australia slips in global pension ranking

The 2025 Mercer CFA Institute Global Pension Index shows Australia has dropped to its lowest ranking in the 17 years of the index. This explores why we're falling and what can be done about it.

Property

Where wine country meets real estate

High-profile wine regions don’t always see strong property growth - volume, exports, and infrastructure investment often matter more than reputation in driving regional property markets.

Sponsors

Alliances

© 2025 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.