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

Indexation implications – key changes to 2026/27 super thresholds

Stay on top of the latest changes to superannuation rates and thresholds for 2026, including increases to transfer balance cap, concessional contributions cap, and non-concessional contributions cap.

The refinery problem: A different kind of energy crisis in 2026

The Strait of Hormuz closure due to US-Iran conflict severely disrupted global energy supply chains. While various emergency measures mitigated the crude impact, the refined product market faces unprecedented stress.

Has Australia wasted the last 30 years?

The 20 years after Peter Costello left Treasury have been deemed wasted...by Peter Costello. The missed opportunities for Australia began long before.  

3 ways to defuse intergenerational anger

With the upcoming budget increasingly likely to include bold proposals to alter the tax code I’ve outlined three incremental steps with fewer unintended consequences.

Navigating the next stage of life in retirement

Retirement planning is more than just saving enough money. Long-term care needs, housing choices, and social networks are just as critical for a happy and enjoyable life.

The missing 30%: how LIC returns are understated, and why it matters

The perceived underperformance of LICs compared to ETFs is due to existing comparison data excluding crucial information, highlighting the need for proper assessment and transparent reporting.

Latest Updates

Superannuation

Do super funds need a massive wake up call?

UK retirement expert, Guy Opperman, believes super funds are failing at supporting members in deaccumulation. Here is what Australia should do about it. 

Retirement

Sequencing risk resurfaces for retirees

A retirement strategy must consider how both the timing of cash flows and the sequence of returns impact the final dollar outcome from which a retirement is funded.

SMSF strategies

Meg on SMSFs: Payday super – why should SMSF members even care?

Not filing your SMSF annual return on time can mean missed contributions under the new Payday super regulation. 

Strategy

There will be no permanent underclass

Worries about AI causing mass job loss are misguided. Far from creating a permanent underclass, Like other technological innovations AI will improve living standards around the world.

Taxation

Reforming the taxation of wealth and wealth transfers

As the budget approaches debate continues about the need and method for addressing wealth inequality. Could reinstating wealth transfer taxes be the answer?

Investment strategies

The biggest oil shock in history. Why isn't the price higher?

While increases in oil prices are dominating media coverage of the turmoil in the Middle-East it is worth exploring why prices haven't gone up more. 

Financial planning

Structured giving's new moment

A big year for philanthropy has seen multiple tax changes impact the approach donors are taking. For those with the intention to give generously there is a third structure available in the structured giving landscape.

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.