When value investing embraces human behavioural patterns

In reviewing one philosophical avenue to funds management, Merlon Capital Partners CEO Neil Margolis examines the nexus of human behaviour, ESG, and value investing. 

Investing in undervalued companies, or “value investing”, has staged a comeback in recent years, after struggling during the “cheap money” era between the Global Financial Crisis and the record monetary and fiscal stimulus during the Covid pandemic. 

We would argue value investing based on free cash flow has performed well through several market cycles and has displayed low levels of volatility when compared to traditional classifications of value such as earnings, book value, and dividends.

When value investing was undervalued 

Value investing struggled during the cheap money era because record-low interest rates facilitated speculation in expensive stocks that had low levels of cash flow, or only the promise of cash flow far into the future. 

We consider current interest rate settings to be more “normal”, in a wider historical sense – thinking which supports value investing based on free cash flow. 

To exploit the outperformance of “value stocks”, an investor needs to understand why it works, which is human behavioural bias that creates the opportunity for stocks to become undervalued. 

Value investing as a process, not a philosophy 

All investors need to understand the expectations and concerns already factored into the process of value investing. 

Such an investment philosophy is clear – we believe people are motivated by short-term outcomes, overemphasise recent information, and are uncomfortable having unpopular views. 

The word “people” deliberately includes us, other investors, prospects, stockbrokers, journalists, and company directors. 

The market often overemphasises the short-term. Only 5-10% of the value of any company depends on the next year’s earnings unless the company has too much debt. Yet the near-term outlook dominates the discussion between company executives, investors, stockbrokers, and the media. 

The market also tends to over-extrapolate trends too far into the future, whether it be deflation, inflation, pandemics, the demise of bricks and mortar retailing, and many event- or news-driven perceptions, fads, and even memes which come and go.

Behavioural psychology and investing 

Finally, investors prefer moving as part of a crowd in endeavours that have made money for others in the past, rather than investing in unpopular companies experiencing difficult trading conditions – an uncomfortable alternative. 

These well-documented behavioural biases create the opportunity for investors with a process to moderate their own behaviour and benefit from others’ greed and fear. 

Our philosophy, process, and culture are all aimed at minimising our exposure to these biases. We commit to clients that we will invest their funds as we do our own and co-invest our entire domestic equity exposure to ensure this. 

Such an investment process is orderly and consistent; through fundamental research we identify undervalued companies where the market has become too pessimistic. We do this by focusing on a valuation range rather than a single scenario. From this, our best ideas arise when we can surmise, through reliable evidence (and experience), that the worst market concerns are already factored into the share price. 

This also has the benefit of limiting the risk of permanent loss. This concept of a range is grounded in humility and recognises the difficulty in forecasting. Our best investments over the past decade traded at or even below our downside scenarios, including Ampol, BlueScope, News Corp, Origin, Pacific Brands, Qantas, TradeMe, Virtus, and coal and oil producers. 

Company directors are equally vulnerable to behavioural bias of greed and fear, jettisoning out-of-favour segments and doubling down on expensive acquisitions. This leads to procyclical capital allocation. 

When Boral acquired US-listed Headwaters in 2016, we noted publicly on our website that the company had paid 38x free cash flow, only to see the business sold for $1.2b less four years later. Headwaters was a “roll-up” and the fact its own share price had climbed 10x since GFC lows was overlooked when it was acquired. 

Regarding Environment, Social and Governance (ESG) factors, we favour active ownership over divestment and engage proactively through formal letters to portfolio company directors to improve investment, business, and community outcomes. We see this approach becoming more widely adopted as ESG matures from its purely exclusionary origins. 

“Activism” is a label with positive or negative connotations depending on who you are talking to. We think of ourselves as “acting like owners” and expect company directors to do the same – for example, by having their own “skin in the game” via share ownership and seeking ASX approval for material transactions in the spirit of the regulations. 

Portfolio company directors are generally surprised by how wide our valuation range is. However, this is the brutal truth of any company with volatile input prices, high fixed costs, and debt: if more directors adopted our humble approach when valuing companies, there would be less value-destructive M&A activity. 

In summary, forecasting is difficult and markets are efficient, making it difficult to consistently “beat the market”. Investors should focus on identifying human behavioural bias and determining what is priced into the share price to improve investment returns over the long-term. 



The word “merlon” is instructive as to our name and method. A merlon, in medieval architecture, is the solid part of a crenellated embattlement, the strongest point that protects the defenders.