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By Hamish FitzSimons

Investors in Australia have been wary of undervalued, risky stocks in recent years. But today, market conditions have improved and many attractively valued companies have strong balance sheets, which we think should support a continued recovery.

Value investing tends to perform particularly well when markets begin to emerge from periods of extreme behavior, such as irrational exuberance and bubbles, or their opposite, excessive pessimism and risk aversion. As these conditions unwind, they create opportunities in companies that are poorly understood, and hence undervalued, by the broad market.

"Fear Trade" Creates an Opportunity

In Australia, the fear trade has dominated the market in recent years. As a result, valuations of apparently defensive stocks (such as consumer staples, healthcare and property) rose to extremely high and unsustainable levels. Although uncertainty persists today, extreme, widespread risk aversion has begun to abate. Correlations are returning to historically normal levels and stock selection is once again being rewarded, as the cheapest Australian stocks based on price to book and price to forward cash earnings have outperformed the most expensive by 8% since August 2012.

As valuations of defensive stocks increased, the fear trade also prompted a decline in valuations of cyclical or non-defensive stocks. The Display below shows the "value spread," or the discount of the cheapest 20% of Australian stocks to the most expensive 20%. While some of the spread has narrowed (resulting in value's strong performance), the opportunity is only slightly below the levels reached during the financial and sovereign-debt crises, and still close to 35-year highs. We also know from past experience that value cycles tend to last between four and five years on average.

Balance Sheets Are Much Stronger

In Australia, many stocks that are trading well below fair value today also have strong balance sheets-which significantly reduce the risk of corporate failures. Listed corporates' debt-to-equity ratios and earnings before interest, tax, depreciation and amortization relative to interest cover are extremely robust (display below). These key measures of balance-sheet strength are much healthier than after the financial crisis (when most cheap companies had weak balance sheets), the 2000 tech crash and the Australian financial crisis of 1991.

As a result, many attractively valued companies can be found with strong cash flows supported by robust balance sheets. This is important for risk management because we would expect stocks of companies with solid fundamentals to do relatively well even if the value spread did not narrow over time (that is, if cheap stocks failed to appreciate relative to expensive stocks).

Will Exogenous Shocks Delay Value's Recovery?

There are many things to be cautious about in the world right now. The fragility of the largest developed economies, a slowdown in emerging markets and geopolitical tensions in various regions all threaten to cause a fresh wave of instability.

Yet over the last 35 years, the performance of attractively valued stocks has often defied concerns like these. For example, the 1982 global recession and Mexican default, the 1988 U.S. military strikes on Iran, the 2002 global recession, the default of Argentina and Brazil's IMF bailout did not prevent value from outperforming. So, while value isn't guaranteed to perform in every situation of macroeconomic and geopolitical uncertainty, the style, in our view, has demonstrated a tendency to be resilient in such circumstances over time.

Concerns that the fear trade might return are understandable. But with many cheap stocks boasting healthy balance sheets and promising earnings potential in Australia, we think there's a good chance that value investing can surmount today's challenging economic and geopolitical environment.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Hamish FitzSimons is Director of Research-Australian Value Equities at AllianceBernstein.

Disclosure: None

Source: Australian Value Returns To Form