Time to go for growth
Illustration: John Shakespeare
Behavioural finance teaches us that people tend to prefer a small, certain reward today over a larger, uncertain one in the future. That pretty much sums up current sharemarket behaviour. When the outlook is uncertain, investors settle for $1 in dividends from a ''safe'' company rather than hold out for $2 in capital gains from a risky one.
This safety-first approach has paid off handsomely during the past 12 months of market turmoil. The dividend yield of the overall market was 4.6 per cent in the year to mid-November, but more than 6 per cent when franking credits are included.
The chief executive of Lincoln Indicators, Elio D'Amato, says franking credits provide a 40 per cent free kick for investors, especially those holding shares in a super fund paying 15 per cent tax on earnings or those in the pension phase paying no tax.
''Say I receive a 5¢ fully franked dividend; when I include the franking credits, that yield grosses up to 7.14¢,'' D'Amato says. ''If I am in the pension phase, I receive that full amount, which means I get 42.8 per cent more than I was initially entitled to. A $500 dividend equals $714, $5000 equals $7140 and it just keeps getting better.
''I can't wait until I turn 65, just because of the great Australian gift.''
The go-to sector for dividend hunters has been, and still is, the banks. The big four have been trading on grossed-up dividend yields, including franking credits, of between 8.2 per cent (ANZ) and 10.6 per cent (NAB). High investor demand has also translated into share-price growth, so cautious investors have had the best of both worlds.
''With cash rates coming down, investors are moving out of bank term deposits paying 3 per cent to 4 per cent to fully franked dividend yields of about 9 per cent for the banks,'' Scott Bennet, a portfolio manager with Russell Investments, says.
An income strategy makes good sense in the short term, but there is a danger that popular income stocks, such as the banks and Telstra, will be loved to death and their share prices pushed to levels that leave limited scope for capital appreciation.
There are also concerns that in an effort to placate dividend-hungry investors, some companies are stretching their payout ratios to unsustainable levels, putting future dividend payments under threat.
The payout ratio refers to the portion of company earnings paid out to shareholders in the form of dividends. The inverse of the payout ratio is dividend cover, or earnings per share divided by dividends.
The chief investment officer of Lachlan Partners, Paul Saliba, says a payout ratio of more than 60 per cent, or dividend cover of less than 1.4, may not be sustainable over the long term.
''If a company is paying a substantial portion of its earnings out in dividends and future earnings are constrained, investors could be in for a shock in terms of payout ratios being cut back,'' Saliba says.
Recent analysis by Macquarie Group found that the payout ratio of the Australian market has stretched to 75 per cent, compared with the long-term average of 60 per cent. At the same time, the growth in earnings per share for the overall market is slowing and is forecast to fall from 9.2 per cent to 6.1 per cent in the current financial year.
The challenge for investors in this market is to be discriminating and seek out stocks that not only offer a good yield but dividends that are sustainable over the long term.
''Dividends are an intention, but not a promise, by a company. Companies can change their dividend policies as the economic environment gets tougher,'' Bennett says.
Even so-called blue-chip companies can spring nasty surprises, such as the decision by Qantas to stop paying dividends in the wake of the global financial crisis. It hasn't paid a dividend since 2009.
But investors can take heart from a recent study showing that far from being overvalued by the market, stocks with fully franked dividends are systematically undervalued (see box, right).
D'Amato says the market is inefficient in the way it deals with franking credits because the people chasing them - individual retail investors - make up just 20 per cent of local market participants.
The Australian sharemarket is dominated by local institutions, such as fund managers and superannuation funds, and foreign investors. They account for 40 per cent each.
Foreigners can't use franking credits and their dividend income is often subject to complex tax rules, so they focus on capital gains.
Local institutions also focus on capital gains, partly because they pay the company tax rate themselves, so the benefits of franking are limited, but also because they compete against each other in performance surveys based on short-term pre-tax returns.
This is beginning to change, with some super funds and managed funds reporting on an after-tax basis, but they are still the exception.
Most Australian investors have a portfolio that's heavy with banks. D'Amato says the latest profit-reporting season confirmed the banks' ability to maintain their dividends, but he thinks there are better opportunities outside the banking sector for investors looking for growth and income.
Childcare centre group G8 Education has been on an aggressive acquisition campaign but D'Amato says debt is at manageable levels and the stock displays strong earnings growth and return on equity. It trades on a grossed-up dividend yield of 5.19 per cent, based on 2011-12 earnings, which is forecast to increase to 7.14 per cent in 2012-13.
AP Eagers has a large property portfolio underpinning its car dealership network, with a grossed-up dividend yield of 6.37 per cent, and 7.33 per cent forecast for next year. ''It has strong financial health, cash flow is solid, it is growing its return on assets and equity and will produce 76 per cent earnings per share growth, in our opinion,'' D'Amato says.
Monadelphous is an example of a good stock in an unloved market sector. After riding the mining investment boom, the engineering services company is in a new phase, D'Amato says. He says the group should continue to grow and increase the payout to investors, with a grossed-up dividend yield of 8.59 per cent this year, rising to 9.48 per cent next year.
Saliba says companies don't have to be fully franked to be attractive. Utility SP AusNet has a forecast yield of 7.8 per cent with approximately 33 per cent franking. ''The company has a defensive income stream and is underpriced relative to its peers on the back of litigation regarding the Victorian bushfires,'' he says.
Saliba says Bradken provides exposure to mining through train wagons, with a fully franked forecast yield of 8.7 per cent. And marketing and communications company STW Communications Group has a higher yield than Telstra, at 8.2 per cent, based on forecast dividends per share, and is also fully franked. It also has a superior dividend cover of 1.5 times, making the dividend considerably more sustainable in the long term.
For investors who want to tap into the income stream from shares but would rather leave the selection to professionals, there are various high-dividend exchange-traded funds.
For instance, the Russell High Dividend Index fund holds about 50 stocks that are actively managed, with relatively high stock turnover of 40 per cent a year in response to changes in company valuations and dividend policies.
In the year to October 31, the fund had a market-beating nominal dividend yield of 6.12 per cent, and a grossed-up yield of 8.2 per cent.
Bennett says the fund recently added APA Group and Seven West Media for the first time. APA is a natural gas infrastructure business with a strong balance sheet and a dividend yield of 6.7 per cent.
''It's not franked like the banks but the income is linked to inflation, so it is likely to be more resilient in a weaker market,'' he says.
For investors prepared to stomach a lot more risk, Seven West has a fully franked dividend yield of close to 20 per cent, but the potential for a high degree of share-price volatility.
''We think the dividend will come under pressure but we still expect it to stay in double digits,'' Bennett says, adding that long-term investors should not overlook mining giant BHP Billiton.
''Its nominal [pre-tax] yield is not that great, at about 3 per cent, but it's fully franked and BHP has the ability to increase its dividend year on year for the next decade,'' he says.
Dividend investors earn a free kick
Lincoln Indicators chief executive Elio D'Amato long suspected that dividends and franking credits were not being fully valued by the market, so he tested the theory.
When a company announces a dividend it also sets a date when new share buyers will not be entitled to receive it. This is known as the ''ex-dividend'' date.
What typically happens on the day the stock goes ex-dividend is that the share price falls by the amount of the dividend. Or that's the theory. In practice, the share price adjustment often fails to fully reflect the size of the dividend size and the value of the franking credits attached.
For example, Wotif.com declared a fully franked dividend of 13.5¢ a share, which went ''ex'' on September 10 with franking credits worth 5.8¢ a share.
This brings the total dividend to 19.3¢ a share. But on the ex-dividend date the share price fell just 11¢. In other words, the shares lost 11¢ in capital value but shareholders received 19.3¢ worth of dividends and franking credits in the mail.
To see if examples such as this were part of a bigger pattern, Lincoln Indicators tested every dividend, with a significant level of franking credit, paid by the ASX top-200 stocks in the past 12 years. And guess what: they were right.
Lincoln found that a total of $129 billion worth of franking credits was paid but the value of the stocks fell by $14 billion more than the cash value of the dividends. That amounts to an average pre-tax profit (including franking credits) of 0.87 per cent for each dividend.
Lincoln also found the most profitable time to buy a stock was 40-60 days before the ex-dividend date.
Studies such as this depend on averages, and averages can hide a multitude of sins. But the lesson for investors is that a strategy based on selecting quality stocks with fully franked dividends can boost overall returns. This is especially the case for investors on low marginal tax rates or those who invest via their super fund, which pays tax of just 15 per cent on investment income.
The fuss about franking
Dividends are not just a source of cash in the hand for investors; they also offer potential tax benefits for shareholders in the form of franking credits, thanks to Australia's system of dividend imputation.
Dividend imputation was introduced in 1987 to end the double taxation of company profits. Under this new system, tax paid by companies was attributed, or imputed, to investors.
When companies pay part of their earnings in the form of dividends, shareholders pay tax on the income at their marginal rate. But if the company has already paid tax on the income at the company level, the Tax Office gives shareholders a personal tax credit called a franking credit. This is how it works. Say a company makes pre-tax earnings of $1 a share. It pays 30¢ tax and returns the remaining 70¢ to shareholders as a fully franked dividend. Along with the dividend, shareholders get 30¢ in franking credits for tax already paid at the company level.
When investors fill in their tax return, they declare a grossed-up dividend of $1 by adding the franking credits to the cash they already received.
If you pay tax at the superannuation rate of 15¢ in the dollar, you will receive a 15¢ tax refund because the company has already paid 30¢ on your behalf. This will give you a grossed-up (after-tax) dividend of 85¢ (the original 70¢ dividend plus 15¢ tax rebate).
If you pay tax at the top marginal rate, you will end up paying tax of just 16.5¢ (46.5¢ less the 30¢ already paid at the company level). You end up with an after-tax dividend of 53.5¢ (the original 70¢ dividend less 16.5¢ in tax).
And if you are in pension phase, you have hit gold. You pocket the full $1 (the original 70¢ dividend, plus a 30¢ rebate of franking credits).
Dividends can be fully or partly franked, depending on the amount of tax the company has already paid. There are no credits for tax paid on overseas earnings, so a company that earns its income overseas, or pays no tax in Australia, pays unfranked dividends.