|Summary: Funds manager Simon Lindsay shows below that stocks paying fully franked dividends have outperformed the market over the past 12 years. He described this as a hidden value signal. However, Eureka Report writer Scott Francis begs to differ, suggesting that while franking credits are important for investors, he is not convinced they are a value signal.|
|Key take-out: A basket of stocks paying fully franked stocks would have outperformed an index strategy over the last decade by approximately 2.7% per annum on an after-tax basis.|
|Key beneficiaries: General investors. Category: Shares.|
Franking of dividends delivers valuable tax credits to long-term equity holders. But franking is also a hidden ‘value’ signal that many don’t understand.
‘Value’ stocks are those typically with strong and mature businesses. They are typically characterised by moderate to high dividend yields and sound fundamental value measures such as a low price earnings ratio (the current share price divided by annual earnings per share). Academics and investors have, since the early 1990s, recognised the long-term outperformance of ‘value’ stocks. The franking of dividends is a reliable and simple ‘value’ signal.
As shown in the chart further below, a simple portfolio of fully franked stocks would have outperformed an index strategy over the last decade by approximately 2.7% per annum on an after-tax basis and is strongly related to common ‘value’ signals.
There are strong theoretical reasons to support this observed outperformance. Firstly, fully franked stocks should be undervalued as stock prices are often set by investors (such as market makers, derivative hedgers, overseas investors) who cannot attribute value to franking credits.
Secondly, fully franked stocks demonstrate a ‘value’ bias. Dividends have long been used as a company stability indicator. Franking is an additional signal of the propensity of a company to pay tax, and so the sustainability and stability of the company. Franking is a unique Australian phenomenon that is poorly understood by global investors and academics.
Franking as a signal
Figure 1 below shows the cumulative value of $1 invested at the end of December 2000 in a number of different simulated Australian equity strategies. This chart shows a pure passive S&P/ASX 200 strategy (blue line), with the full value of the franking credits included in this analysis. This figure also shows the value of investing in only fully franked stocks (red line) on the same basis, and in non-fully franked stocks (green line). This analysis shows a naïve strategy of only investing in fully franked stocks has outperformed the passive index strategy by 2.7% per annum over the period since December 2000, and non-fully franked stocks have underperformed by 4.4% per annum.
Fully franked stocks generally have a higher cash dividend yield than the broad index – approximately 0.5% per annum.
Frankly, there may be other factors
There is no question that franking credits are an important component of investor returns. Indeed, my article today (An after-tax bonus from shares) looks at evidence that highlights their role in making Australian shares the most tax-effective asset class out of those an Australian investor would usually make.
That said, I am not convinced that franking credits, in the form of fully franked dividends compared with partially franked or unfranked, are a ‘value signal’. It makes sense that, like cash dividends, they provide information for the investor about the capacity of the company that they own to make payments out of cash flow – in this case to the Tax Office – which is a good thing.
However, I define a ‘value signal’ as something that shows investors are paying less for a characteristic of a company when compared to other companies. These are things like dividends, book value or earnings – with a value company being one where people pay less for a dollar of dividends, book value or earnings compared to other companies. The difference between fully franked and partly/unfranked dividends does not seem to give the same signal about something compared to a company’s price. If, for example, gross dividends (dividends plus franking credits) were used, that would be something I would see as more of a value signal.
That said, there is Australian academic research that finds that franking credits are an ‘unpriced’ benefit for investors for owning Australian shares – which would contribute to fully franked shares outperforming on an after-tax basis. This is because the additional return from franking credits will be seen in superior ‘after-tax’ returns – providing some support for ‘fully franked dividend’ outperformance.
Here is another explanation for the outperformance of shares that pay fully franked dividends over the past 10 years.
A key reason that some companies pay partly franked or unfranked dividends is that they derive at least some of their earnings from overseas. In December 2000 the Australian dollar was trading below 55 US cents. A low Australian dollar is great for companies earning money overseas – it means that when they bring their earnings back into Australian dollars their profits are increased.
Over the subsequent 12 years those earnings (in Australian dollar terms) effectively halved as the $A soared to well over ‘parity’. This would mean that companies earning money overseas would have seen their returns, in Australian dollar terms, decreased.
If this explanation has some value, then you would expect that in an environment of a falling Australian dollar that this trend would be reversed as companies saw some currency increases to the overseas earnings.
While it is interesting to look at a back-tested investment strategy over 12 years or so, I think caution should be shown in putting too much stock in this statistical analysis. If we looked back over a 12-year period, we can find many patterns in share price movements – the question is whether those patterns will repeat in the future, so that we can exploit them.
I remember an extended period when companies whose name started with the letter ‘W’ (including Wesfarmers, Westpac, Woolworths and Westfield) outperformed the broader market – however you would hardly build a portfolio based on expectations of this repeating.
It would be interesting to know how the strategy has performed back to the introduction of franking credits in 1987 – a timeframe that would provide more support for the strategy.
The research around franking credits is interesting – although limited by the fact that they are a comparatively new addition to the Australian investment landscape. There certainly is some support for the idea that, on an after-tax basis, companies paying fully franked dividends might outperform.
That said, outperformance over the past 12 years may well have been influenced by significant currency movements unfavourable to companies with overseas earnings. Twelve years of back-tested data is not a huge period of time (given that franking credits have been around for twice that length of time) to be finding patterns in share price returns that we might expect to repeat.
Simon Lindsay is a director of Aurora Funds Management Limited. Scott Francis is a personal finance commentator and previously worked as an independent financial advisor.