The trouble with buybacks

Apparently Alan Greenspan has discovered China exists and he thinks it's all a bubble. Well thanks for that, Al, stick to lawn bowls.

I suppose if anyone is an authority on bubbles it's old Al, who, with his ridiculously loose monetary policy, clearly created the US speculative housing bubble. The point I am making is that the comments from the former chairman of the Federal Reserve on the Chinese equity market have had a negative influence on companies exposed to China, most notably Australian resource stocks.

However, I suspect his comments are being used as an excuse by traders and short-termists to take profits and lock in some outpeformance (and, in turn, performance fees). I would be using the "Greenspan effect" as a clear medium-term buying opportunity in the right long-duration China-exposed stocks, and reiterate my view that the emergence of "Chindia" will be the dominant investing theme of our generation. (To read Tim Harcourt Austrade's chief economist writing on Chindia in today's Eureka Report, click here).

Clearly, markets are due for a round of profit-taking, and they were looking for an excuse to take profits. Greenspan's comments gave them that excuse, and in these days of heavy leverage, the corrective phase is quite violent and quick.

Here we are with resource stocks under short-term trading pressure ahead of what will be a bumper full-year earnings and dividend season, and ahead of what will be a bumper M&A season. You can bet your last dollar that those resource companies who see themselves as corporate targets will come out with BIG capital management surprises at their full-year results. You can also expect to see very upbeat outlook commentaries from the resource sector.

This will prove to be your last chance to set portfolios in long-duration resource stocks before the full-year reporting and M&A season, and I strongly encourage you to take advantage of the "Greenspan effect".

Fully franked yield

After the 2006 federal budget I came to the conclusion that the price paid in price/earnings (P/E) terms for assured fully franked dividend streams would rise for two reasons. The first was that one-off changes to superannuation contributions would drive demand for fully franked dividend streams; the second was that reductions in personal income tax rates, and the increases in brackets, would reduce the "top-up tax" individuals would have to pay on fully franked dividend streams. That theory did prove accurate, and high assured, fully franked dividend payers such as the major banks and Telstra did get re-rated in the 12 months after the budget by demand from retail investors and superannuants.

Here we are 12 months later, and to quote the famous US baseball coach Yogi Berra, "it's deja vu all over again". The 2007 federal budget was again supportive of fully franked dividend streams. While it was not as spectacularly supportive as the 2006 budget, the 2007 budget will again see the price paid in P/E terms for assured fully franked dividend streams rise.

The 2007 budget again contained income tax relief for individuals in the form of bracket increases. Those bracket increased are mostly directed at middle-income earners, with high income relief starting in 2008-09 (the top rate kicks in at $180,001).

I just want to give one rough example of why I am bullish on fully franked dividend payers. Now look, I am not a tax expert, other than I pay a lot of it, but the simplified Australian Taxation System does make scenario analysis relatively simple.

If an individual generated $30,000 of fully franked income, the tax paid would be $4350, yet the franking credit would be $9000, generating a rebate of $4650

If an individual generated $30,000 of fully franked income, the tax paid would be $3600 yet the franking credit would be $9000, generating a rebate of $5400 in 2007-08, or an after tax increase of 16%.

I'm just making a basic point above, and there are a plethora of scenarios you can run with different fully franked income streams. The point is that the changes to the income tax system make fully franked dividend streams more valuable to investors, and that's before any consideration is taken into account for the deductibility of financing costs.

It's my belief that the ultimate goal of the Federal Government is for the top marginal rate to be equal to the corporate taxation rate of 30%. The goal could be achieved over the next decade, and if it is the ramifications for assured fully franked dividend streams are enormous.

If that goal is achieved it would make fully franked dividend streams effectively income tax-free for individuals. CBA would trade on a 5% tax-free yield, and that after-tax yield can be aggressively enhanced by financing the investment with deductible interest.

Perhaps the best trade of the next decade for individual investors who want to play this theme is to borrow equity against their home, buy a basket of assured fully franked dividend payers such as the banks, Telstra, Wesfarmers, and Qantas, using 100% debt and no equity. The interest is fully deductible for individuals, while the fully franked income streams will eventually become tax-free income streams over the next decade as income tax rates fall. Sure, the stocks will move around, but over a decade capital growth will be strong and you will have received 50% of your investment back in dividends over that time. Add in the tax rebates for the financing costs and franking credits and you can see the Federal Government is basically funding your investment.

Can't get enough of them

I am a huge believer in fully franked dividend streams. I can see yields in Australian equities being driven dramatically lower over the next decade as share prices of fully franked dividend payers are bid up to reflect the increased tax-effective attractions of those income streams to geared individuals. If that happens that's fantastic, as the capital gains generated will be enormous in the right stocks.

It's been my long-held belief that Australian equities are priced in the longer-term on grossed-up dividend yield multiples. The unique nature of the Australian taxation and superannuation system leads to Australian stocks being priced off prospective grossed-up dividend yield. The reason I recommended Telstra 3 so aggressively was because of the huge prospective fully franked dividend stream the instalment receipts offered. Institutions and analysts shunned the T3 offer, but retail investors and high net worth individuals bought as many as they could and have been rewarded handsomely in income and capital gains terms. Those who geared into the instalment receipts have generated extraordinary gains.

Tight registers

Up to 50% of the registers of Australian banks and telcos are controlled by retail investors who are only interested in fully franked income stream growth. For all the millions of pages of research written on banks, the simple fact is the share prices track dividend growth. Yes, you need to analyse and forecast that dividend growth, but the whole game is about dividend growth. Just look again at this graph of the Commonwealth Bank (CBA) share price versus dividend growth. It tells you the most simple of stories. It shows you that CBA will be a $70 stock through time as dividend growth is delivered. If, however, the market accepts 4% dividend yields from banks instead of 5% dividend yields, as tax breaks generate the same after tax income from that lower yield, then CBA will be an $80 or $90 stock over the next decade.

Boards are being sent a message

The message to Australian boards and management teams is a simple one. The unique Australian taxation and superannuation system leads to individual resident investors paying (in P/E terms) for fully franked dividend growth.

Buybacks don't work in Australia. They generate capital gains tax issues and only lead to superficial earnings-per-share upgrades. The tax office will rule out off-market buybacks with low capital components one of these days and Australian boards will have to find a new way of returning excess profits to domestic investors.

Buybacks do NOT get you a permanent P/E re-rating in Australia. Dividend growth does. I know many company directors and CEOs don't agree with me on this, but in an Australian-centric context, buybacks simple don't lead to permanent P/E re-ratings. They may work elsewhere in the world, but they don't work here, in my opinion.

How else can you explain a stock like BHP Billiton commanding a 50% P/E discount to Telstra? BHP has bought back shares aggressively, yet the P/E remains 10 times. Telstra has held the high fully franked dividend, and is on the cusp of growing it (Telstra remains a strong buy), and it commands a P/E of 16. The Australian market hasn't given BHP even one P/E point for its large-scale buyback programs.

I am BHP's biggest supporter, but I know for a fact that large Australian fund managers have consistently told BHP to forget the buybacks and simply lift the dividend payout ratio: that's how the share price will be re-rated.

Look, the BHP progressive dividend policy has been fair enough, and the buybacks make economic sense, but it's time to get serious and get the dividend yield up. No special dividends, they are a cop out and don't get capitalised permanently in share prices. This is about ordinary and sustainable dividend yield driven from a sustainable payout ratio. Yes, in BHP's case, you have to pay the Poms the same dividend, but the re-rating of the Australian listed scrip will drag up the UK scrip once the payout ratio is increased. That's how you get re-rated in Australia, and that's how BHP moves instantly to 12 times earnings from 10 times. I hope BHP and others use the pending full-year reporting season to address this issue once and for all.

If you believe in the sustainability of the multi-decade commodity cycle, as I do, then the largest fully franked dividend growth you will find in Australian equities will be in resources. This is where the real dividend yield and P/E re-rating lies over the next decade. It's my long-held strategic view that the Australian resource sector will eventually pay "bank-similar", fully franked dividend streams once they turn off the capital expenditure tap. This day will come, and the P/E ramifications are large.

This is one of the reasons I like Fortescue Metals. One day, this company will be a huge fully franked dividend payer. Fortescue has the potential to pay the highest, sustainable, fully franked dividend yields in the Australian resource sector, and that is why it could command a bank similar P/E through time.

Private equity vs fully franked dividends

Australian investors’ love affair with assured, fully franked dividend streams is one clear reason why private equity is having trouble getting results in Australia. The Qantas takeover attempt, or "The great plane robbery" as I like to call it, was the clearest example yet of high fully franked dividend yield beating off private equity cash.

Clearly, Qantas retail and institutional investors were not keen to sell their 5%-plus fully franked dividend stream for a one-off cash payment while concurrently triggering a CGT event. They also, rightly or wrongly, were suspicious that the Qantas board was "having a lend of them" and that the deal was really management buyout in disguise.

Knocking back the Airline Partners consortium has already proved rewarding for Qantas shareholders. They will receive the 2006-07 full-year dividend in August, which has the potential to be jacked up with other capital management initiatives, and even before that the stock is trading 30¢ above the Airline Partners offer on fundamentals. Suddenly, a more upbeat growth tone seems to be being set by Qantas management, and the stock is headed to $7 over the next 18 months.

The clear point is that investors were right to hold on to their big fully franked dividend stream in Qantas. With reforms to the Australian taxation and superannuation system, these reliable, fully franked dividend streams are only going to get more and more valuable. Don't sell them to the highest short-term cash bidder. That includes you Future Fund board of governors. If you sell a single Telstra share, you have lost your mind.

More Charlie Aitken columns, on:

• Coles and Wesfarmers
• Commonwealth Bank/Ralph Norris
• Water, GWA International and Newcrest