Many D-I-Y investors skew their investment portfolios towards shares that distribute franked dividends. This is particularly common amongst trustees of self managed superannuation funds who appear to over value the worth of dividend franking credits.
There appears to be a view that franking offers “a free lunch”, resulting in its overemphasis as a driver of investment strategy.
We believe investors should not favour particular shares simply because they pay franked dividends. The usual thinking behind such behaviour is, in our view, flawed.
The Four “Myths” about Dividend Franking
Below, we consider four widely held franking “myths”:
Myth 1: Higher franking dates indicate better future share returns
Most financial analysts believe a company’s share price is determined mostly by the Stock Market’s assessment of its after-tax profit. If they are right, then choosing one company’s shares over another based on current franking levels alone does not make sense.
Myth 2: Franking benefits low rate taxpayers
There is a view among self managed superannuation fund trustees that they are advantaged by a lower tax rate - 15% on dividends and franking credits, compared to 30% or higher forcompany and individual tax rates.
While there is no doubt that they receive an absolute advantage as a result of their lower tax rate, this will be the case regardless of the level of franking.
Myth 3: Markets value fully franked shares more highly than unfranked shares
It’s often suggested that shares offering fully franked dividends provide a benefit not available from unfranked shares. We hope that the above discussion will cause those with this point of view to reconsider.
However, even if you remain unconvinced by that discussion, it is unreasonable to expect that the share market would remove any such arbitrage profit opportunites.
Stock markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is not a secret and any benefit (real or perceived) is almost certainly already reflected in prices.
If you believe that you will receive a greater benefit by buying a franked share over an unfranked share, then surely you would be prepared to pay a little more for the franked share compared with the unfranked share. Investors will continue to pay up for any franking benefit until the higher price exactly offsets the benefit.
Stock markets simply do not allow any obvious inefficiencies or “free lunches” to persist.
Myth 4: A smart super investment strategy – fully franked, high yielding Australian shares
An investment strategy that emphasises the level of franking is also likely to focus on higher dividend paying shares, to maximise the perceived benefit.
Not only does it defy the basics of a sound investment philosophy, such an approach implies an expectation of higher income and lower growth returns, effectively ignoring the relative tax advantage of capital gains tax over income tax.
Capital gains tax offers better opportunity for tax management than franking. Tax can be discounted and deferred (sometimes indefinitely) to reduce the overall tax rate.
A franked dividend investment strategy is flawed …
An investment strategy based predominantly on exploiting the perceived advantages of fully franked shares is naïve.
Although dividend franking should be a consideration, as a driver of investment strategy it ignores the importance of the primary variables in the portfolio construction equation – risk, liquidity, costs and a comprehensive tax approach.
A better investment strategy should take into consideration portfolio diversification, earnings and dividend forecasts, as well as taxation aspects.
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