High dividends sitting ducks as franking targeted

Any trimming of franking benefits is going to hit Telstra and the banks.

High dividend-paying stocks are in the sights of the Abbott Government. Picture: Gary Ramage

There is now a clear danger that the dividend system on which the entire Australian stockmarket turns may be under threat.

The tax “discussion paper” released this week has put the option of cutting back on franking benefits on the table. High dividends — topped up with franking tax benefits — is the backbone investing strategy for millions of private investors.

Being realistic, no government will swipe at the so-called “dividend imputation” system in one hit, but there is every chance the Abbott government will outline plans in the May budget that will progressively trim back the advantages of the framework.

It’s hard to underestimate just how important such a change would be even if it was to be introduced over a number of years and even if it was — as is expected — partial in its application. The prevailing idea is that the government will tell listed companies that once their dividend payout ratio goes over, say, 80 per cent, there will be no franking credits available to the portion that exceeds the limit.

Such a move would have two immediate consequences:

● Investors would receive lower after-tax dividend income from these companies and would be encouraged to look elsewhere for yield. (Just to recap on how it works: to avoid double taxation, when investors get fully franked dividends they are entitled to a tax rebate — this improves the benefit of the dividend. A dividend worth 4.5 per cent of the stock price might be worth about 6 per cent after franking.)

● And (from a macroeconomic perspective this is positive) a change of this order would force the companies to start investing in their businesses and pay less ­attention to designing their operations around maximising their dividend payouts.

For investors I would say there is no need to be alarmed, but there is certainly a need to know which companies have drifted well above 80 per cent— that is the number that might be regarded as “sustainable” in terms of the dividend payout ratio, or the percentage of profits paid out as dividends.

The list of popular companies with higher payout ratios contains some widely held stocks. But it might be useful to focus on those I’d regard as sitting ducks — quality stocks but with high ratios. Every one of these nine stocks (in the table) is in the frame, even if a tame version of dividend imputation reform goes through.

Outstanding among the high payout ratio group is Telstra (90.9 per cent) — the argument has always been that the telecom group has great cashflows to underpin this framework but in the end the figure stands as a testament to the unintended consequences of dividend imputation.

It’s also interesting that banks feature strongly here. Top of the pile is NAB, which traditionally ran a high payout ratio — today it is at 88.1 per cent. Meanwhile, Bank of Queensland stands at 86.4 per cent.

The irony for shareholders is that while payout ratios have been climbing, actual dividend yields have been falling — largely as a result of the powerful share price increase enjoyed by top dividend payers as the “hunt for yield” rages on. A perfect example of what has been going on is Commonwealth Bank. In 2011 you could get a dividend yield from that stock of 6.4 per cent (all figures here are before franking) and the bank had a “payout ratio” of 72 per cent. Today, CBA has a yield of 4.53 per cent and a payout ratio of 74 per cent.

What to do? Well, staying confined to the sharemarket the most obvious move would be to concentrate on stocks that can continue to grow dividends without finding themselves going across whatever line the government may choose to impose.

In fact finding stocks with lower payout ratios is a healthier option anyway because the same stocks have money in the tank to invest in their own businesses and achieve profit growth long term which is what they must do sooner or later.

A good example is mining-related stocks. Rio Tinto is lumbered with a falling iron ore price but remains attractive to long-term-focused value investors because it is well managed and it has a wider suite of assets beyond iron ore. Better still, while these issues are playing out the miner has become a strong dividend payer. Just now it has a dividend yield of 5 per cent and a payout ratio of just 51 per cent.

The other option is to concentrate on stocks that might make bigger and better profits in the future rather than those that will ratchet up their dividends to unsustainable levels — in the end we will all be better off with those companies anyway.