Franking matters… but less than before

Market insights

Jason Todd, CFA, and the Investment Strategy Team
Tuesday 17 April 2018

Recently the leader of the Labor party announced a proposal to reverse the Howard-era policy of refunds for excess franking credits. It came as quite a surprise to the market, which moved to discount stocks that carry a premium for franking credits versus those that don’t. 

Telcos and Financials (ex REITs) that carry high franking and where yield has been a disproportionately high contributor to returns in recent years were broadly weaker as a result. In contrast, stocks which have franking but are supported by stronger earnings growth and/or higher offshore shareholder bases (Resources) came under less intense selling pressure, as did REITs which have high dividend yields but no franking.

High franking credit stocks hit vis-a-vis yield + growth


Source: MWM Research, IRESS, March 2018

Bank hybrid securities were the other main casualty following last week’s proposal, particularly those with longer call dates (see accompanying chart). All hybrids shown in the accompanying chart pay 100% fully franked dividends. The sell-off has been a fairly logical response given hybrids don’t provide any capital upside (unless trading below par) and low-tax-rate super funds are much more active in this segment of the market. Hybrids are typically valued on a grossed-up assumption (eg grossed-up running yield and yield to call) with the assumption investors can make full use of franking credits. Investors who can utilise franking credits as tax offsets will be unaffected, but those who previously took advantage of tax refunds will likely demand a higher margin as compensation (lower price). 

Westpac’s recent hybrid offer (WBCPH) listed at a discount to par on Wednesday (ending the week at $98.40) after raising $1.7b at a tight margin of 3.2% above bank bills. Commonwealth Bank announced a 3.4% margin on Thursday for its current hybrid offer (CBAPG), which was at the bottom of the 3.4–3.6% range, but it will be interesting to watch issue size and how it trades once listed. Overall, we think SMSFs will require a higher margin for future raisings to compensate for the potential loss of franking credit refunds, particularly given the longer life of recent listings with early call dates in 2025.


Could corporates fast track the reduction of franking?


Source: Macquarie Research, March 2018


Resource stocks dominate franking credit value

Source: Macquarie Research, March 2018

Labor’s proposal may never see the light of day, or if it does, it could differ significantly from the current proposal. Nevertheless, it marks a significant turning point in policy surrounding Australia’s franking credit structure. No longer is this a sacred cow. Regardless of the future path of franking policy, the cushion for a lower benefit derived should now be considered in portfolio construction: We see three long-term implications.

  1. The market should not take for granted the tax status that underpins the premium paid for high-dividend-yield stocks with attached franking credits. We’re not entering the debate around double taxation but the market, over time, has attached a substantial value to income generation versus earnings growth. This is no more clearly evident than in the long-term PE multiple applied to the Australian market which has remained elevated despite multiple years of poor earnings growth (2016–2018 EPS growth has annualised half the dividend yield over the same period at 2% versus 4%).

  2. Retail-heavy stocks (Banks and Telcos), hybrids and LICs are not priced for a long-term reduction in value from low-taxed investors. Net yield and sustainable dividend growth will become increasingly important regardless of whether these proposals are enacted. Similarly, the potential for special dividends and buybacks is now more elevated as firms try to get in front of policy proposals and pre-emptively reduce franking balances (see Franking Matters – 2017 June Year-End Update published 7 December 2017).

  3. Franking credits are less relevant for companies able to significantly grow their bottom line, and therefore their dividend stream, over the medium term. We manage a dedicated income portfolio that is diversified by sector, level of franking, yield and earnings growth. While this has a trade-off in terms of upfront yield and franking credits, it provides some insulation from unexpected policy proposals. We continue to favour areas where value is evident (ie Banks – ANZ and WBC) and/or where earnings growth is strong and the potential for special dividends and buybacks provides cushion for tax changes (i.e. Banks and Materials).


Banks continue to hold value vis-a-vis REIT's


Source: Macquarie Research, March 2018


Telco's valuation hinged on yield sustainability which is poor

Source: Macquarie Research, March 2018

In a tax-uncertain world and where bond yields are rising, we prefer dividend-growers over pure bond proxies or where valuation is a significant cushion for just yield. For the former our picks include Amcor (AMC), Goodman Group (GMG), Orora (ORA), Sydney Airport (SYD) and Transurban (TCL) which all look relatively attractive given the uncertainty created for fully franked dividends. Similarly, the large cap diversified Material stocks – BHP Billiton (BHP) and Rio Tinto (RIO) – both offer a reasonable running yield (fully franked) but with double-digit earnings growth outlooks. What’s sacrificed in yield is offered in the potential for special dividends/buybacks as well as continued value creation.

Last, we continue to have a favourable stance on the banks versus REITs despite banks sitting with a large retail shareholding as well as fully franked dividends. This is because they trade at a ~20% discount to REITs (a ~30% discount to industrials) while providing a positive yield spread of between 1–2%. Banks have a subdued underlying earnings growth profile but in a low growth, favourable credit environment, the potential for banks to return capital to shareholders via special dividends and buybacks is high. The banks sector continues to trade a deep discount to the market, currently at a ~31% discount to industrials (vs LT average of ~20%), and we see relative value at current levels. Our preferred banks are Australia and New Zealand Banking Group (ANZ) and Westpac (WBC).

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