What do the proposed franking changes really mean for Australian equity investing?
Whatever the political outcome in May, companies will need to manage their capital efficiently and to create long-term returns for shareholders.
An interesting theme that emerged during the recent Australian reporting season has been the growing impact of political uncertainty on corporate behaviour.
In particular, the expected Federal election in May has driven companies to dramatically change their short-term capital-management strategies.
Below we discuss what has happened, and some of the implications for the Australian equity market.
Potential rule changes prompt company action
It’s likely that a Labor win at the next election would bring changes to Australia’s imputation system. Labor has proposed to end cash refunds for excess franking credits to zero tax payers, typically self-funded retiree super funds (SMSFs) which have received the cash value of franking credits.
Companies have been proactive as a result to ensure the economic value of their franking balances will not get lost to their shareholders by a potential rule change. Many companies across the market announced special dividends in their results, and bumped up their short-term payout ratios for the period leading up to the election.
As part of their results, we saw a noticeable increase in payment ratios, in particular from resource companies with large franking balances.
Always keeping shareholders in mind
Ahead of the reporting season we pre-empted that Labor’s policy may have a large impact on company behaviour, and had written to every major company held in our portfolios with a large franking balance, reasonable capital position and strong cashflows, to ensure that the excess franking credits were returned to shareholders as part of their capital management strategies.
These companies included Woolworths, Wesfarmers, Woodside Petroleum, Adelaide Brighton Cement, JB Hi-FI, ASX and Caltex.
We received a positive response from each company we contacted, and their subsequent actions during reporting season show that many companies are adopting sensible capital management strategies in relation to the distribution of surplus franking credits.
Will franking have a value in the future?
Goldman Sachs1 has calculated that in 2018, shareholders in ASX 200 companies received total dividends of A$68.6 billion, with A$22.3 billion of franking credits attached. They have estimated that the policy changes will impact only around A$3 billion of these franking credits.
We note that a future value for franking credits does remain, as Labor’s policy allows accumulation investors in the 15% tax rate cohort (that is, the majority of 12.7 million employed persons in Australia2) to still be able to claim franking credits as a deduction against any tax paid on income. Pensioners, charities, foundations and not for profit entities will also be exempt from the policy.
What is the impact on future capital management plans?
While companies have made short-term adjustments pre-election, we see that the proposed policy will also have an impact on how companies think about capital-management longer term.
The value of franking to Australian investors had traditionally created a strong capital allocation culture. Australian companies have historically been very disciplined in dealing with any excess cash, typically distributing this as franked dividends. They would then raise capital only when required. This is a contrast to US and global counterparts, who are more likely to hoard cash.
This capital discipline of no excess cash and also having to justify the value of any new capex to shareholders will be lessened when there is a weakened incentive to distribute franked dividends to investors.
Should the policy be enacted, we see that it could lead to reduced payout ratios. It will also see fewer off-market buybacks by companies, which are usually valued as an effective way to distribute franking credits as they allow investors to choose whether to participate or not.
How will this change investor behaviour?
We see that this change will create a tax arbitrage between pooled superannuation funds and individual superannuation investment (e.g. SMSF) and may have an impact on how capital is allocated to Australian equities by these investors, or how they invest.
Pooled funds will be able to realise franking credit value by using them as a deduction against the 15% tax payers and then channel those benefits to 0% tax payers (or just give the benefit of franking to its pension members to all members). A SMSF in pension phase will not have that ability to channel, as their 0% tax rate means franking will have zero value. This may act as a disincentive for a SMSF to invest in Australian equities, or encourage it to look at restructuring their investments into other structures.
The long-term impact on markets
How you see expected returns depends on if you had previously valued the extra ~2% p.a. return for a 0% tax payer in your projected return assumptions, as we do for our clients3.
The Martin Currie Australia investment process formally values franking credits and penalises unfranked dividends, and therefore franking is a driver of every investment decision.
But we do see that there will be few long-term implications to expected returns for the Australian equity market, as franking is not fully valued by the broader market beyond franking ex dates. Academic studies put this value as only 40% of value being reflected in shares prices4.
Despite the concerns regarding political uncertainty for the value of franking credits, company boards have shown a positive reaction this reporting season. Specifically, we have seen an increased awareness of the importance of releasing imputation credits to shareholders.
A dividend imputation system will remain in place under a potential new government, and we believe that companies will continue to distribute the franking credits attached to their dividends, leading to more sustainable returns.
Whatever the political outcome and potential changes to policy, our focus will continue to be on companies to manage their capital efficiently and to create long-term returns for shareholders.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable
1Source: Goldman Sachs Portfolio Strategy Research: Potential tax changes could trigger a spike in buy-backs. 24 January 2019
2Source: ABS, 6202.0 - Labour Force, Australia, Feb 2019
3Source: Martin Currie Australia; data shown for illustrative purposes only
4Source: Geoff Warren, Australian National University: Are Franking Credits Capitalised into Share Prices? 22 November 2013
Past performance is not a guide to future returns.
The information contained in this presentation has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not
be assumed that any of the security transactions discussed here were or will prove to be profitable
Martin Currie has procured any research or analysis contained in this presentation for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given.