The Sting in the Franking Tail

Well, there’s no question which party the stock market was going for last weekend.

Stocks surged to a 10-year high on the Monday after the Liberal’s election win. The ASX All-Ordinaries index hit dizzying heights not seen since January 2007.

Bank stocks closed up 5.6% on Monday. The big health insurers also rose significantly with Medibank Private booking a stunning 11.5% gain.

All up, the market added $33 billion in a stunning relief rally.

This isn’t surprising really.

With the Liberals in, the franking credit refund policy so beloved of retirees was saved. It was back to business as usual for many investors as they plunged back in.

But here’s the thing…

I think this could be a very dangerous thing for investors to be doing.

Let me explain why…

The hidden cost of dividends

I’ll admit, I thought ending the franking credit refund was actually a good policy.

But not for any political reasons you might’ve read about.

No, my reasons were deeper than the usual fighting between vested interests.

You see, in a world full of tech-driven disruption, I fear our tax system makes our CEOs underinvest in their businesses.

They’re beholden to shareholders who rely on dividend income and the associated franking credits.

Which means they’ve little choice but to pay out a consistent dividend year after year. The share price — and in turn their own bonuses — rely on this state of affairs.

The problem is, I think this will cause issues for the business down the line.

It’s all to do with a wave of tech-competition whose time has come. Especially in the world of banking and insurance.

You’ve seen this in areas like retail already.

Consider the rise in e-commerce and the invasion of tech giants such as Amazon…

A cautionary tale

For years Harvey Norman Holdings Limited [ASX:HVN] was a staple of many investor portfolios.

They were a dominant company in a profitable and growing industry. The share price grew from $0.50 in 1997 to hit a high of $6.76 in 2008. All the while paying shareholders a cut of the growing profits through dividends.

And right now, they’re paying an astonishing 11.37% gross yield.

Which would be a great return if the share price can hold where it is or rise. But with the rise of Amazon over the past few years, the share price of this once stable company is looking increasingly precarious.

Tech-driven competition is starting to eat their business alive. The share price is a tad over half its 2008 peak.

And in the past three years it’s been gradually trending down.

Could a Harvey Norman that had invested previous dividends into creating a viable e-commerce business have done better? We’ll never know I suppose. But it’s too late to find out now.

That’s part of the reason why I thought getting rid of this policy could potentially be a good thing. It’d help CEOs drive re-investment into the capabilities of our companies.

It might allow the banks and insurance some leeway to invest sufficient funds and take on this tech threat before it’s too late.

Which would actually be better for the retirees too.

Sounds weird, I know, but let me explain why…

Remember Timbercorp?

As I mentioned before, it leads to poor long-term investment decisions from CEOs. But it also leads to poor decision-making by investors themselves.

Some investors rejoicing now may get caught by a sting in the tail down the line.

The fact is you should invest in a company based on the business first, not the tax policy.

Tax strategy is a consideration of course, but it’s a consideration only after you’ve assessed the viability of the investment.

Let me give you a recent example of why this is so important…

You might remember the huge failures of agriculture managed investment schemes (MIS) that occurred around 2009–2012.

These schemes gave huge tax incentives to encourage investors to invest in all manner of timber, almond and olive plantations.

The main draw card was that you could get an immediate tax deduction on your initial investment to offset your other taxable income.

So, if you invested say $50,000 and earned $100,000 in your job, you could immediately deduct the $50,000 from your taxable income when you did your taxes.

This sounded fantastic to a lot of high-income earners.

I personally knew a partner at a big-name accountancy firm who was borrowing hundreds of thousands of dollars a year to invest in these schemes.

You see, not only could he claim the capital invested as a tax deduction to offset his $500K per annum wage, he could also claim the interest on the borrowings.

Being on such a high wage, he got a ridiculously large tax refund at the end of the year too. It was an accountant’s dream!

Unfortunately for him, and many other tax driven investors, it turned out that agriculture is a very risky business.

Ask any farmer how confident they are about the next five years and they’ll tell you that it’ll probably be famine or feast when it comes to their finances.

And for most of these MIS, it turned out to be a famine.

Investor funds were decimated.

Timbertop investor for example got just 5% of the $2 billion they put in. That’s almost a total wipe-out of your funds. And no amount of tax deductions can make up for that.

To make matters worse, many investors still had to pay back significant borrowings they were hoping future capital gains would cover.

The crux of the matter

My point is this…

It comes back to something I’ve harked on about over the past two weeks. No matter what governments do they always create a problem down the line.

Tax policy skews investor decision making.

In this case, our unique and very generous dividend policy — which you don’t get this in the USA or the UK, for example — is driving significantly less investment in our home-grown companies than would otherwise occur.

That in turn is making our companies less competitive and more vulnerable to VC backed disruptors from fintech to retail and everywhere in between.

And that could in turn lead to a huge problem for dividend investors if the value of these current dividend paying stocks starts to fall as the competition heats up.

Remember, you look at the business you’re investing in first, not the tax advantages.

Good investing,

Ryan Dinse,
Editor, Markets & Money

Ryan Dinse is an analyst at Markets and Money. He has two decades of experience in financial planning, equity analysis and credit markets. Ryan combines fundamental, technical and economic analysis to identify and invest in good ideas at the appropriate stage of the economic cycle. He has a strong interest in technology, economic history and disruptive business models. His focus at the moment is as lead analyst on two of our most recent and potentially innovative investor services, Crash Market Investor and Sam Volkering’s Secret Crypto Network. He will write about the exciting opportunities that investors could benefit from the significant changes in world markets. He is a member of Fintech Australia, a former member of the Digital Currency Council, and is a fully accredited financial adviser.

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