LESSONS OF THE FALL 21st March 2001

Peter Freeman - Bulletin

LESSONS OF THE FALL



Sustainability is the key to successfully playing the stockmarket



Wall Street has been hit hard and may be set to fall even further. Not surprisingly, even the optimists are finding it hard to see anything positive about this sharp correction. Yet among all the pain there is one worthwhile aspect that needs to be highlighted. This is the way the increasing tendency by some Australian sharemarket experts to put the emphasis on investing almost entirely for capital gain, rather than dividends, has been finally subjected to a very sharp reality check.

Driven by a combination of our new capital gains tax system and the example provided by the huge gains made on Wall Street in the late 1990s, the local investment mantra has increasingly stressed the view that it is better to get your sharemarket returns from growth rather than focusing on dividends. The most obvious manifestation of this has been the recent string of share buybacks, while a less widely reported feature has been the increased talk about companies retaining more profits, so as to finance growth, rather than maintaining their upward trend in dividend payouts.

Peter Thornhill, the head of Motivated Money, a specialist investment consultancy firm that advises many of Australia's leading financial institutions, says this mantra is wrong. His hope is that the Wall Street shakeout, which has seen the Nasdaq slump more than 60% in the last year and the much more broadly based S&P 500 drop 20%, will snap both company executives and Australian investors out of their fascination with the "growth is best" approach to delivering shareholder value.

"All the talk about dividends being less important than in the past, and the emphasis being put on investors getting more of their return in the future from capital gain, has been overdone," says Thornhill. "The rush to use share buybacks has being particularly poorly thought out. I suspect quite a few of the companies simply don't know what they are doing and are going along with some of the more aggressive advice provided by investment banks." The trouble with a lot of this advice, he adds, is that it is being provided by teams who "barely have a grey hair among them", and so have only experienced good times – at least until now.

It also needs to be remembered that an emphasis on cutting back dividends to boost a company's share price, as well as the use of other capital management strategies, tends to suit executives who have large holdings of options. There is the risk that, unless the ability to exercise these options is linked closely to a company's profitability and ability to pay rising dividends, a policy of using earnings to boost a company's share price rather than to pay dividends will be driven more by the financial interest of senior management than that of shareholders.

Russell McKimm, deputy managing director with stockbroking and advisory group D & D Tolhurst, is less critical of the recent buybacks but agrees that Wall Street's troubles are likely to prompt a sensible reassessment of the view that getting your sharemarket returns largely from capital gain is better than targeting shares that pay good dividends. "Obviously it is sensible to try and get both a solid gain and good dividends," says McKimm, adding that, in any case, good dividend paying companies are also the ones that are most likely to deliver reliable capital gain over the longer term.

"The trouble with trying to get your return mainly from rising share prices rather than dividends is that it is often difficult to time your selling well," he says, noting that, more often than not, the time when investors need to take profits is not actually a good time to sell from the point of view of maximising their capital gain. "Quite frankly, we don't believe the changes to the capital gains tax system should have more than a marginal impact on investment strategies," he argues.

The emphasis, he says, should still be put quite heavily on targeting companies that pay solid, sustainable dividends, partly because without good dividends, investors have no protection when the sharemarket suffers a shakeout. "American investors who focused heavily on technology stocks are learning this lesson the hard way," says McKimm.

Not that all companies in the United States are poor dividend payers. Some aren't. However, the surge in share prices in the late 1990s pushed down average US dividend yields last year to less than 2%, almost half that of Australian firms. The recent market slide may simply be a case of prices adjusting so as to return the yields to more realistic levels.

Probably the main justification for the US emphasis on chasing capital gains rather than getting dividends is that Americans don't enjoy the benefit of the sort of dividend imputation system available in Australia, a point made by Anton Tagliafero, head of investments at Investors Mutual. "Some people have become a bit carried away with the supposed benefits of the new capital gains tax system and are forgetting just how valuable dividend imputation can be," he says. "It certainly gives investors an important tax incentive to target companies that pay fully franked dividends."

Significantly, even after the corporate tax rate falls from 34% to 30% on July 1, everyone other than those on the top marginal tax rate will continue to get a higher net return from a fully franked dividend than an equivalent amount of capital gain. What's more, even those on the top marginal tax rate will be only slightly worse off if they get a fully franked dividend rather than the same amount as a capital gain (assuming the CGT 50% discount applies).

As for superannuation funds and funds that pay allocated and similar pensions, the tax rules strongly favour getting a fully franked dividend rather than a capital gain. This is due to a combination of their tax rates (super funds pay tax on income at 15% while allocated pension funds pay zero tax on all their earnings) and that, with effect from July 2000, any surplus franking credits are refunded to all investors by the tax office. Previously those who didn't have sufficient taxable income to absorb all the franking credits lost them, a system that seriously disadvantaged superannuation and allocated pension funds.

Thornhill of Motivated Money, while enthusiastic about the benefits of the imputation system, argues that most investors would still be better served by companies paying good, sustainable dividends even if they are unfranked. "Part of the new emphasis on delivering investor returns via capital gains rather than dividends is due to the way a range of Australian companies now have substantial offshore operations and so aren't able to fully frank their dividends," he says. "I suspect, however, that most investors would be better off if they simply received the dividend, even if only partly franked."

He is particularly critical of the Lend Lease buyback, in which the company last year paid almost $20 each for shares now worth less than $15. "The fact is the company paid too much and many investors have paid the price," he says, adding he is doubtful whether most companies have boards and senior management teams that are sufficiently astute to handle the present buyback mania properly.

Given this, the corporate caution that will almost certainly follow Wall Street's correction may have come just in time for many Australian investors. At the very least, it is likely this share slump will have provided a valuable reminder to investors that a fully franked dividend paid now deserves to be valued a lot more highly than the possibility of a capital gain in the future.


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