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 Dividends, oh dividends! Eureka Report article 

Dividends, oh dividends!

By Scott Francis
October 20, 2010

PORTFOLIO POINT: Dividends form an important part of any investor’s strategy, but there are traps for unwary players.

Like all Eureka Report readers, the lack of poetry dedicated to financial matters sometimes causes me to despair. Love, nature and sunsets have all provided the muse, but where can one find poems dedicated to compound interest, or hear songs from EBITDA, the musical? Don't cry for me, arbitrageur perhaps.

Fortunately, after much digging I have found an ode to dividends, a thing of such beauty that many investors dedicate their lives to finding strong and steady examples.


      Evaluation of the Rule of Present Worth

      A cow for her milk
      A hen for her eggs,
      And a stock, by heck,
      For her dividends.

      An orchard for fruit,
      Bees for their honey,
      And stocks, besides,
      For their dividends

      – John Burr Williams, 1937

Apart from being a great poet, John Burr Williams was a well regarded financial academic who focused on the value of income – or dividends – for investors. Part of his work in investment values was to propose a formula for calculating the expected return of a share based on its dividend yield, suggesting that:

Total return = dividend yield + dividend growth

This is a simple and powerful formula that is useful for guiding our medium-term thinking; if we buy a company today with a dividend yield of 5% and we expect the company to grow dividends by 5% a year for the next 10 years, then the total return we can expect will be about 10%.

What Burr Williams didn’t get around to doing, however, is explaining the value of franking credits through verse and while nothing that follows will hold a candle to those opening stanzas, they might service to alert you to some of the hidden benefits of dividends while avoiding the pitfalls.


Franking

Most of the time when we talk about dividend yield we tend to just refer to the cash component. Equally, when we talk about the indices that measure the return of sharemarkets, the common indices measure the change in value of shares (ASX 200) or the change in value plus dividends (ASX 300 Accumulation index). All of these measures completely ignore the value of franking credits.

So how do we calculate the value of franking credits in a dividend?

The shorthand way to calculate the value of franking credits for a fully franked dividend is to multiply the cash dividend by 3, and then divide by 7. For example, a cash dividend of $700 would have franking credits of ($700 x 3) ÷ 7 = $300.

If the dividend yield of a fully franked share is given as a percentage, we can use a similar calculation to work out the franking credit return. For example, a 5% yield will have franking credits of (5% x 3) ÷ 7 = 2.14%. So the total dividend return (cash dividend plus franking credits often referred to as 'gross yield' will be 7.14%).

Damien Cannavan, Frank Finn and Stephen Gray, in an article titled 'The Value of Dividend Imputation Tax Credits in Australia' and published in the Journal of Financial Economics in 2004 (click here) attempted to measure how franking credits were valued by the market. They found that “the implied value of tax credits has been insignificantly different from zero”.

This is interesting because it suggests that franking credits are an “unpriced benefit” that Australian share investors can benefit from. If we assume that the current market yield is 4.2% and the average level of franking in the market is 70%, then the additional return from franking credits is an additional 1.3% of returns which, over time, should deliver considerable benefits.

Dividend stripping

The income that dividends can generate has of course given rise to all number of strategies designed to exploit them and, at its most basic level, dividend stripping. Briefly, this is a strategy where investors buy shares in a company before they go “ex dividend”, hold the shares while the dividend is paid and then sell the shares in the hope of making a profit.

This is something that might work especially well in the Australian environment given the franking credits that add to the cash component of the dividend. One rule that needs to be understood in considering this context is the “45-day rule”, which says that to benefit from the franking credits, we have to own the shares for at least a 45 day period. Naturally this rule increases the risk of a dividend stripping strategy, as shares can fall significantly in price over a 45-day period.

It is interesting to try to model the strategy, which we will do using the following assumptions:
  • The shares are owned in a superannuation fund in pension mode (facing a 0% tax rate).
  • The parcel of shares is $10,000.
  • The shares targeted for the dividend stripping strategy have a fully franked dividend of 5.5% a year – payable in two equal dividends. Therefore each dividend is worth $275, and the franking credits are worth a further $118.
  • Brokerage to buy and sell is $20 (assuming an online discount broker is used).
  • On the ex dividend day the shares tend to fall in value by the cash value of the dividend (there have been many “dividend drop off” studies over time that seem to come up with a variety of results, although this seems the most substantial result and consistent with the study by Cannavan et al, referred to previously).
  • The average annual price return (ie, return excluding dividends) is 6% a year, or 0.5% a month. Therefore the expected price return over 45 days (1.5 months) is 0.75%, or $75.
The expected return from the dividend stripping strategy over a 45-day period is the value of the franking credits ($118), less the brokerage ($40), plus the $75 expected increase in value of the shares. (We assume that the shares fall in value by $275 on the day they trade ex dividend the $275 dividend – which is $0 net result).

Overall the total expected benefit from the strategy is $153. This is hardly a huge sum of money – however the benefit might be even less than this. If the $10,000 was not employed in the dividend stripping strategy it could be invested in an online bank account earning a “risk free” return of 6%. Over 45 days the risk-free interest earned would be $75, so the return from the dividend stripping strategy is only $78 more than what could be earned in a bank account.

Of course, the dividend stripping strategy is far from risk-free. If the shares were to drop in value by even a reasonably small amount – say 5%, or $500 – suddenly the investor is looking at a significant loss. The underlying volatility of the sharemarket makes a return of $78 over a 45 day period with $10,000 exposed to the volatility of just one company seem relatively unattractive.

The value trap

Over time there have been a variety of studies that have suggested that “value” companies – those companies with lower price/earnings multiples, higher dividend yields or a lower share price compared to company assets (price to book ratio) have provided investors with a higher return. One example of this was the paper 'Excellence Revisited' by Michelle Clayman published in the Financial Analysts Journal (click here), which found that “the market appears to reward profitable companies selling at reasonable multiples”.

A more practical application of “value companies” in investing has been the “Dogs of the Dow Strategy”, where the highest-yielding investments in an index are bought and held, in the expectation of above-average returns. The Dimensional Australian Value Trust, which selects shares on the basis of their price to book ratio, has a 10 year return to the end of August of 11.5% a year (after fees), comfortably outperforming the ASX 200 index, which has provided a return of 7.3% a year over the same period.

Of course, any value strategy would also be likely to earn the investor some additional franking credits – a further source of returns – so the short answer to this question seems to be yes.

But any commentary on investing in value companies would be incomplete without mentioning the “value trap” – that is that often shares with low prices compared to their dividends, earnings or assets have low prices for a reason.

At a practical level, companies that have experienced large falls in share price or collapsed completely – including MFS, Babcock & Brown, Credit Corp, Allco and ABC Learning – would all have looked to be good value for a period, but the reality was that they were cheap because they were under severe financial pressure.

Depending on your investment horizon, dividends are likely to form an important part of your investment strategy. With the benefits that Australian investors receive from franking credits, and the evidence that suggests that “value” companies provide investors with higher returns, dividends are an important part of the investment puzzle.
Scott Francis' articles in the Eureka Report 

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