This month:

Income investors need to overcome their obsession with franked dividends and focus more on growth

Marcus Padley

Iknow a lot of you have big holdings in banks for income, but it has, in hindsight, been one of the biggest Australian investment mistakes of the past five years.

In that time, as you know, the banks have been pummelled. It all started with a Commonwealth Bank rights issue in March 2015, which led to $12.4 billion worth of bank sector capital raisings by year end. That first CBA issue marked the peak of the sector.

After that initial bout of indigestion came a series of negative waves starting with those unnecessarily prudent APRAled “restrictive lending practices” in 2017, now repealed. They kicked off a slowdown in the bank sector’s lifeblood, the housing market, and as credit lending slowed, and as Labor’s Bill Shorten threatened measures to pique the investment lending market, we saw the first bank sector earnings downgrades in years.

Then came the royal commission, which started with a discovery process that paralysed department after department, involving thousands of employees who were rendered unproductive and demoralised by millions of wasted hours in front of a photocopier finding, scanning and printing documents. With the royal commission itself came the loss of reputation, the brand damage, the destruction of their wealth management brands and businesses, asset sales, business restructuring, more employee demoralisation and more earnings downgrades.

And then in November, just when the sector was getting back into uptrend, the AUSTRAC revelations cratered Westpac by 14.7% in a month, with ANZ and NAB both down 11% in a month. (CBA survived, up 0.3% in November, having already been through the AUSTRAC fiasco.)

All in all, since the March 2015 sector peak, when Commonwealth Bank announced the first of the 2015 rights issues, the sector is down 27.7% against the All Ordinaries, which is up 14.8%. Including dividends, the total return from the All Ordinaries Index is up 42.51% since March 2015 with the total return of CBA, Westpac, NAB and ANZ individually underperforming the index by 34%, 59.1%, 47.2% and 52.9% respectively.

Despite this underperformance, most fund managers, intimidated by the fact that the banks formed 25% of most benchmarks, didn’t sell. They didn’t sell because they like to hug their benchmark and getting a big sector like the banks wrong is suicide. So they sat with neutral holdings.

And retirees didn’t sell because no one ever told them to. Few advisers would, could or will ever advise retirees to sell their banks. They are an Australian institution, an oligopoly, and they’ll be all right in the end. Won’t they?

On top of that, the advice industry sees it as a value add to collect franking credits for clients, and that’s what the banks are used for. Getting a refund is clever, taking money off the tax office an astute strategy, surely. But for the past four years, chasing a franking credit refund through banks has been a mistake. The credit still arrived, but the loss of capital more than matched it.

And there are other reasons retirees do not sell. Some boringly call themselves long-term investors with a blinkered “buy and hold forever” approach. Some are wealthy enough not to need to sell, so underperformance is not their concern. And others do not sell because they cannot find investments with similar yields, because they would rather lose money than pay the government capital gains tax and because they have shut their eyes to the loss of capital, consoling themselves that they don’t care what the share price is because they are never going to sell and “it’s my kids’ problem”.

But the truth of the matter is that a dollar is a dollar whether it comes from dividends, a cash refund from the tax office or a capital gain, and while I wouldn’t want to burst the bubble of the traditional yield-reliant retiree, chasing income stocks has not only cost money because of the banks but will continue to cost you money because it corrals you into mature companies with few growth options and nothing better to do than return money to shareholders. And then there’s the opportunity cost of not holding quality growth companies with high returns on equity because of their low yields.

CSL, for instance, has returned 216.9% since the bank sector peak in March 2015, Aristocrat Leisure 315%, Cochlear 175.8%, Treasury Wine Estates 296%, ResMed 156%, ASX 127%, Woolworths 60.7% and Wesfarmers 70.6%, to name a few. And none of these companies yield more than the market average. CSL has a yield of 0.8%. Meanwhile, they continue to earn a 32%

return on equity and reinvest their profits at 32% for a far superior total return than anything available from high-yielding stocks.

In the US they will tell you that bonds are for income and equities are for growth. That culture is why the US market yields 2.5% while Australia yields 4.5% plus franking, or around 5.89% on average – because some Australian chief executives pander to the siren-like obsession of their Australian shareholders with fully franked yields.

But with term deposits paying around 1% it just doesn’t make sense for companies to give money back to a shareholder who earns 1%, not when the company’s return on equity is 20%. Far better they keep it and reinvest it at 20%.

The American culture is to reinvest for growth all the time, which is why Microsoft and Berkshire Hathaway resisted paying dividends for decades. In the US paying a dividend is seen as failure, the sign of a company lacking ideas and ambition.

The bottom line is that if you are investing in equities to provide an income, you would be better off focusing on total return rather than dividend yield. Yields, franking and the cash refund are distracting you from the best stocks in the market. Of course, you will have to sell shares to buy the groceries, but if you can get your head around that little conundrum you’ll be eating smashed avocado for breakfast and going to bed dunking chocolate, not plain, digestives.

Chasing income stocks corrals you into mature companies with few growth options and nothing better to do than return money to shareholders