The curse of dividend imputation

Ben Heap

Listed Australian companies have paid out $72 billion in dividends since the start of 2017, and that is a disaster for the country. This may come as a shock to those for whom dividends are an indicator of sound financial performance or a source of perceived return corporate stability going forward or a source of retirement income. The simple reality is that the zeal with which Australian companies seek to maximise their dividend payout ratio undermines the long-term potential for these companies, and for the nation as a whole.

Company boards have two choices with respect to net profits: that is to retain the capital; or to return capital to shareholders, typically in the form of dividends. In Australia, since 1987, our dividend imputation system means that these dividends arrive in the hands of investors with an imputation or tax credit. The purpose of dividend imputation is to avoid double taxation of company profits, which is in itself a laudable aim but has created unintended consequences. It has led to an unhealthy obsession with dividends, over and above reinvestment of earnings, amongst Australia’s largest companies; so strong that a decision to cut a dividend (to invest in company growth, for example) is – to quote Sir Humphrey Appleby in the BBC series “Yes, Minister” – a courageous decision indeed.

Australia is the highest dividend paying country in the G20 - an average equity dividend yield of 5.4% as at January 2016 (versus 2.3% in the United States, to provide some context). Furthermore, the dividend payout ratio across the ASX50 is above 70%, versus 40% a decade earlier and just 29% for the S&P500 in the United States. While most investors celebrate Australia’s high average dividends, we are missing the bigger picture.

The corollary of the high dividend payout ratio in Australia is that Australian companies are not reinvesting in their own companies at anything like the rate of other global firms. Is this evidence of a superior corporate discipline here in Australia; or perhaps a paucity of investment opportunities? I don’t believe so. I believe this obsession with dividends is the easy option, to operate a corporate to maximise near-term profits and to satisfy dividend-hungry investors, without regard to the opportunity or necessity to invest in the long-term future of the business. Our corporates must remain competitive and hungry, and remain focused on growth.

I contend that corporates should proactively seek to reinvest their profits in their own growth, and only pay dividends if they cannot utilise those net profits to continue to generate outperformance. A decision to payout a significant share of net profits ought to indicate that management believes the business is mature, that its options to grow have dwindled. Perhaps this is the case – perhaps many of Australia’s largest companies are already mature? In this regard, we are certainly very different to the US market where relative newcomers – Apple, Alphabet (Google), Microsoft and Amazon – each extraordinary growth engines, make up four of the top five listed companies.

I recognise my views may be unpopular. We have been indoctrinated to believe that progressive dividends are the primary measure of financial performance. Some might argue that when companies retain a high proportion of earnings, there is a tendency for poor investments, which subsequently leads to poor earnings growth. I disagree. Poor management decisions are simply poor decisions, which is unrelated to a decision to payout dividends or to retain earnings. They might say that a high dividend is indicative of corporate confidence about future earnings, but I contend that the opposite argument is more relevant. A high level of retained earnings is indicative of corporate confidence in its ability to deliver growth and outperformance. Or they may argue that a higher dividend payout ratio indicates a higher level of confidence that earnings are real and sustainable, i.e. backed by cash flow. Again, I disagree. For how long can investors have confidence in the earnings of companies that are not reinvested in their own assets, brands, infrastructure and customers?

Over the past 30 years, the dividend imputation system in Australia has created a culture that has led to impressive and sustained dividend performance, but at what cost? Australian shareholders ought to insist that their companies seek to grow and to use net profits for this pursue and only when that is not possible, to return dividends to shareholders.


Comments

Please sign in to comment on this wire.
Avatar fallback

Henry Kaye

Exactly - look at TLS - what % of that name's register should really be invested in bonds? Now the company will eventually be forced to raise new capital while maintaining its crazy yield. Businesses like that had a name once that started with 'P'

Medium david s profile photo

David Yabsley

"Wire"? Clearly a North American view. Shareholders are entitled to a return on their investment that does not require them to sell down their holdings and loose their relative proportion of the enterprise ie. Retain their proportional voting rights, after all they are the ones who enabled the enterprise to exist in the first place.

Avatar fallback

John Wilson

I disagree, If a company can't see good opportunities to re-invest profits then pay them to me as dividends. This gives me the opportunity invest the money into growing companies. So much shareholder wealth has been destroyed by companies that acquire other businesses at high prices with the aim of "growing" their businesses.

Avatar fallback

Neil Hampton

This assumes that big is always better and the growth, growth and more growth is not just desirable but an insatiable human hard wired into our genes desire. Yes it is, imo too. But, keep growing until you fail, then fall back to where you were in past without anything to show for it (food on the table) seems a poor strategy. Consider what TLS would look like if it had grown even quicker and bigger and used revenue rather than debt to get there. Probably not a lot different, but shareholders would be a lot poorer without the real gain of dividends and still with paper losses (for long term holders).

Avatar fallback

Brandon Kibby

The argument that Ben puts up as i read it is that Dividend Imputation{DI} is stifling growth.Nothing could be father from the truth.As a company grows it has a choice to keep cash for growth or pay it out to shareholders.DI puts pressure on management to allocate the free cash flow where they think it is best used.At one end of the spectrum there is the banks who pay a lot out because they have no growth options.On the other end companies like Challenger,Sol Pats,Westfield that retain a lot for growth.Everyone is somewhere in-between.If Ben is alluding that companies are taking the soft option of paying out i would say that is the fact we have developed cultural process driven board rooms, that is what lets us down If the USA had DI it would not have produced the Enron disaster and the 100 billion Apple has offshore, that is not being held for growth, would be back in America in the hands of the tax office and share holders. We should be very proud of the outcomes of our dividend imputation system.Trump should take a look at our system.

Medium john kimber

John Kimber

I am pretty sure that the US fund manager thought I was lying when I explained that Australian fully franked dividends are essentially free of tax for Australians and free of withholding tax for foreign investors. Advocates of no franking would be right at home in the US where corporate taxable income drives buy backs, massive takeovers, huge salaries, and tax inversions in Ireland and other low tax jurisdictions. The only US investment that comes close to a fully franked dividend is a tax free municipal bond. Unlike Australian fund managers who receive the cash benefits of franking there is much less choice in the USA about how corporate profits are allocated. If you want unfranked, visit the USA.

Avatar fallback

Timothy Cole

Excellent Ben. IMHO one has to leave aside the boomers & retirees obsession with divs, and look at the make up of ASX listed boards. As you point out boards are often process driven and arguably require mgt talent to avoid the (all too often) capital destroying acquisions

Medium bah portrait nov2015

Ben Heap

Thanks all for the feedback. Some good points for any against; not surprisingly there are a variety of opinions. My key argument is that Australian companies and boards must not be afraid to reinvest in their own businesses - dividends are always well received, but should not be at the expense of ensuring iconic Australian companies remain great companies well into the future.

Avatar fallback

S Leung

In theory the author may be right- but in practice corporates often have not so great track records when they have too much cash in their hands. Eventually a poor CEO would come along and blew it all in poor, overpriced investments. A higher payout culture would force more disciplined management practices- they must have a growth story so compelling as to convince the buy in of shareholders, thus enforcing more considered deployments of capital.

See 6 more comments