The Curse of Dividend Imputation

Ben Heap, Founding Partner

18 April 2017

 

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 out-performance. A decision to payout a significant share of net profits ought 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 new comers – 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 out performance. 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 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.