One of our most lucid sharemarket commentators, Roger Montgomery, the chairman of Clime Capital, ruffled more than a few feathers in a recent edition of Eureka Report with a thoughtful criticism of what might be called the dividend payout mentality on the ASX. In A pox on dividends, Montgomery argues that companies pay out too much in dividends. He says the constant shareholder demand for franked dividends forces many of the best Australian-listed companies to waste money on dividends, money that could be reinvested. Crucially, he argues that the best Australian listed companies would profit from scrapping dividends. The suggestion prompted a stream of letters from subscribers. However, the most entertaining and instructive correspondence was exchanged between Montgomery and Neville Ward, who runs Neville Ward Advice, a successful financial planning company. Ward probably reflects the views of many shareholders who find the prospect of a franked dividend in their bank account a lot more attractive than the promise of higher returns on equity. Who's right? Can Montgomery really produce a compelling argument when his own listed company – Clime – pays out dividends. Below we run the key points in his argument, as described by Ward, and Montgomery's blow-by-blow rejection of each of Ward’s contentions. Neville Ward: Company tax is a payment in advance against the shareholder's tax bill. It is held by the ATO and later credited to the shareholder. It is therefore part of the return the shareholder receives in return for his investment. Not returning these franking credits to the shareholder denies shareholders paying less than 30% tax of this return and increases the total tax take by the Government. Roger Montgomery: I am not suggesting the franking credits accumulate indefinitely. In a country like Australia, most companies will experience diminishing returns at some future date. When that occurs, the pay out ratio can be lifted. Here's a comment from the world's best known investor Warren Buffett on the subject, written in 1981: "(A) company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas." Neville Ward: The shareholder should be the judge of where his profits should be reinvested and the directors should give him that opportunity. And there are plenty of ways of doing this. A dividend reinvestment scheme, for example, both gets the cash back (if the shareholder believes that the company is his best opportunity) and gives the shareholder the franking credit. Roger Montgomery: My argument is purely an economic one. Yes there may be merit in letting shareholders decide. However, if one assumes: a) that shareholders don't know what may best for them/are not rational with money; and b) the company and its management can generate a higher rate of return on equity in the future than the shareholder can, then the company should keep the money and compound it. Neville Ward: The net present value of an investment by a shareholder paying less than 30% tax must be better if dividends and dividend reinvestment plans are maximised rather than minimised simply because in the latter the Government keeps the franking credit. Roger Montgomery: This assumes again that the dividends are never paid out. Not what I was suggesting. There comes a time when they should be. See below. Neville Ward - Share prices are influenced more by changes in dividend than by changes in earnings. Roger Montgomery: So what has Berkshire Hathaway’s share price been influenced by since 1968? Neville Ward: Your assumption that the price/earnings (P/E) multiple will not change if the dividend is eliminated is not sustainable. Roger Montgomery: I have every confidence that for most companies the P/E would collapse in the event of a dividend suspension. Yet I also believe an opportunity would be concurrently presented in many instances. Neville Ward: Your own company, Clime Capital Management, recently increased its final dividend by 22%. I challenge you to announce to shareholders that Clime will no longer pay dividends because you believe that you can manage the funds better than his shareholders can. Roger Montgomery: Our shareholders are asking us to do exactly that. The 22% figure you mention makes the change look dramatic. Considering we could have paid out 6¢ or even 13.5¢ to get rid of all the franking but only paid out 2.75¢ sheds a different light on the issue of where I stand on the subject of dividends. I will sound out our shareholders at the AGM on November 16. I have always said to shareholders that we will pay dividends when we can't find opportunities to reinvest and will withhold when we have more ideas than cash. Neville Ward: Having said all the above I strongly agree with Roger on one point: that the financial advice that portfolios should lean progressively away from "growth" and towards "income" is flawed. I go further – who cares whether our future wealth comes from so-called "growth" or "income"? All anyone should want to do is maximise it (after tax of course) within acceptable degrees of risk and liquidity. I guess I can summarise my thoughts in two points: 1. Let the owners decide. They like deciding and, on average, are not bad at it. And it’s their dough. 2. Holding back the franking credits puts (for a time) cash in the hands of the Government which would otherwise (depending on tax rates) be deployed at the discretion of the punter – who will more than willingly give it back to the company if he is persuaded that that is his best opportunity. All other things being equal, the company plus the owners should be better off if they have these funds rather than the Government. |
Dividends: