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Why the ASX 200 has gone nowhere in 16 years

Here’s an interesting piece of information about the S&P/ASX 200 index:

  • November 2007: 6851 points
  • October 2023: 6853 points
  • Total Capital Gain: 0.02%
  • Annualised Capital Gain: 0.00182% p.a.

That’s some result, don’t you think? 16 years and no capital gain. And it’s not the first time.

Back in November 2017, in a blog post entitled Active Versus Passive When Prices are Extremely Stretched I asked; “The ASX/S&P200 has gone nowhere in a decade; why invest in the index?”

In September 2017, the S&P/ASX200 index traded at 5672 points, 12 points lower than in December 2006, almost 11 years earlier.

There are many long periods where the broad Australian index does nothing in terms of capital appreciation, even though, according to S&P Global, the S&P/ASX 200 “is recognised as the institutional investable benchmark in Australia” and “is widely considered Australia’s preeminent benchmark index.” Somewhat disturbingly, it will happen again and again.

Why it's happened

I want to explain the major contributor to this situation, which won’t change and will continue to provide material for journalists to ponder over for many years and decades. The explanation will also raise questions about investing in an ASX200 ETF and, if the yield is all you receive, whether it is worth the risk.

Many investors believe the macroeconomic picture determines the performance of Australia’s largest companies, as measured by broader Australian market indices such as the S&P/ASX200 index. Others quite rightly point out that it is company earnings that drive share prices and, therefore, the aggregate earnings of the ASX/S&P200 companies that determine the performance of the index. In truth, it is perhaps a combination of both that determines performance over the short and medium term. But earnings and macroeconomics aren’t the whole picture.

What is missing is dividends.

The above references to poor long-term performance only look at capital gain and therefore confirm that all of the returns investors have made from investing in the S&P/ASX200 over the last 16 years have come from dividends, either taken as cash or reinvested into the same index that has gone nowhere. It is the compounding of dividends upon dividends that explains the only return investors have received.

And that fits with the payout policy of Australian companies, driven as it is by our taxation system, which produces franking credits that have no value to a company and enormous value to those on lower rates of personal tax than the company tax rate.

Let me break it down.

The mechanics are simple. Suppose a company has $100 of equity, generates a sustainable 20 per cent return on equity and pays out none of those earnings as a dividend. In that case, that company’s earnings will grow at 20 per cent per annum. The earnings growth rate always equals the rate of Return on Equity if the payout ratio is zero.

If the same company pays out 100 per cent of its earnings as a dividend, no money will be retained as additional equity for the next year, and therefore, the company will earn the same 20 per cent on the same equity as last year. And therefore, earnings won’t grow at all.

If I start a business with $100 of equity and generate a 20 per cent return on that equity each year – which is $20 of earnings – and I then pay out that $20 each year, then my equity will stay at $100 every year, and my earnings will stay at $20 per year and won’t grow.

Putting aside changes in the popularity of stocks, which is reflected in the Price-Earnings (P/E) ratio, the only way I can sustainably grow the share price of my hypothetical company is if I grow the earnings. But if I pay out all the earnings as a dividend each year, and the return on equity remains the same, the earnings will also stay the same, and so will the share price.

I must grow the earnings to grow the share price. If the earnings don’t grow because I pay out as much as possible in dividends, the share price won’t grow either.

This is happening in aggregate at Australia’s biggest 200 companies and is why the index is not going anywhere. Before Covid-19, the average dividend payout ratio of S&P/ASX 200 companies was 72 per cent. That means 72 per cent of all company earnings are paid out as a dividend rather than retained and compounded to grow their earnings in the future.

As Figures 1. and 2. reveal, a high proportion of Australian company earnings are paid out as dividends.

Figure 1. Listed Companies' Profits and Dividends (Top 100 companies by market capitalisation, log scale)


Source: Thomas Mathews, RBA, June 2019

Figure 2. Dividend Payout Ratio


Source: Thomas Mathews, RBA, June 2019

Reasons behind the dividend fetish

Why is the payout ratio persistently so high in Australia (and compared to the U.S.)? It’s all to do with tax and franking credits in particular.

To avoid the double taxation of dividends in Australia - at both the company level and at the recipient level - franking credits are attached to dividends to the extent that corporate tax has been paid on a company’s profits. These franking credits are equivalent to additional cash for dividend recipients whose tax rate is lower than the corporate tax rate. But these franking credits are of zero value to a company.

The result? Australian companies tend to pay out the franked dividends to make their super fund and retiree shareholders happier. Of course, shareholders would be better off if a company earning a high rate of return on equity kept the dividends and reinvested them. Even after discounted capital gains tax and franking credits are considered, the investor who insists their company retain profits at 20 per cent rates of return on equity will be far better off than if they take the dividend.

Warren Buffett’s Berkshire Hathaway is a prized example of this decision in action. Berkshire has generated circa 20 per cent returns on equity (ROE) for over 50 years and never paid a dividend. Most income investors would be aghast. But the result is that the equity grows each year by 20 per cent, and as long as the ROE stays at 20 per cent, the earnings also grow by 20 per cent per annum. That’s why Berkshire’s share price today is US$512,000 per share. If an investor needs some income, they can sell a share. And if they want a really entertaining year, they can sell two!

If Warren and Charlie can generate 20 per cent per year on your shareholder money, why would you want them to pay it out to you? The best you might do is five per cent in a term deposit. It’s smarter to let Warren and Charlie keep the money and earn 20 per cent a year for you.

I explain how the math works in this blog post entitled: If You Are an Income Investor, It Pays to Think Long Term.

Change is unlikely

For investors in the broad Australian stock market index, the other problem is that the average return on equity isn’t 20 per cent. Many of the businesses are mature and already dominate their market, so they have few places to reinvest their earnings for growth.

Indeed, if a company cannot earn a rate of return on its equity better than you can generate elsewhere, its board should pay out its earnings to you as a dividend. If they don’t, you are worse off. For example, suppose a company can only generate a five per cent return on equity, which is the same as you can achieve in a Term Deposit at the time of writing. In that case, you are better off taking the dividends as cash and reinvesting in the Term Deposit because it has lower risk. In fact, in that example, you might want to ask why you are invested in that company at all. Some companies listed in Australia need to retain profits, not because they want to grow, but because they need to reinvest just to stay in the same competitive position and to stop them from going backwards. That’s the worst treadmill to be on and a company you don’t want to own.

Of course, when you invest in an index like the S&P/ASX200, you don’t have a choice about which companies you invest in, so you will inevitably be holding these cash burners too (think Telstra and look at its share price performance over 20 years!).

Thanks to our system of franking credits, our companies will be incentivised to keep paying out most of their earnings as a dividend. Go back to Figure 2., and have a look at Australia’s dividend payout ratio versus the U.S. payout ratio. With more profits retained for growth, it should be no surprise the U.S. market, as measured by the S&P500 has, and will continue to, outperform the Aussie equivalent. And that certainly raises questions about which index ETF you should not invest in.

When dividends are high, capital gains are low. The only exception is when a company can pay all its earnings as a dividend and expand its Return on Equity.

For investors in Australian companies, the onus is on you to find better businesses, big or small (those generating high rates of return on equity and are simultaneously able to reinvest large portions of their profits) in which to reinvest your dividends, ensuring you grow your wealth and maintain your purchasing power. Or find an active fund manager who can do that for you.

 

Roger Montgomery is the Chairman of Montgomery Investment Management and an author at www.RogerMontgomery.com. This article is for general information only and does not consider the circumstances of any individual.

 

90 Comments
Max Z
November 25, 2023

Hi Roger

Your article has attracted negative comments and although I agree with some of those negative comments , I can see the positive aspects to your point of view .
Investing in an Index Fund will give you ordinary results and sometimes very poor ones, but Investing in Good Businesses at attractive entry prices should lead to superior returns and that really was the point you were trying to make. Companies which generate high ROE and that retain high amounts of Profits should as you point out give superior results compared to Companies with very high Dividend payout ratios.
Investors have different Finance needs though - some prefer all their returns in the form of Dividends and Franking credits, others prefer Capital Gains and some like myself prefer a combination of both (as far as ASX Companies go). I'm all for a Company that can grow Dividends over time and can also grow it's Equity and Market Share Price to deliver Capital Gains to compensate for Inflation. Selecting those Companies requires patience and buying at an attractive entry point. It's also important to be disciplined and sell when prices become 'frothy". I don't believe in holding a Company forever.

Paul
November 19, 2023

Thanks for your comment Roger, much appreciated (Why the ASX 200 has gone nowhere in 16 years). It prompted me to check on the past performance of some actively managed funds. The result, I promptly bought more units in my passively managed ASX200 ETF. Roll-on more dividends!

Brian
November 16, 2023

Look at MOGL as another example. Around the $3.35 mark in Dec 2017, and around that now....

Joel
November 14, 2023

Thanks for jumping into the comments, Roger Montgomery. This really highlights the benefits of outsourcing these decisions to a professional fund manager rather than thinking one can do it all themselves.

Duncan Dean
November 14, 2023

Maybe. But it is really an issue of risk assessment when it comes to deciding on purchase of ASX company shares. Fund managers are largely risk averse and thus will never achieve greater P/E advantage than a well-researched, albeit riskier, portfolio allocation. Gold producers (and explorers) are likely to be a prime example of this "unprofessional" but very rewarding alternative to fund managers, particularly if the price of gold increases exponentially - for whatever reason.

Roger Montgomery
November 14, 2023

I should point out Duncan; small cap and micro fund managers are frequently in those stocks, too.

Acton
November 13, 2023

The title "Why the ASX 200 has gone nowhere in 16 years" is misleading because it compares the ASX now with a pre-GFC peak in 2007 and then draws an incorrect conclusion of no growth. Rather than no growth, there has in fact been a doubling of growth.

ASX 200 growth over 20 years:
Nov 2003: 3,186 points
Nov 2023: 6,976 points
Total gain: 218%

ASX 200 post GFC growth from its low point in 2009 (14.75 years):
Feb 2009: 3,344 points
Nov 2023: 6,976 points
Total gain: 208%

ASX 200 growth figures can be verified from the ASX 200 graph set to 20yr.
https://www.marketindex.com.au/asx200

Roger Montgomery
November 14, 2023

I made that point clear Acton. 1) WHile I have selected one period of 16 years, there are multiple long-term periods that show the same 'nothing' capital return, and 2) Over the 16 year period selected the US S&P500 has achieved circa 154%. Combined, the two points demonstrate an "issue" for the Aussie large cap index.

Algynon
November 17, 2023

Total return figures for those 2 periods tell a similar story:
20 years:
ASX300 8.5%
S&P500 10%
14.75 years:
ASX 300 9.2%
S&P500 14%
Even with dividends and compounding, the ASX lags.

David Roberts
December 16, 2023

It is exactly why all my ETFs are international and mainly US. Also a mix of hedged and unhedged to handle currency movement. I’m well into retirement but my ASX portfolio is 90% growth stocks with minimal or zero dividends. When I need to take out pension ‘income’ I simply sell the worst performing growth stocks and keep the rest. There is no difference between cash coming from dividends or distributions and cash coming from the sell down of capital.

Andre
November 12, 2023

While dividends, gives money back which is welcomed, has the earning capacity of an investment in the ASX 200 been watered down through the years? I mean, for example, what is the ASX 200 share of GDP? If this share is maintained then, there can be inference that that there has been no effective capital loss while the earning capacity has been sustained. What is the point of holding capital if in final count sustained cash is not returned, be it in the form of dividends?

Roger Montgomery
November 14, 2023

Hi Andre, perhaps for an individual investor, it's more important to compare to inflation than to a productivity measure like GDP, especially for retired investors.

AlanB
November 12, 2023

What is more predictable for any company this time next year - the share price or the dividend? Of course the more predictable figure is the dividend because dividends determined by the company show less volatility than share prices determined by the market. So for reliable returns most of us choose to invest in sustainable dividend producing companies, than speculate on share price growth, that may or may not happen. But every so often one finds that gem which has a rising dividend and a rising share price.

Roger Montgomery
November 14, 2023

You are right, Alan; over a single year, it's hard to predict share prices, but over a few years, five or ten, for example, the predictability of capital gain for seriously good businesses earning high ROEs consistently is reasonably reliable. You can read about a comparison here: https://rogermontgomery.com/if-you-are-an-income-investor-it-pays-to-think-long-term/ Of course, if you want monthly cash income and much lower, or even zero, volatility, you need to think outside of equities and look at Private Credit, perhaps. And yes, we offer that too.

Mike G
November 12, 2023

I think the Author is missing the obvious.

Since 2000 there has been around 161 takeovers of companies, many of which were $1 billion or more. Certainly they would likely be worth hundreds of billions today.

Yes cash or shares are received but these takeovers effectively deprive Australians of long term growth opportunities.

JanH
November 12, 2023

I agree. I have felt absolutely robbed when companies I invested in were taken over. Now we are about to see Origin go too. An energy company like this should not be in foreign private hands.

Roger Montgomery
November 14, 2023

Hi Mike, When those companies receive a takeover bid, 1) their share prices rise, which also increases the index, and it still hasn't helped investors over that 16-year period. 2) Once those companies are taken over, you don't own them anymore, so you don't benefit. Investors in the index are in the same predicament described in the article.

MB
November 12, 2023

Dividends are real money. Companies are the only assets able to increase the income (dividends) to offset constant increases in the cost of living and provide lifestyle sustaining income. Dividends are also paid based on the number of shares, not the account balance.
Therefore, what number the ASX200 sits on is irrelevant. If you disagree, try to take your account balance to Wollies to pay for your groceries.

Roger Montgomery
November 14, 2023

I made the point MB by using Berkshire Hatahway as an example. It seems to have missed its mark, if you didin't see it, so let me try and explain it another way. Berkshire Hathaway, the company helmed by Warren Buffett has NEVER paid a dividend. Because Warren And Charlie Munger have managed to generate 20% returns on equity on average annually for more than 60 years, they have compounded money faster than you can and so they are right to keep the money and not pay it out as a dividend. The result is that the share price has risen along with the growth in equity and profits. If you had bought the B-class shares 16 years at US$72 each, they now trade at US$227 for a capital gain 215%. For income needs, investors sell a few shares. Those investors who bought the A class shares 16 years ago for US$100,000 each can sell a share today for $530,000 and meet all their income needs for several years. It's a far better policy than owning a lumbering mature Australian company that pays all its profits out as a dividend.

Max
November 12, 2023

The problem I have with comparing US and Australian payout ratios, such as in Figure 2, is that they usually ignore the buyback yield which, for the S&P 500, has been about 1.5 times the dividend yield on average over the10 years to 2022 . When dividends and buybacks are combined, the average yield in the US over this period was about 4.5% and the corresponding payout ratio was 91.5% (https://pages.stern.nyu.edu/~adamodar/). By comparison, the current ASX 300 payout ratio of about 65% seems modest.

Roger Montgomery
November 14, 2023

Buybacks lift prices (and they lift 'value' when conducted judiciously), which is why Buffett has contemplated them and engaged in them instead of paying divvies Max.

Paul
November 15, 2023

Hi Roger, thanks for engaging with the comments. I have often thought buybacks were misguided as they invariably happen when times are good and share prices are high. Perhaps more so in the US than Australia.

The best time to buy back your shares is when the share price is low. Instead we see capital raising at low prices and buybacks at high prices.

Lyn
November 11, 2023

I understand both sides of if retain profit or pay dividend but think what is overlooked re poor increase in share price is there are purportedly a lot of direct small investors in our steady companies who maybe research without professional help and use proven history of divs as a marker of performance, perceived reliability, liquidity if profit 1/2 billion plus, where it sits in top 200, things easily understood. I disagree stock investing is based mostly on imputation which is implied drives our market, it's just an outcome and that outcome may be insurance against retained profit use/misuse with no guarantee of future C. Gain, could be why we have many stable golden companies in low populated country. CEO's forced to be resourceful and not rely on access to higher retained profit to fund daft decisions or remain afloat which you referred to. Profit only after expenses deducted so past poor decisions already brought to account without expectation of funds to waste/survive/whittle future profit so high dividend expectation is an extra discipline to rein in Boards and Management. You said "which produces franking credits that have no value to a company and enormous value to those on lower rates of personal tax than the company rate". $1 is worth $1 to everyone. Thus credits of 'enormous' use(not value) to high taxpayers as less to find at taxtime when applied to bill. Why is your statement relevant when no differing value to any taxpayer? If divs & fr. credit when added tip people over only just into a higher rate on all income there is diminished worth to credits due to higher rate due on rest of income, but not value. A refund to lower taxpayer and divs may go back to economy as by definition they have more need re expenses so they may not care re C. Gain and if loyal to chosen shares for many years eg. JBhifi,Coles,Telstra, Ampol, NRMA insurance arm which supports local repairers so it creates an indefinable benefit to our companies for assured longevity plus safe investing, hard to put a price on for small investors. I don't disagree with principle of article as figures don't lie for those who can wait but there is alternative view from different angle which is not as bad as painted.

Roger Montgomery
November 14, 2023

The difference for one tax payer is a cash inflow versus a reduced cash outflow for the other. But economically you are right and the value is the same. its the cash flow consequence that is different.

Dudley
November 10, 2023

For 0% marginal tax rate tax resident shareholders, reinvesting after tax dividends or capital gains results in the same amount of capital, after 0% tax.

For non-0% marginal tax rate tax resident shareholders, receiving profits as dividends results in more tax than receiving profits as discounted capital gains.

Progressive taxation of shareholders.

SGN
November 11, 2023

Not many if any Active ETF or Fund mangers have been able to get 20 % return on equity.
ever year on year.
In Australia our equity investment philosophy is different and can not be compared with any global markets.My long experience investing with my money is just fine.
Holding ETF Passive and ASX top 200 shares has served me well for the last 20 years due to Compounding ,Imputed credits and in particularly less management cost.

Roger Montgomery
November 14, 2023

You really need to read this post on the arithmetic Dudley. I hope it helps: https://rogermontgomery.com/if-you-are-an-income-investor-it-pays-to-think-long-term/

Dudley
November 15, 2023

In 1981, had the opportunity to buy 200 Berkshire Hathaway shares at $USA200 per share. $USA100,000 CPI adjusted $338,601 today..
Like many I did not: "Out performers commonly subsequently under perform".
Worth $USA106,000,000 today, less capital gains tax.

Performance of Montgomery Fund is very similar to ASX300:
https://www.montinvest.com/our-funds/the-montgomery-fund/

Fund did not put all eggs and basket into CSL?

Dudley
November 15, 2023

Err; $USA500 per share

Geoff R
November 16, 2023

>Worth $USA106,000,000 today, less capital gains tax.

Dudley I think CGT did not start until Sept 1985 so it would have all been your money!!

Dudley
November 17, 2023

Geoff R: "I think CGT did not start until Sept 1985 so it would have all been your money!!":

Lets ask the Oracle:

How much capital gains tax would I pay on 200 Berkshire Hathaway shares bought in 1981 for $500 per share, each share now worth $546,635?

https://iask.ai/?mode=question&options[detail_level]=detailed&q=How+much+capital+gains+tax+would+I+pay+on+200+berkshire+hathaway+shares+bought+in+1981+for+%24500+per+share%2C+each+share+now+worth+%24546%2C635%3F

'Therefore, if you were in the highest tax bracket in the United States and sold 200 Berkshire Hathaway shares bought in 1981 for $500 per share and now worth $546,635 per share, you would owe approximately $21,845,400 in capital gains tax.'

Dudley
November 17, 2023

As an Australian do I pay USA tax on capital gains made in USA?

https://iask.ai/?mode=question&options[detail_level]=detailed&q=As+an+Australian+do+I+pay+USA+tax+on+capital+gains+made+in+USA%3F

'Under the Australian-US Tax Treaty, Australian residents are exempt from US tax on capital gains made on the disposal of assets located in the United States, if the gain is derived by an individual who is a resident of Australia and is not a citizen of the United States.'

Mark
November 10, 2023

Logical article, but the reason it won’t change is that a dividend and franking credit is money in your bank account, whereas money retained by the company in an effort to grow the share price is at the mercy of the company and can disappear in the blink of an eye if they make bad decisions or the market decides to trash/ short your stock price. Also companies in Aus do retain funds for growth and to smooth out future dividends, perhaps not as much as the US.
I’ll stick with the current arrangement and not have my retirement funds completely at the mercy of the greedy hordes on the market.

Roger Montgomery
November 14, 2023

Its not uncommon to prefer a lower risk and lower return. Thanks Mark.

James
November 10, 2023

"For investors in Australian companies, the onus is on you to find better businesses, big or small (those generating high rates of return on equity and are simultaneously able to reinvest large portions of their profits) in which to reinvest your dividends, ensuring you grow your wealth and maintain your purchasing power. Or find an active fund manager who can do that for you."

The problem is, and perhaps the moot point, fund managers and individuals cannot consistently beat an index, despite their rhetoric! Being out of the market on a few of the best days or not owning those few companies that shoot the lights out results in material underperformance, especially over longer periods of time. Jack Bogle sagely wrote profusely on this and established Vanguard. Warren Buffett recommends that the average investor would be better served by index funds. Sure the ASX is super concentrated but don't belittle the benefit of dividends and especially franking credits, especially to the retiree! Overseas indexes offer diversification, more growth and access to some off the world's best companies!

Do any of us really think we are a Buffet or a Lynch? Individuals and fund managers alike overestimate their ability to pick the winners and avoid the losers. Fund managers to survive and thrive, must convince us that they have some preternatural ability to beat the index. Sadly as the SPIVA Indexes indicate, over more than 20 years of data and research, actively managed funds measured against their index benchmarks worldwide do not beat their respective indexes!

Finally as William F. Sharpe mathematically demonstrated in his seminal paper "The Arithmetic of Active Management"

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the
average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return
on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition,
subtraction, multiplication and division. Nothing else is required.

Roger Montgomery
November 14, 2023

Here's the maths James: https://rogermontgomery.com/if-you-are-an-income-investor-it-pays-to-think-long-term/

And here's some examples: https://www.kiplinger.com/investing/stocks/603777/30-best-stocks-of-the-past-30-years

Van James
November 16, 2023

Going to focus on the maths of the SPIVA reports. Active fund managers consistently, en made, do not deliver.

DubsGee
November 10, 2023

Roger, always interesting.While our tax system encourages boards to pay dividends and the associated valuable tax credits to owners who can use it rather than chasing fairy dust acquisitions or inflated buybacks, it's probably saved shareholders billions. It has certainly funded many a retiree. The double taxation in other global jurisdictions is hardly the ideal where it encourages management to do endless value destroying buybacks well above a fair share price to juice their option grants or chase 'EPS accretive acquisitions' that seldom work and mostly blow up capital while lining the pockets of investment bank parasites. One could argue there is much more integrity in the Australian market. What you should be arguing for is regulation mandating companies with prospective ROE>RR to retain their profits for redeployment. Good luck with that in a democracy. In Nov. '07 the market PE was 17.9x, today it is 14.77x. Using your own formula you should be arguing the Au market in 2007 was significantly overpriced (but instead you are on record as mostly invested) where today the market is around fair value. Thus the prospective returns from today are much better than they were in '07, my guess is the 5y forward total market return is ~11% plus franking. Comparing a high point to a lull is a bit rich Roger.

John Dakin
November 10, 2023

Well said - I agree that all too often vainglorious management embarks on vanity projects with shareholder funds that bring nothing but grief..

Ramon Vasquez
November 10, 2023

Well said John . Good Luck , Ramon .

Greg
November 13, 2023

Exactly. The best thing that could happen to corporate governance would the irradiation of (management) self serving buy backs. They have already gotten rid of off market buy backs and they should do the same thing with on market buy backs. You only need to look at the Qantas/Joyce fiasco to see why. Companies should only be able to return shareholders capital through dividends or tax free capital returns (as Wesfarmers has done multiple times). Of course that won’t juice the stock price….

Roger Montgomery
November 14, 2023

Hey DubsGee, yes mostly invested in 2007 and then higher cash levels in early '08. I see the other argument you make about our tax treatment of dividends being superior, which it is. The article's point is to consider the need to invest in companies that can and do reinvest large proportions of their profits at high rates of return. https://rogermontgomery.com/if-you-are-an-income-investor-it-pays-to-think-long-term/ and https://www.kiplinger.com/investing/stocks/603777/30-best-stocks-of-the-past-30-years

Andrew Smith
November 10, 2023

Interesting, and suggests looking at the US where many co's do not pay out (high) dividends e.g. CSL has a significant presence and pays out modest dividends, but has a track record of very high ROE with presumably investment in R&D, for future earnings; swings and roundabouts?

Jon Kalkman
November 10, 2023

Roger has made a common error. He says: “These franking credits are equivalent to additional cash for dividend recipients whose tax rate is lower than the corporate tax rate”

In fact, franking credits are additional cash for ALL Australian recipients of dividends that are paid out of after-tax profits. If a company earns $100 profit and pays out $70 in dividend, regardless of their personal tax rate, the shareholder’s taxable income is $70 dividend PLUS the $30 company tax held by the ATO. For high income earners whose personal tax rate is higher than 30%, this money held by the ATO is a tax credit that can be used to pay some or all of their personal tax liability. For taxpayers whose personal tax rate is lower than 30%, some or all of this tax credit is refunded in cash.

This highlights the elephant in the room. If the company retains and invests more of its profit, it should increase the share price resulting in a capital gain for the shareholder, as Roger advocates. High income earners prefer their return from shares to be delivered as capital gains because a capital gain is only taxable when the asset is sold and then they are entitled to a 50% discount if the asset is held for more than 12 months. In addition, shares can be sold in small parcels allowing considerable tax planning.

By contrast, the shareholder has no discretion over a dividend and must declare the dividend income, in addition to the franking credit, as taxable income in the year it arrives and that additional taxable income is not always welcome.

Clearly shareholders on high marginal tax rates prefer capital gains, and those on low marginal tax rates prefer dividends with associated refunds of franking credits. Note that some of our largest investors now are super funds that pay no more than 15% income tax - they adore their franking credit refunds and they now dictate policy to company boards.

But it’s not all bad news. Franking credits encourage Australian companies to pay tax because, even though they are absolutely no use to the company they are extremely beneficial to ALL their Australian shareholders, either as additional cash to pay their personal tax or as a cash refund.

Roger Montgomery
November 14, 2023

Just prioritising the actual cash flow received Jon. Thanks for the clarification though, as it makes the point regarding the company incentive even stronger.

Kevin
November 10, 2023

I'm a bit baffled by the article.None of my companies pay out 100% of profits.Pay out ratios would probably run at 60-70% and occasionally more to keep the dividend income stable.I get the choice of reinvesting those dividends,which I did,or taking income,which I do now.Some of that income is still going into DRPs.

At the recent WES AGM with a slight change in the board and the direction of the company some navel gazing was done. Comparisons were given, AXJOA in 1984 at 1500,that was worth just over $60 K now.That would be after fees looking at AXJOA now.The same $1500 put into WES shares was just over $1 million,I take it that is 30/6/23. The numbers seem reasonable to me. I did my own calculation for BRK that was around $12- 1300 a share in 1984 ,now say $530K. WES compounding @ just over 18% CAGR for 39 years and BRK at around 17% over the same period. CBA and Macbank have also outperformed BRK,with all dividends reinvested .Macbank probably isn't a fair comparison as it is a growing company still ( hopefully ). BRK is mature and growth will probably continue to slow down ,and the $150 billion in cash of course sitting in BRK.I wouldn't be concerned if I held BRK and it came back to 8 - 11% CAGR for the next 10 to 20 years.

November 2007 ,well,I have no doubt that all of the numbers are correct or close enough,but it is a bit of cherry picking to prove a point,the market high before the GFC. Perhaps the date to start everything would be 1/1/2000.Then we have gone through the whole mess that this century has been for most indices.The Australian index does seem to hold up well as the high dividends are reinvested until retirement.

The rubber hits the road when the money is spent, on the date it is spent.Not a lot of that happens. The fear of losing one penny will always be greater than the joy of perhaps gaining £100?.

I don't think Australia should ever be compared to the USA.Different tax structures etc.If you can get 10% of the US market as customers that is more than 100% of the Australian market and a powerful base to set off on world expansion .

Kingsley Smith
November 10, 2023

Some observations 1) to make the claim you have made here Roger you would need to do a multi variate regression analysis. To say between point A and point B the index didn't rise, therefore the cause MUST be franked dividends just is not going to hold water. What happened to interest rate here and overseas, commodity prices, property prices etc the list goes on? All of these non exhaustive list of things could in isolation or combination have a greater effect on the markets performance than dividend imputation over a particular time frame. 2) Dividend imputation was introduced in 1987. The company tax rate was 49 % then and was slowly whittled down to the current 30%. Therefore the imputation effect was considerably more powerful in the earlier years of imputation yet the index got to 3000 in '98 coming off low 1,000s post 87 crash. If your hypothesis is correct that should not have happened. 3) The vast majority of countries don't have dividend imputation so the markets that performed worst than the ASX 200 over this timeframe without dividend imputation by your simple analysis also contradict your hypothesis 4) You are presuming without evidence that the capital allocation discipline that higher dividend ratios places on listed companies is outweighed by the more lazy undisciplined re investing of capital of boards back into their own companies. Getting companies to pay out profits and then having to compete to get the capital back in, is face value a far more likely capital efficient system 5) I see no evidence and cannot think of a single company that is achieving genuinely high ROI complaining they cannot get the capital they need to grow 6) Likewise I see no evidence that high ROI companies are being criticised for retaining higher levels of profits . Where it is rational for a company to retain higher levels of profits ie earning higher ROIs investors have been completely happy to see this. 7) to argue franking has hurt investors you would need to demonstrate that their overall final returns would have been higher from higher retained profits versus lesser retained profits plus the dividends and the compounding earnings on the re invested dividends. It seems you are presuming dividends are not reinvested and don't in turn earn even more dividends. It would be very very unlikely that a system that removes the awful economic distortion effect of double taxation and imposes a high degree of capital allocation discipline on boards would result in lower overall returns to investors.

Roger Montgomery
November 14, 2023

Yes, Kingsley, I have known many analysts, myself included, who needed a significant sample size before making a decision. The facts are the facts though. ASX had 0% capital return and the highest payout ratio, S&P500 had 154% and a lower payout ratio, and Berkshire Hathaway had a 215% return and zero payout ratio over the same period. If you regress thousands of companies' two-decade share price performances against their payout ratios, I am happy to bet that you will arrive at the same conclusion. Interest rates, currencies, commodity prices all feed into company revenues and costs and are therefore 'noise'. Don't be distracted or waste your time. The relationship has to be logical remember? I can find a relationship between Australian GDP and the rate of hair growth on a Nepalese goat, and if its strong it doesn't mean there is actually a relationship.

Patrick
November 10, 2023

Hi Roger, I believe that Berkshire Hathaway paid a dividend once in its lifetime.

Roger Montgomery
November 10, 2023

Thanks Martin, The point is the return for an investor would be higher if they CAN retain and redeploy capital at high rates of return. Because the bulk of the ASX200 constituents haven't done as well as CBA at redeploying capital, that explains why the ASX200 performs less well than CBA. Have a look at teh following post I wrote in 2015 for a clear appreciation of the mechanics: https://rogermontgomery.com/chasing-dividends-often-overlooks-growth-2/

Edward
November 10, 2023

There are plenty of companies in the All Ordinaries (and beyond) reinvesting most or all all of their earnings into business growth. If this investment approach is so successful then build a portfolio of companies doing as such and outperform the market every year, charge a performance fee and get rich and famous. Easier said than done right....

raf
November 10, 2023

asx is a disaster in australia most people are into having port folios in the property market

Can’t Wait for Pension Phase of Super
November 10, 2023

If retained by the company, that $20 ROE becomes $20 equity. If paid out to an individual at 0% tax rate (low income earner, pension account or SMSF), the taxpayer now has $28.57 after franking credit refunds. That’s $28.57 as opposed to $20 that could be reinvested into the company via a Dividend Reinvestment Plan or directly.

Roger Montgomery
November 10, 2023

Thanks for your comment which ignores the compounding effect of 20% per annum over time. There's a deeper dive on the arithmetic I wrote that will help here: https://rogermontgomery.com/chasing-dividends-often-overlooks-growth-2/

Can’t Wait for Pension Phase of Super
November 10, 2023

Thanks for your comment, Roger, which ignores the compounding effect of 20% per annum over time of a larger amount of capital ($28.57 vs $20).

Reinvesting $28.57 into a company with a ROE of 20% p.a. would beat the company retaining $20 and returning the same 20% p.a ROE. The post-franking-credit-refund capital would be larger than any retained dividend every year and compound faster.

I did read your other article before posting. It’d be great if you posted a similar example for taxpayers at 0% tax rates? This comment section unfortunately precludes me posting one. In some cases, the tax tail does indeed wag the investment dog/cash cow. Kind regards

Roger Montgomery
November 14, 2023

Thanks CWFPPOS, you cannot redeploy your $28.57 at 20% in the same company because you aren't buying at the Equity Per Share. If a company is achieving 20% ROE, it's calculated on the equity, not the share price. if you receive your $28.57 and want to redeploy it, you are buying at the market share price, which is usually a material premium to the Equity Per Share, especially for companies generating high ROE. You could reinvest the funds into another stock whose share price you think might rise at 20% per annum (or less plus a dividend), but that's subject to speculation rather than corporate capital allocation.

Roger Montgomery
November 14, 2023

The problem is you cannot reinvest at the equity per share. You have to buy the shares on the market which are typically trading at a premium to equity. And that reduces your return substantially.

John
November 09, 2023

The Thornhill data seems to be contradicted in this article Can someone explain the discrepancy?

Aussie HIFIRE
November 09, 2023

I don't remember exactly what the Thornhill data says, but it is probably a mix of using a different starting date which can make a massive difference, and Thornhill using an Index which excludes resource companies, plus probably some other factors as well.

Alex
November 11, 2023

I’m pretty sure Thornhill uses an accumulation index (i.e. with dividends included).

Roger Montgomery is emphasising capital growth in this article.

Data I’ve found shows the ASX 200 accumulation index (AXJOA) was 41,416.70 points in November 2007 compared to 87,710.49 (as at 10 November 2023).

4.8% CAGR. Not an amazing return over that 16 year period but better than the flatline capital growth in isolation.

Over the same period the total return index for the S&P500 (S&P500TR) increased from 5,111 to 9,535. A 3.97% CAGR. Similar (slightly worse) to the ASX total return.

Dudley
November 11, 2023

A helpful web site function:
https://www.marketindex.com.au/asx/stw/advanced-chart
To see % change in value, including (capitalised) dividends:
. Click 'ADJ' in bottom right,
. Click hexagon just above,
. Click 'Indexed to 100%' in menu,
. Click and hold on Time Axis and stretch / compress time axis to required time range.

STW CAGR:
To 2023/Nov/01 (day 45231) = 205%, from 2008/Nov/01 (day 39753):
= (205% / 100%) ^ (1 / ((45231 - 39753) / 365.25)) - 1
= 0.049
= 4.9%

Dudley
November 11, 2023

121 days later, from 2009/Mar/02:
STW GACR: 9.57%

Dudley
November 11, 2023

Err;
from 1/Nov/2007 (day 39387):
= (205% / 100%) ^ (1 / ((45231 - 39387) / 365.25)) - 1
= 0.046
= 4.6%

Michael Toal
November 12, 2023

Peter uses both price and accumulation indexes and looks as ASX200 v Industrials stripping out, as mentioned, resource companies who typically chew through capital and make some expensive choices.

US a different tax regime. Easier to borrow money and do a buyback then repatriate profits and pay tax.

More than half our market returns are dividends. Also assuming CEOs have Buffet like sensibility.

The other thing is the starting point is November of the GFC in 2007.

Pick March 2009 to March 2024 and let’s review this 15 year period as a comparison perhaps????

bluey
November 14, 2023

Don't ignore the fact that an avid individual investor can SELECTIVELY reinvest the dividends into whatever blue chip has a languishing share price around that time ["buy low"], or into a different stock that hasn't yet gone ex-dividend ["extra div dip"]. These may further amplify the compound return.

John
November 09, 2023

Australia's stock market is dominated by large comfortable, slow growing oligopolies which like things to stay that way. If you are in retirement and happy to fill your $1.6m-$1.9m TBC with their 8% tax free weighted average dividends (including franking's 42% boost) via the major banks and dominant resources companies, you won't go broke. Then use your taxable capital to seek better gains via the Nasdaq. e.g. AAPL and MSFT are both up almost 900% over 10 years, before considering their miserly (sub-1%) taxable dividends. They are similarly durable to our banks and you will pay almost zero tax until you sell at a time of your choosing. Of course, these 2 can't grow that fast for another 10 years, but technology provides other opportunities once you have your 8% tax free ABP dividends funding the "necessities" of life.

Billy
November 09, 2023

I agree the dividend imputation regime does encourage companies to pay out all their profits as dividends. And I agree that this means there are no retained earnings for growing the company

BUT

If the company is a good one, then the company will have no problems in raising capital by issuing new shares.

AND

from an investor point of view, this is better.

BECAUSE

if companies just retain earnings, then their is no choice by the shareholder whether to stay with the company or invest elsewhere. Paying dividends and seeking a capital raising (assuming no costs involved in capital raising) lets the investor have complete control, so theoretically will produce a better outcome for the shareholders, which after all, is all that really matters

AND AS A BONUS

overseas shareholders, don't get the benefit of dividend imputation, so the government collects company tax and doesn't have to give the tax paid (like a with-holding tax) back to the individual shareholders when they submit the individual tax returns. Anything that an overseas shareholder pays in tax is less tax that I have to pay, and that is a good thing

Roger Montgomery
November 10, 2023

Thanks Billy, There's something you are missing when a company issues shares to replace the capital it has paid out as dividend. This dilutionary revolving door of capital is arguably the worst thing a company can do to it's shareholder, especially those who are on higher tax rates than the company tax rate! The dilutionary impact also reduces the value of your shares, especially if shares are issue at a discount to their intrinsic value. So from an investor point of view, it is actually far worse, not better, as you suggest. There is nothing in theory or in practice that is better. If a company retains the profits and generates high rates of return on capital, you will be better off. See this post I wrote in 2015 on the subject: https://rogermontgomery.com/chasing-dividends-often-overlooks-growth-2/

Roger Montgomery
November 14, 2023

Thanks, Billy, it's just that issuing new shares is dilutive to existing owners (unless it's done via a renounceable rights issue - then people have a choice). there's also a cost associated with conducting a raising that goes to the investment bankers.

Sean
November 09, 2023

The 'pithy' marketing one liner of 'most active funds also underperform the index' mentioned in the 2017 blog is disturbingly accurate and also applies to the Montgomery Fund.

Dan
November 10, 2023

Give me the index, with franked dividends, any day of the week.

Harvey Dickinson
November 09, 2023

Without saying it, the article draws attention to the folly of investing in an ASX 200 based Index ETF and expecting growth long term. What then of an LIC which is based on the same index but not slavishly following the index ?
It is no news that LICs build reserves and are not conduits like ETFs. As an investor in both, an article which contrasts the two would be of much interest.

Greg
November 09, 2023

Pick a different starting point and you get a different answer. November 2007 just happened to be before the GFC and after a long period of significant share price appreciation. Do be an honest appraisal the starting date should be something more like the past 20 years, which will show that there has been capital growth.

Roger Montgomery
November 10, 2023

Thats right Greg, I expected that feedback, which is why I pointed out two things: First, that there are many similar periods that can be selected. And 2) It is also why I showed that over the same selected period the US S&P500 has appreciated 154% when the Aussie went nowhere.

JanH
November 09, 2023

A person in super pension mode who receives dividends and franking credits income without depleting the capital base that generates that income annually can reliably depend on that income to live on. But, if you have to keep selling down your capital to provide an annual income, eventually you will run out of money, unless, of course, the capital keeps growing. IMO, the latter situation would be more worrying because capital growth is not guaranteed. Of course, dividends and franking percentages can both be cut as they have this year. But at the same time, "growth" companies have also seen lower share prices. At least, in the former case, the dividends keep coming even when the share price may have dropped. This is why so many self-funded retirees, who seek income to live on, invest in the big companies. They know they will pay dividends and over time, franking will most likely be at 100% and their share prices rise too as their 10 year plus trendline charts show. As Martin points out, many retirees hold their shares for decades and so over time their capital keeps pace or outpaces inflation.

Warren Bird
November 09, 2023

I think you point to the solution near the end. In a world where all profits are paid out as dividends then investors who want growth need to reinvest. Personally I think that's better than the companies holding onto the profits they make with our capital, presuming that we shareholders want them to reinvest our money. Far better for them to have to come to the market regularly to raise capital than to presume existing investors are an on-going source.
So that $100 you use in the example, with a $20 dividend pay-out, can become up to $120 of invested capital if that's what the investor wants. Then the 20% RoE generates $24 the next year. Earnings grow.
And even better, if the investor needs to hang onto some of the income generated by their capital being invested with that company, they can do that rather than having to sell shares to get cash flow. With many more investors now approaching (and in) retirement, that's a good feature of our markets, not a problem feature.

Roger Montgomery
November 10, 2023

Yes. I was quite clear about that Warren. If a company cannot generate 20% returns from reinvest, they should NOT reinvest. The SHOULD pay it out to shareholders. The maths is irrefutable however if a company can generate 20% returns on equity. You will be better off if they do. Check out: https://rogermontgomery.com/chasing-dividends-often-overlooks-growth-2/

Warren Bird
November 11, 2023

My point is that the company should ask me if I want them to reinvest on my behalf rather than presume it. Offer a dividend reinvestment scheme for those willing to give them the capital on an on-going basis or come to market with an equity raising if they need more. But make the case frequently by pointing to track record, executive and workforce skill, new market opportunities, etc. Creates appropriate discipline for all financial stakeholders.
I think this makes for a more efficient equity market.

David
November 09, 2023

While this article makes perfect sense, it is only recently that 5% interest is obtainable on term deposits. Only a year ago, interest was a miserly 1% if you were lucky, and virtually nothing on bank saving accounts. Fully franked dividends were the only means of producing income for SMSFs, driven by the politically correct compulsory requirement to take out of the SMSF increasing amounts of cash, whether you need it or not.

Roger Montgomery
November 14, 2023

Hi David, Equities aren't the only option. You might be interested in Private Credit. Have a look, for example, at: https://www.montinvest.com/aura-private-credit-funds/

G Hollands
November 09, 2023

Once again this article overlooks the fundamentals of statistics! The ASX may only be the same now as it was compared to the base rate, BUT, there are a myriad of invested companies that have an individual gain ( and for some it is astronomical). So exactly what argument might be made is a bit of a mystery, but to ignore fully franked dividends to make your argument is a bit pointless.

Roger Montgomery
November 10, 2023

Seriously G Hollands? C'mon. The article is precisely pointing out what you are. We are in agreement. Pick individual companies, not that index. Hopefully the mystery is cleared up for you.

Aussie HIFIRE
November 09, 2023

The article touches on the problem of companies being mature and not having anywhere else to invest their money, but doesn't mention the scale of the issue. Over half of the ASX200 is Financials and Materials (ie resource companies). Does anyone want to see the Big Banks blow up tens of billions of dollars on failed overseas expansions again? Or the big miners buying ever more marginal projects and then writing them down to zero a few years later?

No they don't, and thankfully this was made very clear to the managers of these companies which is why we see such high dividend payouts from those companies.

The reality is that if you are investing in Australian Equities, unless you are excluding much of the index then most of the profits made by companies will be returned to you as dividends. Obviously there are exceptions to this such as CSL, but in general you shouldn't be expecting as much capital growth from Australian shares as you would from International shares which have much better opportunities to grow.

Roger Montgomery
November 10, 2023

Good summary Aussie HFIRE

Andrew Beaton
November 09, 2023

I would like you to show a graph of Goodman in the last 15 years compared to a bank. It seems a good example of retained earnings

Martin
November 09, 2023

And what about the effect of inflation over those 16 years? If one had invested in an index tracking ETF in November 2007, one would have lost 1/3 of capital due to inflation. The culprits are the likes of WBC, NAB, ANZ, QBE. Their EPS have not grown at all, let alone keeping up with inflation, and are about the same today as in 2007.

Maurie
November 09, 2023

Buffett and Munger are rare - how many listed companies/fund managers make a 20% compound return for 10 years let alone 30+ years. If you had a fund manager that could sustain that level of alpha, then fair enough reinvestment of earnings is the way to go and capital appreciation would be a worthy measure of long term performance. At the end of the day, Berkshire's investment model is all about businesses that deliver sustainable long term cash flow returns - either directly or indirectly in the form of dividends. Capital appreciation of the stock is a sideshow. How many companies factor capital appreciation into their investment models. Answer: none. So why should I? Cashflow is the only true measure of returns from an investment irrespective of the investor's vehicle. More than happy to see companies reward shareholders with dividend payouts. Over the last few decades, the word "wealth" is probably the most overused word in the English language (with the possible exception of "awesome"). Modern generations ruminate over it. However, my guess is that once your working years are over, wealth becomes a nebulous (almost irrelevant) concept..

Neil
November 09, 2023

Question: how is a fund manager remunerated? Answer: FUM drives management fees, total (before-tax) returns drives performance fees.

High dividend payout ratios (assuming not reinvested) will reduce FUM; QED: a fund manager would prefer low or nil payout ratios. Shareholders / unitholders will be driven by their post-tax returns. Perhaps the two sides are not aligned. Agency risk?

Martin
November 09, 2023

There is no requirement for a company to pay out 100% of its NPAT. In fact, most companies have a dividend policy to pay out a proportion only the upper limit of which is usually around the 70% level.
The article refers to investing in the index but an entirely different picture emerges if one compares the position of a shareholder who bought CBA at or after the float at under $6 and now has shares worth some $90 more, having received a handsome dividend twice a year since - the last few being $2.00 or more in the last few years.

Roger Montgomery
November 14, 2023

Yep, Martin, a different picture emerges when you look at individual companies. That's why the article suggests looking at individual companies!

 

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