What’s behind the divergence between US and Australian markets?
As a country that weathered the GFC better than most, Australia is now seen to be a major underperformer behind the US. Or are we? Headline figures reveal the primary US stock market index, the S&P 500, has now exceeded pre-GFC highs by around 50 per cent, yet Australia’s equivalent, the S&P/ASX 200 was still lagging at 13.5 per cent below all-time highs at the end of April. But this ignores the strong role that dividends play in Australia, which go a long way towards reducing the perceived gap.
Dividends make up more than half of the returns for Australian equity investors every year
Australia is the highest paying dividend country in the G20 group of major global economies, and in April, our average yield of 5.64 per cent was almost three times that of the US at just 1.95 per cent. But these strong dividends paid to investors in Australian companies can mean lower capital returns and the potential for companies to underinvest in their future.
In fact, in simple index terms, the annual returns of both markets in the post GFC-era1 reveal the US more than doubles Australian returns (S&P 500 at 15.5 per cent per annum versus S&P/ASX 200 at 7.25 per cent per annum). The caveat is that the dividends are missing from these highly reported figures. By recalculating them to include that reinvestment, the annualised return for Australia increases to 13.73 per cent – significantly closing the gap on the US now at 17.94 per cent.
Australia’s imputation system is a key driver of the higher average dividend payout ratio
Our imputation system allows corporate tax entities to distribute profits on which income tax has already been paid to members – such as shareholder dividends. They have the option of passing on ('imputing') credits for the tax, known as ‘franking’ the distribution. These franking credits are attached to the distribution and can be used by the recipients as tax offsets.2
Around the world, companies generally distribute a portion of after-tax profits to shareholders as a dividend. Under a classical taxation system, they’re taxed at both a corporate level (on generation of a profit) and in the hands of investors, on receipt. But to stop this double taxation, Australia implemented its imputation system in 1987. Before this, ASX-listed companies paid out on average 47 per cent of earnings as dividends, but fast forward 30 years and the average dividend payout ratios are now above 80 per cent. Compare this to the US where there is no imputation system and investors are taxed at their full personal income tax rate – the average payout ratio for a similar S&P 500 company is 52 per cent.
It can be argued that this is a primary driver of the higher average dividend payout ratio for listed Australian companies and, consequentially, the greater portion of shareholder returns being derived from dividends. So, how does our imputation system impact companies and the wider economy?
Imputation and high corporate dividend payout ratios have several unintended effects
At a company level, a higher payout ratio results in lower overall free cash flow available for reinvestment within the company, such as new projects. And at a time when Australian corporations are facing an influx of global competitors and increasingly disruptive technologies, this lack of reinvestment may render traditional businesses uncompetitive – an increasing risk in a very concentrated Australian market. While this often appears as the major argument against imputation, there are several considerations to the contrary.
Firstly, with less capital available for reinvestment, there may be reduced owner-manager agency problems as companies are forced to come to market to raise additional cash. This allows investors to play a more active role and apply more scrutiny (major raisings generally require shareholder approval) to any major reinvestment decisions.
Secondly, Australian companies may be more likely to confine operations within Australia (and hence contribute to economic growth through business expenditure) to qualify for and pay Australian corporate tax. This enables the payment of franked dividends to shareholders, which is attractive to shareholder capital.
It’s important to consider more than just your dividend yield when investing locally
Many of us have a level of comfort with familiar companies that we can see and monitor, and that provide preferential tax treatment on dividends. This home bias however means that as Australians, we are holding a very high allocation of domestic shares, particularly in comparison to our overall size in global equity markets.
What is some cause for concern is that the bias for Australian companies to pay out high levels of dividends may in fact push towards this underinvestment in future growth – particularly with globalisation and technological changes placing pressure on traditional business units. With higher payout ratios, companies generally have lower levels of cash reserves during times of economic downturns (as seen by the myriad of capital raisings during the GFC) potentially resulting in higher levels of volatility and risk of long-term under-performance. This will be visible in comparison to those companies maintaining strong cash balances through earnings retention and who invest more heavily in growing their businesses.
While some corporations may not always get that reinvestment decision right, in an ever-changing global environment, it’s important to consider more than just the dividend yield when making your next investment decision for the longer-term health and diversity of your portfolio.
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.