Is franking a free lunch …Franked Dividends - Free lunch?

Many D-I-Y investors skew their investment portfolios towards shares that pay franked dividends. This is particularly prevalent amongst trustees of self managed superannuation funds who appear to over value the benefit of franking credits.

There appears to be a view that franking offers "a free lunch", resulting in its overemphasis as a driver of investment strategy.

We believe investors should not favour particular shares simply because they pay franked dividends. The usual thinking behind such behaviour is, in our view, flawed.

Four franking "myths" …

Below, we consider four franking "myths":

Myth 1: Franking levels indicate better future share performance

Most financial analysts believe a company’s share price is driven primarily by the share market’s assessment of its after-tax earnings prospects. If they are right, then choosing one company’s shares over another based on current franking levels alone does not make sense.

Myth 2: Franking benefits low rate taxpayers

Some low tax rate shareholders (e.g. self managed super fund trustees) believe they get a better relative advantage (compared to higher rate taxpayers) as a result of receiving franked dividends.

While there is no doubt that they receive an absolute advantage as a result of their lower tax rate, this will be the case regardless of the level of franking.

Myth 3: Markets incorrectly price the benefit of franking

It’s often suggested that shares offering fully franked dividends provide a benefit not available from unfranked shares. We hope that the above discussion will cause those with this point of view to reconsider.

However, even if you remain unconvinced by that discussion, it is unreasonable to expect that the share market would not adjust to allow for the claimed disparity.

Share markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is not a secret and any benefit (real or perceived) is almost certainly already reflected in prices.

If you believe that you will receive a greater benefit by buying a franked share over an unfranked share, then surely you would be prepared to pay a little more for the franked share compared with the unfranked share. Investors will continue to pay up for any franking benefit until the higher price exactly offsets the benefit.

Share markets simply do not allow any obvious inefficiencies or "free lunches" to persist.

Myth 4: A smart super investment strategy – fully franked, high yielding Australian shares

An investment strategy that emphasises the level of franking is also likely to focus on higher dividend paying shares, to maximise the perceived benefit.

In addition to defying other elements of a sound investment philosophy, such an approach implies an expectation of higher income and lower growth returns, effectively ignoring the relative tax advantage of capital gains tax over income tax.

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