Do-It-Yourself investors bias their portfolios towards companies that distribute franked dividends. This is particularly common amongst trustees of SMSF’s who appear to over value the worth of dividend franking credits.
Dividend franking is considered by many to provide a “free lunch”. Consequently, fully franked shares are overweight in the investment decision process.

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.

The Four “Myths” about Dividend Franking

Below, we consider four widely held franking “myths”:

Myth 1: Higher franking dates suggest better future stock performance

Analysts believe a company’s share price is driven primarily by the stock market’s opinion of its after-tax profit. Therefore, there is no reason for investing in a fully franked share over an identical but unfranked share.

Myth 2: Low marginal rate tax payer benefit more from franking credits

There is a view among self managed superannuation fund trustees that they are advantaged by a lower tax rate  -  15% on dividends and franking credits, compared to 30% or higher forcompany and individual tax rates.

Although 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

There is a school of thought that fully franked shares provide additional benefits due to the franking credit attached to the dividend. 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.

Stock markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is well known 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.

Stock markets simply do not allow any obvious inefficiencies or “free lunches” to persist.

Myth 4: That investing soley in fully franked, high yielding Australian shares is a smart Super strategy

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.

Capital gains tax offers better opportunity for tax management than franking. Tax can be discounted and deferred (sometimes indefinitely) to reduce the overall tax rate.

A franked dividend investment strategy is flawed …

In our opinion, an investment strategy based predominantly on exploiting the perceived advantages of fully franked shares is naïve.

While franking should be a consideration, as a driver of investment strategy it ignores the importance of the primary variables in the portfolio construction equation – risk, liquidity, costs and a comprehensive tax approach.

An investment strategy that considers these broader issues is far more likely to meet your long term requirements.