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Election2019: Investors urged to seek other sources of income if franking scrapped

Morningstar Analysts  |  17 May 2019Text size  Decrease  Increase  |  
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The Morningstar equity analysts team has produced a special election report entitled A Coalition Defeat Need Not Be Labor-ious for Your Portfolio. The report, a full version of which can be found here, examines:

  • Franking credits
  • Proposed changes to negative gearing and capital gains tax and their potential effects
  • Labor’s policy on renewable energy and climate
  • Private health insurance
  • The impact of Labor’s child care proposals

We begin part two of our election coverage by examining one of the most contentious aspects of the campaign: Labor’s plan to scrap cash refunds for excess franking credits.

Frankly my dear, I do give a damn

Should Labor’s proposed ban on surplus franking credits get up, Morningstar recommends investing in high-quality stocks with strong earnings growth prospects paying low or zero franked dividends.

The implementation of Labor's proposal to ban the refund of surplus franking credits for Australian investors on a zero percent marginal tax rate could reduce the income of hundreds of thousands of individual self-funded retirees and self-managed super funds, or SMSFs, in pension phase, if current investment asset allocations are not altered.

What could low-tax-paying individuals and/or the trustees of pension phase SMSFs do, to reduce the impact of the potential franking credit changes? Reallocating substantial parts of one's investment portfolio from high-yielding, moaty stocks trading within comfortable margins of safety to our valuations to high-yielding less moaty stocks is risky, expensive and could potentially trigger capital gains tax liabilities while simultaneously putting capital at risk.

Morningstar suggests investors wait for tomorrow’s result and the possibility the surplus franking credit proposal will be watered down in the Senate. It is unlikely Labor will have enough support to pass the proposal in its current form as conservative-leaning independents are likely to hold the balance of power.

Individual investors and SMSFs are typically overweight the S&P/ASX 20 Index, including fully franked dividend stocks such as the major banks, the big miners, the large consumer stocks, the general insurers, and leading health care stocks. The alternative we like most is investing in high-quality ASX-listed stocks with strong earnings growth prospects paying low or zero franked dividends. Morningstar sees some possible investment alternatives to popular high-yielding, fully franked, blue chip stocks should the proposal be implemented.

Attractive stocks within Morningstar’s financial services coverage include:

Key companies

Outside financial services, Morningstar cites:

It is difficult to identify enough good-quality stocks with sustainable dividend yields high enough to offset the grossed-up dividend yields offered by many of the top 20 stocks by market capitalisation. Based on Morningstar forecasts, the average grossed-up fiscal 2020 dividend yield of the four major banks ANZ Bank, Commonwealth Bank, National Australia Bank, and Westpac Bank is currently 9.8 per cent; the two big miners BHP and Rio Tinto average about 8.8 per cent; the two big domestic insurers IAG and Suncorp average about 7.6 per cent; and Telstra 7.0 per cent. The average fiscal 2020 distribution yield for A-REITS under our coverage is currently about 5.2 per cent, mostly unfranked, with the average distribution yield for Australian utilities and infrastructure stocks under our coverage currently about 5.7 per cent, mostly unfranked or with low franking.

A greater exposure to offshore stocks, either directly or indirectly via managed funds neatly steps around the franking issue, although we caution that investment risk and transaction costs could increase, and currency risk is introduced. Investing in small-cap Australian managed funds focused more on growth than income stocks is a potential alternative. Small-cap funds are more targeted toward capital gains than traditional large-cap high-yielding fully franked dividend stocks.

 

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Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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