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Franking debate: 3 alternative ideas to consider

Lex Hall  |  11 Apr 2019Text size  Decrease  Increase  |  
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The federal election battlelines have been drawn for 18 May. This brings into even sharper focus one policy area that has dominated debate since it was first launched back in March 2018: Labor's plan to axe cash refunds for franking credits.

What are investors to do? Two things, suggests Morningstar's senior banking analyst David Ellis: first, wait for the result and the possibility the surplus franking proposal will be watered down in the Senate as it’s likely to be thwarted by conservative-leaning independents.

Or secondly, consider alternative investments.

“The alternative we like most is investing in quality ASX-listed stocks with strong earnings growth prospects paying low or zero franked dividends,” says Ellis.

“We see some possible investment alternatives to popular high-yielding, fully franked ‘blue-chip’ stocks should the proposal be implemented.”

Global asset manager and investment bank Macquarie Group (ASX: MQG), QBE Insurance (ASX: QBE) and UK holding company CYBG (ASX: CYB) are attractive stocks that should be considered as part of a diversified portfolio to minimise the impact of Labor’s plan, says Ellis.

“The key attraction of the three stocks listed above attractive forecast earnings and dividend growth, irrespective of franking rates,” says Ellis.

“We expect MQG’s dividend to be 45 per cent franked for the next few years at least, QBE’s dividend is expected to be 10 per cent franked from 2020 and CYB’s dividend is zero franked.

All three stocks have a substantial proportion of offshore earnings, with MQG 66 per cent, QBE 70 per cent and UK-based CYB 100 per cent.”

Macquarie Group

Macquarie Group has a narrow-moat, medium uncertainty rating. It is trading 3 per cent below Morningstar's valuation and its forecast FY20 dividend yield is 5.1 per cent.

“We like the long-term earnings outlook for MQG, particularly the global focus on infrastructure assets, renewable energy, corporate lending, investment banking and domestic investment, commercial and consumer banking,” says Ellis.

“Our medium uncertainty rating is anchored on the group’s large exposure to non-capital market-facing businesses, with the so-called annuity businesses accounting for 60 to 70 per cent of group business unit profit contribution.”

QBE Insurance

QBE Insurance has no moat, and a high uncertainty rating. It is trading in line with Morningstar's valuation and its forecast FY20 dividend yield is 4.7 per cent.

“We like the earnings growth outlook for QBE and the potential for strong dividend growth,” says Ellis. “The global insurer’s balance sheet is strong and based on improved earnings resilience. We forecast a dividend CAGR of 8 per cent for the next five years to end 2023.

"We think shareholders will benefit from attractive future returns as new CEO Pat Regan delivers sustained improvement across the group.”

CYBG

CYBG has no moat, a high uncertainty rating. It is trading 24 per cent below Morningstar's valuation and its forecast FY20 dividend yield is 5.7 per cent.

“UK regional bank CYBG continues to impress and we like the bank’s attractive long-term earnings outlook despite ongoing Brexit uncertainty,” says Ellis.

“CYB’s primary listing is the London Stock Exchange with CHESS Depository Interests (CDIs) listed on the ASX. Good volume growth, better than expected net interest margins, in-line loan losses, and an uplift in expected cost savings underpin our earnings forecast. Being a UK company, CYB does not generate Australian franking credits and dividends are unfranked.”

A word on global equities and small cap funds

There are of course other alternatives, such as global equities, but such a reallocation presents its own set of risks, Ellis says.

“A greater exposure to offshore stocks, either directly or indirectly via managed funds neatly steps around the franking issue, but investment risk and transaction costs increase, and currency risk is introduced.

“Investing in small-cap Australian managed funds focused more on growth is a potential alternative. Small-cap funds are more targeted toward capital gains than traditional large-cap high-yielding fully franked dividend stocks.”

is content editor for Morningstar Australia

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