The Dividend Trap
Chasing Income Stocks May Cost You
Why Growth Should Be a Priority for Long-Term Investors
Marcus Padley | 24 May 2024 | Education Corner
There are plenty of very experienced investors who sell big income stocks just before they go ex-dividend because income stocks often peak on results ahead of the ex-dividend date. This has been especially true in classically recognised income stocks like the Banks and Telstra.
They sell because experienced investors know the folly of investing for income. They know that chasing dividends is a nil-sum game and corrals you into low-growth stocks. They know that income stocks get "pregnant" with dividend chasers before a dividend which means they can drop hard after the dividend. They know total return is more important than dividend return. They know that advisers over-promote income stocks because (1) they are large quality stocks that they can't be sued for recommending, and (2) they can quietly take their fees out of the cash refund of franking credits rather than send an invoice for their fees, and (3) the process of collecting the cash refund makes it look like they are adding value when your tax return could do the same thing for a lot less.
The Ex-Dividend Drop
It goes without saying but is ignored by the blind, that a stock drops by the amount of the dividend on the ex-dividend date and sometimes by the dividend plus the franking, especially in big income stocks where people have been hanging out (not selling) because of the impending dividend.
Ex-dividend dates often also start short-term downtrends or extend existing downtrends. Stocks in downtrends heading into the ex-dividend date build up a group of shareholders who want to sell but have delayed because of the dividend. Then they all cascade out afterwards.
The Franking Trap
One of the sad realities of Australia is that half the Australian population think they are being terribly clever by collecting franking, and particularly the cash refund of franking, but it is pointless if you lose more in capital over the ex-dividend process than you collect through the dividend. A dollar is a dollar however it arrives, and thinking franking is some miracle giveaway does little more than trap you in stocks, especially stocks that are in a downtrend, to your cost.
A Different Perspective
My guide would be this, but this is me, not you. I wouldn’t care when the ex-dividend date is, if I wanted to buy or sell I’d buy or sell. Franking is not the Messiah; it is just a heavily marketed tax break sold by financial planners as some miracle they can access on your behalf, or by brokers as a reason to roll your huge holding in one bank into another bank and create a bucketload of commission in the process.
Discover the key to successful ETF investing with our free 5-part video series.
Join Marcus Padley as he shares essential tips and strategies to help you navigate the market confidently - Sign up now.
Rethinking High Yield Investments
Don’t bother emailing me telling me that you live off the franking credit refunds and couldn’t do without them—I know—but think outside your brainwashing for a moment. High-yielding stocks tend to be mature, boring, low-growth stocks. That will suit you if you are a low-risk investor focused on income rather than capital gain (and there are many of you—nothing wrong with that), but for a younger growth-phase investor, don't get dragged into income and franking investment. Chasing income distracts you from growth stocks. Filter the ASX 200 on yield, and you will be doing little more than excluding all the growth stocks that could make a difference to your life, because income stocks won't make a difference to your life—they are there to maintain an income, not grow your capital.
The US Perspective: Growth Over Income
In the USA, "Bonds are for income" (not so much anymore) and "Equities are for growth." That culture is why a lot of companies (Microsoft, Berkshire Hathaway) resisted paying dividends for decades, and why very profitable companies like Microsoft still only yield 0.8%, and Apple yields 0.6% (despite a 157% ROE). Because paying a dividend in the US is seen as a failure. Paying a dividend says, “I can’t earn more than you can, so have the money back.” US shareholders understand—have always understood—that if Amazon can earn 20.4% on every dollar they invest every year and the best they can do is invest in bonds and make what, 4%, why wouldn’t you give Amazon the money? And why would you ever want Amazon to return any money to you when "Amazon money invested" is compounding every year at 20% and that compounding value is turning up in the capital value of their shares? You should be upset if high ROE companies pay dividends. You want to see zero yield. You want to see earnings reinvested by the company, not returned to you.
The Australian Obsession with Dividends
The same culture does not apply in Australia. In Australia, it's all about dividends and franking; it's about return, it’s not about total return. Australia has this zombie-like obsession with the very average returns from boring, mature, no growth, low growth (safe and reliable) income stocks. In so doing, you are corralling yourself into stocks that have no obvious growth options, return the money to shareholders, and because of Australian tax legislation, it is seen as "clever." Meanwhile, all the growth stocks with high ROEs are seen as ‘risky’ and dangerous. But that’s where the total return is. Growth companies compound earnings, which turns up in market capitalisation.
The Bottom Line
Bottom line: You will be richer for filtering stocks by ROE, not gross yield. Invest for income, and your nest egg will quietly shrink. Don't get caught out investing like a retiree if you still have a long runway before you need income.
Of course, not chasing income stocks means you might have to sell some Pro Medicus shares to fund your groceries in retirement, but if you can get your head around that, you'll be the one with the Chocolate Digestive biscuits on Bingo night.
