THE WEEKEND AUSTRALIAN, JUNE 13-14, 2015

theaustralian.com.au/wealth 33V0 - AUSE01Z01MA

The dividend trap can leave you out of pocket

Chasing yield and ignoring growing income is a mistake — and in the long run it will prove costly for its adherents.

Take a business with $10 of equity a share and earning 20 per cent returns on that equity (ROE).

In the first year, the earningswill be $2. If the directors acquiesce to shareholder demands and pay all the earnings out as a dividend, the dividend will also be $2 a share.

Now, if we assume the popularity of the shares never changes and they trade at 10 times earnings, they will be priced at $20 in the first year.

You will note the dividend yield is 10 per cent.

It all seems very attractive inthe context of the present miserable returns on cash and term deposits.

If we then assume in the second year the company begins with the same equity it had at the end of the first year — $20 — and it earns another 20 per cent return, then the earnings will also be $2. You will note there’s no growth, but as the popularity of Telstra shares has shown, you don’t need growth in earnings or dividends to keep a share supported.

The reason there is no growthin earnings is because we are assuming the ROE stays constant. It is also a fact the company pays its entire earnings out as a dividend, so there is no capital retained to grow the equity base. All this is rather academic until you get to the return you are going to make.

If we assume the company’sshares trade at 10 times earnings when you buy them and also at 10 times earnings when you sell, then provided the above pattern of returns and dividend payments continues year after year, your return will just be 10 per cent a year.

Now here’s where it gets really interesting.

Suppose the company paid nodividends, instead retaining all the profits so the equity grew

each year, and the company continued to earn 20 per cent returns on the increasing equity.

If you bought and sold this company’s shares on a price-earnings ratio of 10 times, you would end up with an annual return of 20 per cent and double the return compared with taking the dividends.

In other words, by demandinga dividend equivalent to 100 per cent of the earnings, the opportunity cost is as much as double. The rubber really hits the road with an example.

In 2005, you could have bought $100 of Telstra shares at $4.69 on a 5.97 per cent yield — paying $5.97 on your $100. Alternatively you could have purchased shares in another, much smaller telco, M2 Telecommunications. Unfortunately the M2 dividend yield wasn’t as attractive as Telstra’s at 3.91 per cent, so your income on a $100 investment was just $3.91.

You’d be forgiven for optingfor the higher-yielding Telstra shares, but as we demonstrated a moment ago, the returns are higher when a company can retain profits and continue to generate high returns.

And that’s what M2 did.Your $100 investment in

Telstra in 2005 is now worth $132. Importantly the dividends have been steady and you are now earning $6.40 a year in dividends.

Contrast this with M2. Because M2 has been able to grow its equity by retaining profits — and admittedly other techniques such as capital railings — and employ the additional capital at high rates of return, the growth in the value of the business has been much greater than Telstra’s.

A $100 investment in M2 hasnow grown to $3453 as the share price surged from 32c 10 years ago to more than $11 at present.

More importantly you shouldrecall you didn’t buy M2 shares because you needed the higher income Telstra was offering in 2005. That’s a pity because the income on the shares you originally purchased for $100 is now $93.75. In other words, going for growing income rather than yield has delivered more income and more wealth — it’s the best outcome.

Roger Montgomery is founder and CIO of The Montgomery Fund.

ROGER MONTGOMERY

China market’s moment is now

The Chinese CSI 300 — thenation’s leading share marketindex that is a composite of theShanghai and Shenzen exchanges— has the real possibility oftripling or even quadrupling fromcurrent market valuations by ornear 2020.

On May 9, the Morgan StanleyComposite Index (MSCI), argu-ably the world’s most importantglobal shares benchmark, an-nounced “China’s A-shares (are)on track for inclusion”.

The announcement was greet-ed by many commentators as anegative.

It is, in fact, a positive, as itpresents another huge andparticularly timely opportunityfor Australian investors to tacti-cally position into a market withhuge potential.

The delay of China’s A-sharesinclusion into specifically theMSCI Emerging Market, Chinaand World Indices provides Aus-tralian wholesale investors an-other chance to astutely front-runthe predictable eventuality thatthe Shanghai-Shenzhen CSI 300will be represented throughoutthese important global bench-marks one day very soon.

MSCI indices matter — a lot.This is because, as of June 30,

2014, they have $US9.5 trillion($12.3 trillion) in known assetsbenchmarked against them.

Australian ultra high net worthglobal investors have been advised— at least by us — that this is themoment to take action and do sowith conviction.

More than simply ringing thebell, this is a once-in-a-quarter-century opportunity that won’tbe repeated, at least not duringthis contributor’s professionallifetime.

Stripping out the geopoliticsand stereotypical noise surround-ing China’s ascent, such a step-change is plausible and makes alot of sense when explained in the

following light. The Chinese Com-munist Party’s state-led modelallowed its population to invest inreal estate so China couldcontinue its progression fromdeveloping to developed econ-omic status over the past 15 years.

The excesses seen within whatwe refer to as shadow banking —off-balance sheet non-bank lend-ing — were permitted, primarilybecause this allowed a circuitbreaker when domestic Chinesereal estate investment overheated.

The CCP has now consciouslyopened a new gate for its citizenryto invest more easily — contraryto their own rhetoric — into theCSI 300 and other Chinese share-markets for two primary reasons.

The first is that China nowwants advanced capital marketarchitectures, just like we have inthe OECD; and second — andmore interestingly — it purposelywants to inflate its bourses, withvery specific outcomes in mind for2017, 2018 and beyond.

These forethought outcomesinvolve China’s CSI 300, in thenear future, joining the MSCIWorld indices, where, as discus-sed, they are not currently repre-sented.

Until very recently, piercingthe walls of these “iron curtain”capital controls has been nearimpossible — or at least not legal.

While the May 9 announce-ment explicitly said MSCI and theChina Securities RegulatoryCommission would form a work-ing group to resolve “a few import-ant remaining issues related tomarket accessibility”, it is likelythe CSRC, on direct instructionsfrom the CCP, and more import-antly President Xi Jinping, will notbudge on these iron curtain con-trols until the following occurs.

What the CCP wants is aninflation of its sharemarkets’ valu-ations. Only when this has hap-

pened, it would be fair to predict,would they then have plans toloosen these capital controls andprogressively allow more foreigninstitutional investors to enter themainland bourses. When thishappens, CSI 300 prices will be farhigher than they are now andthese foreign institutional inves-tors will be purchasing Chineseshares with fresh foreign capital,namely US dollars.

This is why now is a cruciallyimportant time for Australianglobal investors to pay particularattention to China and globalaffairs.

Remembering that these Chi-nese bourses aren’t yet in MSCI

World indices, when they achieveIMF “Special Drawing Rights”status sometime soon — whichthey will — it will further allow theconvertibility of yuan to USdollars, even more foreigninstitutional capital will, by forcedmandate, be directed towards theCSI 300.

The logic for this is simple.When China’s bourses are thenincluded in the MSCI WorldIndex or any similar benchmark,then a plethora of global insti-tutional passive investment man-agers, by mandate, must thenpurchase CSI 300 exposures, sole-ly to satisfy their prescriptive port-folio guidelines.

The CCP knows this and ismaking every effort now to stokebourses such as the CSI 300 tomuch higher levels.

Put simply, the delays willdissipate when the CCP and Xibelieve the CSI 300 is at valuationlevels they are comfortable with.

Coincidentally, it is the CCPitself, which as a significant stake-holder in a majority of state-owned enterprises stands tobenefit when such new price levelsare reached.

This is not a conspiracy, this is

capitalism in practice — the USinvented shadow banking andspent the past six years inflatingtheir own bourses. Then the Brit-ish, Swiss, Japanese and now theeurozone have followed suit.

Clearly short-term trading onthe CSI 300 is like riding a wildtiger and at Larkin Group we havepeople watching this Chinesemarket on a full-time basis.

This is a truly exciting time forAustralian UHNW investors, andrather than licking our woundsabout former iron ore export lev-els, let us look forward towards2020 and what could very likely bea golden, not iron, opportunity.

Separately, Australian SMSFinvestors should consider passivefive-year “Rip Van Winkle” op-portunities.

Waking up in 2020 to a CSI300 index exposure priced quitedifferently than it is at present,could be a shrewder alternativethan doubling down on currentlyrudderless ASX investments.

Larkin Group is a wholesale wealth adviser focusing on high-yielding global investments.

www.larkingroup.com.au

It’s time to pay close attention to China’s share market indices

STIRLING LARKINGLOBAL INVESTOR

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Source: Bloomberg20152010

IndexShanghai Shenzhen CSI 300 Index, past five years

AP

China’s shift towards global economic integration will give astute investors a once-in-a-quarter-century opportunity

Tax wise: year-end donations are fine, but charitable trusts the way to go for a lasting legacy In the coming weeks many peoplewill be thinking of giving tocharity: it’s a way to reduce yourtax bill for the year to June 30.What most people don’t realise isthat you can commence a philan-thropic foundation with signifi-cant long-term tax advantages foras little as $20,000.

While it’s easy to respond tothose appeal letters that find theirway into mailboxes at this time ofthe year, this isn’t really the bestway to support charities.

It is easier to establish a per-petual charitable trust than mostpeople think, and it does not needto be expensive or complicated.However, the misconceptions

about establishment, operationand flexibility of such trusts, oftendeters people. There is also aperception that charitable trustsare just for the very wealthy, whichjust isn’t the case.

Ultimately, a perpetual chari-table trust can help to better fulfil adonor’s intentions in a much moreappropriate and lasting mannerand will ensure a greater impact ontheir chosen charity or causerather than ad hoc donations.

Typically, there are two optionsfor establishing a charitable trustor fund: private ancillary funds(PAFs) and charitable accounts orsub-funds. PAFs are often used forfamily foundations and are suit-

able for those who can donate atleast $300,000 in investible assets.

Charitable accounts or sub-funds are individual funds set upunder the umbrella of these publicancillary fund (PuAF). PuAFs arerecommended for those who wantto start small but nevertheless wishto have some direction over whichcharities or causes they support.Sub-funds are a particularly goodoption for people who don’t wantto be involved with investmentdecisions.

A sub-fund is quick and simpleto establish. Using the EquityTrustees Charitable Foundationas an example, the minimumestablishment amount is $20,000.

You can name your account your-self, within certain Australian Tax-ation Office guidelines, and allbeneficiaries must be eligible Aus-tralian charities with DeductibleGift Recipient status.

Once established, the trustee,which might be a well establishedfoundation or an independenttrustee company, will manage theinvestment, governance andadministration of your account.You notify the trustee whichorganisations or projects you wishto support with the income gener-ated from your account.

Additional contributions canbe made to your account over timeto build up the capital base. There

are no restrictions on the fre-quency of subsequent donations.You can also direct a bequest toyour account in your will and youraccount can receive donationsfrom the public.

The trustee will advise theamount available for you to granteach year based on investmentperformance and minimum distri-bution requirements and the trus-tee will issue grants on your behalf.Grants can be made in youraccount’s name or be anonymous.

You can involve family mem-bers as grant-making advisers,making recommendations to thetrustee. In this role they have nolegal responsibility or liability.

Donations to sub-funds attractthe same tax deductions and con-siderations as making a donationdirectly to a charity. For those on ahigh income, there can be signifi-cant tax advantages in thisapproach as donations are tax de-ductible and the deductions to thedonor’s income can be upfront orspread across five years. Theincome generated from the chari-table account or sub-fund is dis-tributed year after year tocharitable organisations.

Among the financial advanta-ges of setting up a PuAF sub-fund,the initial start-up capital is tax de-ductible; the income from thefund’s investments is generated in

a tax-free environment; and fur-ther donations to the fund can betax deductible.

In the past 10 years many newphilanthropic trusts have been es-tablished. The primary reason forsetting up a foundation is to cre-ating a lasting legacy. Family foun-dations can strengthen familiesand bring them together with acommon altruistic goal. It can be agreat way for parents and childrento get together to discuss familyfinancial matters, inheritancearrangements and identify howthey can support charities.

Tabitha Lovett is general manager Philanthropy at Equity Trustees.

TABITHA LOVETT

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