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These high yield LICs could be hit hard by Labor’s changes to franking

Labor’s proposed changes to franking have consequences for almost every investor.

By removing the cash refunds for franking credits, it makes the income stream from Australian shares somewhat less attractive. That’s especially true for those of us on lower tax brackets, as we tend to value a strong fully franked dividend and look at shares based on their ‘grossed-up’ yield.

Axing the refundable nature of franking credits will mean a loss of dividend income for some of us.

It occurs to me, some LICs seem to trade at premium prices, implying that investors are valuing those companies based on their gross dividend yield, as opposed to just the cash dividend paid to shareholders.

This makes sense when you consider much of these companies’ shareholder base is retail investors who are in pension phase. If franking refunds were axed, these LICs would likely fall out of favour.

In my opinion, the LICs most at risk are those with the largest gross yields, as franking can often add 2%-3% to the dividend yield. For example, a company trading on a fully franked yield of 6%, is a gross yield of 8.57%.

The most obvious examples to me are WAM Capital Limited (ASX:WAM) and WAM Research Limited (ASX:WAX). These are currently some of the highest yield LICs out there, with gross yields of 9.15% and 8.72% respectively. Instead of receiving a 9% dividend, you may only end up with a 6.3% dividend.

Removing franking clearly makes the income stream less attractive to that particular shareholder base. Investors are likely to look around for other high yield alternatives. Whether they can find any suitable is another matter.

This is much more of a concern in LICs with high turnover, as the company pays a lot of tax on its capital gains, which it regularly harvests to create those large fully franked dividends.

Foolish takeaway

The manager of these LICs – Wilson Asset Management – has certainly proven themselves over the last 20 years with strong performance and regularly paying large dividends to shareholders.

I’m a happy shareholder myself, but I would definitely caution people against paying a large premium right now to invest in these LICs, as the risks are now higher. It’s unlikely investors would jump ship if franking refunds change, but it’s still a risk to be very mindful of.

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Motley Fool contributor Dave Gow owns shares of WAM Capital Limited and WAM Research Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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