To DRP or not to DRP?
To DRP or not to DRP?
April 8, 2011
PORTFOLIO POINT: Whether to join a dividend reinvestment program can be a difficult decision. Here are some factors to consider.
Twice a year, generally following the half-yearly reporting season, dividend payouts remind us that owning shares is not just about capital growth. Shareholders in some companies have the added benefit of being able to reinvest those payouts at a discount through a dividend reinvestment program or a DRP.
Over the years many investors have mulled over whether to participate in these programs. Hopefully today I can explore a number of reasons that might help your decision.
Historically about half of the return from shares comes from dividends, although Macquarie Bank’s forecast for the year ahead is that dividends will account for 30%. Either way, it is a significant amount. Popular investment theorists like Ben Graham suggested that a true investor keeps a stronger focus on dividends that on price movements of the shares they own.
Nobel Prize winners in economics, Franco Modigliani and Merton Miller, considered the impact of how companies managed capital decisions like borrowing money, issuing shares, paying out dividends or reinvesting the funds on the value of a business. Their conclusion was that it made no impact.
As investors, we face a similar decisions, when presented with the opportunity to take a cheque or reinvest dividends back into the company. I think that there are arguments for and against participating in a dividend/distribution reinvestment program.
This somewhat mirrors the Modigliani and Miller conclusions: that investors are better off considering their decision in the context of their own circumstances. Without knowing your personal circumstances and the details of the company in question I can’t answer this question for you.
But what I can do is provide you with a framework to help you answer the question yourself.
Most dividend reinvestment schemes offer the opportunity to purchase shares in place of a dividend – at a discount and without paying any brokerage. This can be a particularly attractive way for small investors to build their investment portfolio. In the case of a diversified investment such as a listed investment company or managed fund, reinvesting dividends (or distributions) is a simple and cheap way to build a diversified investment holding.
The discipline of a dividend reinvestment program also has considerable value. The fact that cash is automatically redirected back into an investment helps keep a person on the path of improving their financial situation because reinvesting dividends is “compound interest” in action.
If you reinvest a dividend, you are buying more shares/units in the investment, which in turn creates a greater dividend in the future, which can then be reinvested – and so on. A key warning with “the miracle of compound interest” is that it takes many years for the impact of compound interest to be felt in an investment portfolio, and I think that many people give up before their investments are able to benefit.
What happens if a share pays a $99 dividend, with a dividend reinvestment price of $50? The answer in some cases is that the investor receives one share, and the $49 left over is added to the next dividend –which may not be for another six months. This is an extreme example, but there are plenty of stocks with relatively high share prices that leave investors vulnerable to the prospect of “left overs” – money they don't see any benefit from until the next dividend period.
At a company level, a dividend reinvestment plan generally requires the issue of extra shares. This is problematic for all investors – if more shares are issued in a company, then an investor who does not participate in a dividend reinvestment plan suddenly owns a smaller proportion of a company. This can be a significant problem when the share price is low, and large numbers of shares are issued to pay a dividend.
Not that long ago a key argument against dividend reinvestment plans was their complexity for tax purposes. Each dividend re-investment is effectively a purchase of shares – and often these happen twice a year. Tracking these purchases for capital gains tax purposes becomes a handful, however I think the advent of share registries negates this argument somewhat, although you still do end up with a lot of transactions that need tracking.
Another argument for caution with dividend reinvestment plans – especially as a portfolio grows in size and requires more sophisticated investment decisions – is that participating in a plan gives away some control over the price and timing of investment purchases. It means that you have 'pre-made' the investment decision to invest the cash amount of a dividend into the same investment at the dividend reinvestment price. This assumes that it will be the best available investment at that point in time which is not always going to be the case.
Large capital gains may see you end up with a disproportionate exposure to company you are not entirely comfortable with. While this might be a reasonable strategy when the underlying investment is well diversified, such as a listed investment company, giving away this investment choice around individual investments essentially sees you cede your carefully constructed asset allocation plant to the whims of the company.
Dividend reinvestments plans can be used to distort company performance. The most significant and recent example of this was BrisConnections. Investors were offered a nice cash distribution with their investment – offering them the appearance of investing in a company with strong cash flows but the dividends were not paid out of cash flow; rather they were to be financed through the issue of additional units.
When the unit price of the project collapsed, so did the capacity to pay the distributions, leaving investors out in the cold. The moral is that paying dividends in cash is a great financial discipline on a company, and that real dividends paid out of real cash earnings should provide confidence for investors that the company they have invested in is performing well. Manufactured dividends paid for by issuing more shares or units are far more problematic, and are no indication of financial discipline at all.
To my mind there is no easy answer to the question of whether to participate in dividend reinvestment plans. The headline discounts can be attractive, especially for smaller investments and for investments in diversified portfolios. There are arguments against, the biggest of which is that you are giving away some control over the timing and pricing of investments that you make. The bottom line is that most investors will have to carefully consider the merits of each plan individually. It’s time-consuming but the only way you can be truly certain you’re doing the right thing.