Cash goes in, cash comes out. At its heart, this describes the type of company you should buy shares in. Businesses that generate free cash flow – or those that eventually will – are what every investor should seek.
The problem is that not all shareholders need the cash coming out (you’ll know this cash as ‘dividends’). After all, the very definition of investing is delaying spending now so that you can spend in the future. Dividends landing in your bank account create the problem of what to do with the cash.
Financial markets being what they are, there’s a solution to the problem (isn’t capitalism wonderful?). It’s called a ‘dividend reinvestment plan’ or DRP for short, although only some companies offer them. The idea is that, instead of paying you cash, the company issues you additional shares to an equivalent value.
- DRPs should only be used if the stock is underpriced
- May be better to build cash in a dedicated bank account
- Beware companies that use DRPs as de facto capital raisings
So are they worth it? The answer is more complex than it might appear. Particularly so because some companies offer DRPs less as a convenience to shareholders and more as a way to limit the cash flowing out. More on that in a moment, but for now let’s consider DRPs purely from the shareholder’s perspective.
One of the golden rules of investing is ‘never, ever buy a stock unless it’s underpriced’. This includes shares bought under DRPs; so if the stock remains underpriced then it may make sense to participate – particularly because the stock is often offered at discount of a few per cent. And of course if the stock's in your portfolio, then it should at least not be obviously overpriced.
|• Is the stock underpriced?|
|• What other opportunities are available?|
|• Will you spend the cash?|
|• Is there a discount?|
|• Is the DRP a de facto capital raising?|
The problem is that this means you need to keep an eye on your DRPs at dividend time and make judgments about the value on offer. And even where you're comfortable that a stock remains underpriced, it may not be the best use for the money. There are over 2,000 companies listed on the ASX it's unlikely that your existing holdings will always the best investments on offer. If your portfolio is small or otherwise poorly diversified, it also makes little sense to keep adding to existing holdings.
So what’s the alternative?
A good solution is to accumulate your dividends in a dedicated bank account (we would say a ‘high interest account’ but there's not much chance of that at the moment). While you’re at it, set up a direct debit from your salary to turbo-charge your investment capital. Very soon you’ll have accumulated sufficient funds to buy another stock.
If you conclude that an existing holding is the best use for the money then that’s perfectly fine; at least you’ve made the decision actively. This is more important than it sounds: you’ll become a better investor by taking an active role in stock selection. Using a DRP is a passive investment decision which won't help you improve your skills.
Of course, every investor is different and using a DRP might be the best option for you. If you want to keep it simple for example, you could buy a listed investment company with a DRP, allowing you to compound your returns over the very long term. You might also use a DRP if you don’t trust yourself with the cash (hmmm, should I get the grey or the silver iPhone?).
DRPs priced at a decent discount to the market price might also be worth considering, although they’re few and far between now. There’s also something to be said for avoiding brokerage, but that should probably be considered a side-benefit rather than the main reason for using DRPs.
Tales from the dark side
There’s a reason why few companies offer DRP shares at steep discounts these days. As with many other share issues, DRPs create winners and losers.
Issuing shares to selected groups of shareholders is fundamentally discriminatory. Every time it happens, there’s a transfer of value from those that don’t participate to those that do. Shareholders in the DRP end up owning a larger slice of the business over time, while everyone else has their ownership interest diluted. Recognising this, most companies have reduced the incentive to participate in the DRP by eliminating significant discounts.
Did you know that the dividend is assessable income whether you receive it as cash or shares? The Australian Tax Office considers you’ve received the cash and immediately decided to buy shares with it. So put aside some cash from other sources if you’ll need to pay tax on the dividend.
Remember that each dividend reinvestment is also a separate share purchase, which makes the administration more complicated. When it comes to sell, you or your accountant will need to calculate the capital gain or loss on each parcel. Keep good records.
Even more sinister are the companies that use their DRPs as a sly method of raising capital. Earlier, we mentioned that some companies prefer to limit the cash flowing out, perhaps because they’re experiencing poor market conditions.
Rather than cancelling or reducing the dividend – the sensible course of action – they may choose to underwrite their DRP (issue shares to a third party to obtain cash to pay the dividend). This is tantamount to not paying a dividend at all.
As a general rule, you should beware companies with a significant upward creep in their number of shares on issue over time. DRPs, option issues, ‘performance shares’, capital raisings and the like all tend to dilute the interests of non-participating shareholders. Companies that are profligate with their shares tend to be less shareholder-friendly than those that keep the creep under control.
No issue at all?
There’s no real reason why large companies with liquid share registers need to issue shares to satisfy their DRPs. Westpac Banking Corporation, for example, buys the shares on market and then transfers them to DRP participants. Other companies buy back shares over time to offset dilution from their DRPs. This is the sort of shareholder-friendly behaviour you should seek out.
The decision to participate in a DRP is, as you can see, less than straightforward. Companies that offer DRPs aren’t necessarily doing it out of the goodness of their hearts. Or they have ‘capital creep’ issues that mean they might not be the best investments anyway.
If you can find underpriced stocks with DRPs, then by all means participate. Just remember to cancel your election when the stock’s no longer obviously underpriced and there are better opportunities for new investments (many share registries let you do this online).
For many investors the DRP is more trouble than its worth. Learn to enjoy those dividends coming in, invest them when you find an underpriced stock, then sit back and wait. Before long the problem of all that cash coming in will get a whole lot bigger. And that, of course, is a nice problem to have.