To DRIP or Not to DRIP.
Kevin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
About this time last year I was looking into Dividend Reinvestment Plans (DRIPs) and Direct Stock Purchase Plans (DSPPs). (I'll refer to both as "DRIPs" from here on.) I was intrigued with the thought of compounding my returns by having my dividends automatically reinvested, so in January I decided to jump in and get my feet wet (so to speak).
I decided to investigate a few DRIPs through companies' Investor's Relations pages and several transfer agents. After I felt I'd done enough research I determined the criteria for my investments. They were as follows:
1. I should feel comfortable holding onto the stock for several years if not decades since this is a long-term investment strategy.
2. The selected DRIPs should have few if any up front fees. (Some of these plans have fees for various services; all of them have fees for selling shares.)
3. Dividend Aristocrats (companies that have a history of increasing dividend payouts every year for 25 years or more) were preferred. After further consideration, however, I would say companies that held up well during the financial crisis (from 2007 to the present) and have continued paying and/or increasing dividends during this time would also be preferred.
4. Plans that gave a discount on purchases and/or reinvested dividends were preferred. Companies offering these incentives do so to further entice investors to purchase shares to raise money obviously, but they usually do so because they need to raise money. This is fine, but it could also be need for concern, so due diligence must be performed.
5. I excluded REITs, even if they offered discounts on optional shares and/or reinvested dividends since they do not receive the special tax treatment regular dividends receive. It would be better to include REITs in a tax-sheltered account.
6. Payout ratio should be 60% or less.
7. Yield should be 2.5% or greater.
8. P/E ratio of less than 20.
[Note: This list of criteria has been revised since I made my initial investments. It represents criteria for an ideal investment, but that doesn't mean there can't be exceptions. If monthly or bi-monthly optional purchases are made--which would typically be the case for dollar cost averaging--criteria such as yield and p/e ratio will matter less over time.]
Advantages
1. Can start with very little money, in many instances as little as $50 or less.
2. There are often few if any fees to start a DRIP, though there are usually fees to sell the stock you accumulate.
3. You can dollar cost average into a position over time with optional payments, both scheduled and one-time as well as reinvested dividends. This makes purchase price and p/e ratios less of a concern since those will fluctuate as more shares are accumulated over time.
4. Some plans offer discounts on optional share purchases and/or reinvested dividends.
5. These plans typically purchase fractional shares, which makes book keeping more difficult but enables all of your money to work for you so you continue purchasing more shares as time goes on.
6. You can "turn off" the DRIP at any time and have the dividends sent to you either via postal mail or direct deposit depending on the company, the plan, and/or the transfer agent.
Disadvantages
1. No control over when exactly shares are purchased or sold. If an event should occur which would require you to get out of a stock fast (think Citigroup (NYSE: C) which also cut its dividend thus killing the benefits of reinvestment or Lehman Brothers) good luck because you're going to need it. Of course, this is why we choose solid companies with a proven track record, but still, anything could happen.
2. Detailed book keeping is a must to determine cost basis for tax purposes when selling. (Since most companies keep downloadable records for this it shouldn't be a problem, but it is something to keep in mind.)
3. Even when using the same transfer agent for all the companies with which you invest, paperwork for each is separate as is the tax documentation they send out at the beginning of the year. You will receive a separate 1099 form for each company and those documents will come in for each company at various times.
4. Discounts on optional shares and reinvested dividends need to be factored in for tax purposes. Discounts aren't a free lunch from the long arm of the IRS.
5. Unless you don't have enough money to open an account with a discount broker or are buying stocks that offer a discount, it may be more advantageous to start a synthetic DRIP with a broker that offers that option.
6. "Authentic" DRIPs entail having at least one full share registered in your name. This can require more time and money than it's worth depending on your tempermant and objectives. (DSPPs are easier to set up and in every other aspect identical to the authentic variety. Synthetic drips--also known as pseudo drips--are automatic dividend reinvestment plans set up with a broker which offers that service.)
7. Using options, limit orders, and other investment devices are out. If you want these features you'll need a broker.
Other Considerations
With discount brokers offering commissions of $10 per trade and lower, as well as synthetic DRIPs, there are fewer instances where I believe it's practical to invest in these plans. Unless you don't have enough money to open a brokerage account or don't mind dealing with the tax implications and intensive book keeping involved, it would seem a synthetic DRIP in a tax-sheltered account would be the best way to go for small investors.
I currently only have one direct DRIP (DSPP) running, and that's with Aqua America (NYSE: WTR), which offers a 5% discount on reinvested dividends. All my other DRIPs are within my IRA since I can only contribute $5,000 a year to it. If I were able to contribute more to it throughout the year or if I were earning enough in dividends from the stocks in that account to make it worthwhile to make other purchases, I would probably reinvest my dividends manually in companies when they're on sale as opposed to automatically reinvesting those dividends in the companies paying them. I reinvest dividends manually in my taxable account since I regularly add money to that account.
Think about it. Big investors and institutions like Warren Buffett's Berkshire Hathaway do this. Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) owns 200 million shares of Coca-Cola (NYSE: KO), its largest position and one that hasn't changed since Buffett stopped buying the stock in the late 80's. That one investment currently yields Berkshire $376 million a year, and Coca-Cola is a Dividend Aristocrat, so it will most likely continue to increase that dividend every year for years to come. That $376 million may be a little small for Berkshire to open a new position, but that is only one of around 30 companies it owns stock in, and most of those pay dividends. Buffett reinvests those dividends, but in new opportunities or adding to positions in companies he already owns if the price becomes attractive. He doesn't do DRIPs.
As a small investor, it's generally not a bad idea to put dividend reinvestment on autopilot. However, if you're earning enough in dividends, it may be more worthwhile to manually reinvest in good opportunities when they arise. Still, if you're just starting out and have limited funds, dividend reinvestment plans may be just what you need to start building wealth one DRIP at a time.
[Update: As of February 12, 2012, I closed my position in Aqua America.]
Motley Fool newsletter services recommend Berkshire Hathaway, The Coca-Cola Company and Aqua America. The Motley Fool owns shares of Berkshire Hathaway and The Coca-Cola Company. kbdunn9 owns shares of The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. 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.
