Dividend Reinvestment Plans: The Case for DRIPs

Is it worth enrolling your shares in a Dividend Reinvestment Plan (DRIP)? Experts in the marketplace appear to strongly endorse these plans. After various banking, sovereign, and other financial crises, the widespread endorsement may cause one to worry. Many websites are dedicated to the topic, or have articles and blogs which propose that the average investor will benefit from DRIPs. I have found it difficult to find a well-researched article which challenges this “universal truth". Therefore, let us explore how DRIPs may, or may not work, for the investor.What is a Dividend Reinvestment Plan (DRIP)? According to Wikipedia,A dividend reinvestment program or dividend reinvestment plan (DRIP) is an equity investment option offered directly from the underlying company. The investor does not receive quarterly dividends directly as cash; instead, the investor's dividends are directly reinvested in the underlying equity. In other words, the investor reinvests his dividend returns in additional shares of the company, ETF, or other security.As with any other investment approach, there are strengths and weaknesses in using DRIPs. I will divide the argument into two articles. This first one will support reinvesting dividends through DRIPs. The second article will argue against this investment strategy. My goal is to arm you with additional insight, so that you can make more informed decisions about participating in Dividend Reinvestment Plans.The Case for DRIPsIt was relatively easy to find information supporting DRIPs. This is a widely endorsed and documented approach to improving investment return from dividends through price appreciation and compounding. I will not bore you with a regurgitation of the power of compounding argument - it is reasonably intuitive that if you reinvest your returns, then you will earn a compounded return. Of course, this assumes that your asset appreciates, or at least retains the same value over the time that you own the security.Buy Lower-Cost SharesDRIPs can be used as a mechanism to buy shares at a lower than average cost than what is priced in the market. There is no need to time your incremental investments - the nature of buying the shares regularly, and typically at quarterly-average costs, provides you a lower-than-peak price. Therefore, DRIPs can help investors avoid price highs and improve the overall, long-term return.Let’s examine the DRIPs of two widely-traded Canadian bank shares as the basis for the analysis - The Bank of Nova Scotia (BNS), and CIBC (CM). For disclosure purposes, I own both. They trade on the Toronto and New York stock exchanges (same tickers), and are widely held, with relatively high daily volumes for Canadian financial services companies.First, I need to explain some relevant assumptions. Unlike some other analyses which I have reviewed, I removed the outliers, and did not choose the highest highs and lowest lows for the comparisons and calculations. With a high-volume trading stock, there is generally only one transaction that is bought at any low, and only one that is sold at a respective high. I have never been so lucky as to have bought or sold at the beneficial extremes of the spectrum. Therefore, the Higher Price $ column is a reasonably-higher price than the DRIP unit cost during the two weeks which straddle the dividend date. This is not exactly empirical, but represents a higher price at which one would execute a share purchase.Bank of Nova Scotia (BNS) Dividend ReinvestmentDividend DateDRIP Unit Cost $Higher Price $Lower Price $DRIP Variance to High $DRIP Variance to Low $DRIP Variance to High %DRIP Variance to Low %27-Jul-0646.4946.6145.630.12-0.860%-2%29-Jan-0751.2151.9451.120.73-0.091%0%26-Apr-0754.0954.2253.260.13-0.830%-2%27-Jul-0749.5049.8249.270.32-0.231%0%29-Oct-0752.5353.4949.850.96-2.682%-5%29-Jan-0847.6148.2547.020.64-0.591%-1%28-Apr-0847.6048.9247.631.320.033%0%29-Jul-0848.8748.9647.700.09-1.170%-2%29-Oct-0838.2840.8038.742.520.467%1%28-Jan-0928.0130.3528.762.340.758%3%28-Apr-0933.7035.8533.932.150.236%1%29-Jul-0943.7146.3045.002.591.296%3%Averages45.1442.4141.021.25-0.263%-1%All values in Canadian Dollars. Based upon twelve sequential DRIP payments between 2007 and 2009. BNS only recently introduced an additional 2% savings for shareholders who participate in their DRIP, so this is excluded. That said, the additional 2% on the 4% dividend yield would not make a material difference to this discussion. Now, if you do not agree with the approach of estimating a reasonably higher or lower price, then you can perform the same assessment with the 52-week high. The differences will be exaggerated, but the same point will be made. The DRIP will provide a lower price than the 52-week high. I have seen, but do not subscribe to, the many business articles and television interviews that state something similar to “... if you purchased shares of XXX at the low on March 9, 2009, then you will have earned a 300% return if you sell them at their high, today...” This is not what an average investor will experience when he trades in the market, so I have used a less scientific approach to estimating a “reasonable high” during the respective fiscal quarter.Examining this table, we learn that purchasing shares through this DRIP would have saved an average of 3% of the reasonably higher market price. In other words, the BNS DRIP gave the investor a 3% price reduction for new share purchases. The other benefit is that the investor does not need to watch and time the market in order to obtain an entry point to beat the market for the incremental purchase. The plan administrator does this for him, and provides a quarterly statement. The table ignores the cost of the initial purchase; the DRIP participant may be averaging up or down with the reinvestment, depending upon the price of the initial purchase.Why is there a differential? As explained on the BNS website, through DRIPs or stock dividends: “Shareholders… may elect to have their dividends automatically reinvested in common shares of the Bank at a cost of the average market price of common shares…”. This average market price is below the highs, so the DRIP participant automatically buys below the higher values.Other Cost AdvantagesThere are other cost advantages to DRIPs that are worth mentioning. These additional benefits may be unique to the DRIP or to your own circumstances.Some DRIPs allow reinvesting your dividends by purchasing shares at a discount to the market price. BNS provides a 2% discount on shares purchased through dividend reinvestment to provide additional incentive to participate in their DRIP. Although this is not as generous as some other discounts that are offered in the marketplace - some reach 5% or 6% - it is more that the typical zero-discount, and augments your return.One special case is employee discounted share purchases and DRIP plans. Certain employers match a portion of the employee investment in shares and in the DRIP. For example, for every $1.00 an employee invests in shares through purchases or reinvests through a DRIP, the employer may match it with $0.50. The assets in the plan vest to the employee after a period of time. The employer-matching magnifies the benefit of the DRIP, so people in this circumstance typically find it very beneficial. I have heard of an exception where the share purchase plan administrators stacked the deck in favour of the directors. This is a small-cap company with fairly closely held shares and low trading volumes. They would take the opportunity to divest some of the directors’ shares in conjunction with the quarterly employee plan share purchases, in order to realize a higher price for the directors. This substantially and negatively impacted the benefit of the employer matching.There are various cost advantages published in other articles, which explain that there are reduced transaction and share purchase costs. Most brokerages charge either no, or a nominal fee, when investors participate in DRIPs. Therefore, the opportunity is to avoid brokerage fees for stock purchased through dividend reinvestment, or for new share purchases within the plan. The other reduced costs are for the few companies, such as BNS, which do provide a discount. Are these sufficiently compelling financial arguments to participate in a DRIP? I believe that it depends upon your personal preferences and goals.Challenged to Save?Your personality traits can help identify whether DRIPs are for you. Many people are living with tighter budgets and have an inability to save. DRIPs are invisible asset accumulation mechanisms. Cash is not deposited to your account, so there is nothing to withdraw and spend. Saving is automatic. If you are a hoarder, then this may not be your issue, but for some people, a DRIP can help promote long-term savings.On the subject of long-term savings, one must recognize that this strategy will take time. As the average dividend yield (and reinvestment amount) is relatively small, the impact of DRIPs are realized over long periods. For example, even with a solid 4% dividend yield, and assuming a flat share price, it will take 5 years for 100 shares to become 122 shares. If you require instant gratification, then DRIPs are not your investment vehicle; they are designed for the patient, buy-and-hold investor.Do you feel badly when your investments decline with the stock market? Perhaps ironically, DRIPs should make you feel good when the market price of your security goes down. The dividend will buy more shares at the lower average share price, so you will accumulate more shares when the average price declines. This adds to the power of compounding - recognizing that you will get a higher return, due to the lower share-purchase price. Over a longer timeframe, when the price of your security recovers, you will enjoy a proportionally larger gain in value on the DRIP shares. Let’s take an example of a Dow 30 closed-end fund (I use DPO, traded on the NYSE, but this applies equally to any security). My purchase price was $11.10, and I believe that over the next five-to-ten years, the value of the Dow 30 will grow. Currently it is trading for around $9.44, so I am not doing very well. My yield is about 9% on my original investment and I have this enrolled in their DRIP. I am now purchasing additional shares at this lower price, so that the value of my holdings is increasing, and my average cost is declining with each dividend payment. Moreover, I do not need to think about managing this investment return, as it is automatically reinvested.Maintain Proportion of PortfolioWant to maintain (or methodically grow) your gold, Asia, Europe, or sector holdings as a portion of your total portfolio? A DRIP is an automatic mechanism to manage asset allocation.Let’s say that you want to maintain a 5% gold holding in your portfolio. If your gold fund pays dividends, and provides a dividend reinvestment plan, then the additional share purchases will maintain or increase your gold holdings. In a previous article, I used Gabelli Global Gold and Natural Resources Income Fund (GGN on AMEX) as an example. Participating in their DRIP, I continue to grow my number of units, and gold position, in my portfolio.A DRIP is also a good mechanism to reinvest returned capital for Real Estate Investment Trusts (REIT) and Closed-End Funds (CEF). If a REIT or CEF does not earn what it pays-out, then the difference is paid to the investor as a return of capital. This is advantageous from a taxation perspective, as it is not income, but reduces the trust or fund Net Asset Value (NAV) by an equal amount. For example, if a REIT is earning 6%, and is paying out 8%, then the NAV is being eroded by 2% in that year. The reinvestment of the distribution maintains your capital investment position. This tactic would support a goal of deferring and increasing your future income streams; it provides for future higher yields and lower taxation.You should recognize that there is an “equal and opposite opposing force” to maintaining the relative proportion of your portfolio. Your DRIP will continue to concentrate your investments in your current holdings, which may be perceived as either a positive or negative aspect. We will explore this consequence further in the follow-up article.ConclusionFor a diversified, buy-and-hold investor, who is not actively monitoring his portfolio, the DRIP can unleash financial benefits, through average cost purchasing and the power of compounding. There are also benefits for those pursuing certain asset management strategies, and for supporting other investment behaviours. Now that we have examined the positive aspects of participating in a DRIP, my next article will re-examine the facts from the contrarian perspective - proposing that investors should not leverage Dividend Reinvestment Plans. Stay tuned! This is coming in the next few weeks.... Read more