Topic: How To Invest

Canadian stock market: The pros and cons of dividend reinvestment plans (DRIPs)

DRIPs

Dividend reinvestment plans, or DRIPs, are plans some companies offer to allow shareholders to receive additional shares in lieu of cash dividends. DRIPs bypass brokers, so shareholders save on commissions.

DRIPs also eliminate the nuisance effect of receiving small cash dividend payments. Second, some DRIPs let you reinvest your dividends in additional shares at a 5% discount to current prices. Third, many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.

Generally, investors must first own and register at least one share before they can participate in a DRIP. Registration will generally cost $40-$50 per company. The investor must then notify the company that they wish to participate in the company’s DRIP.


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You can register for dividend reinvestment plans at no cost through most discount brokers (these are called “synthetic DRIPs”). However, the broker may or may not pass along any reinvestment discount to you.

As well, you can only buy whole shares through these DRIPs, so dividends paid must be greater than the share price. For example, say you receive a $35 dividend, and the stock is trading at $30. Assuming the company does not offer a reinvestment discount, you would receive one share and $5 in cash. Moreover, broker DRIPs do not allow for additional commission-free share purchases.

Overall, we think that DRIPs are okay to participate in. But here are a few things to keep in mind:

  • Many investors select their Canadian stock market investments solely on the basis of the existence of the DRIP option. We think the availability of a DRIP is only a bonus, rather than a reason to invest by itself. Investing in only stocks that offer DRIPs limits both investment choice and opportunity.
  • The advent of the low-cost discount brokerage and online investing has reduced the commission cost of investment trades. Thus, the commission-free investing that DRIP investing allows is less of an advantage today than it was in the past.
  • Taxes are still payable on dividends that are reinvested.

Most companies that offer DRIPs provide details on their web sites. Another place to look for information is the inside back cover of most companies’ annual reports. You can also contact the investor relations department of companies you wish to invest in.

Bonus Tip: While investors increasingly seek out cash dividends, few are as excited about stock buybacks. Still, in many ways, stock buybacks, or share repurchases, are better than dividends.

Stock buybacks raise the value of a given stock holding in two ways:

  1. First, stock buybacks raise a company’s earnings per share. It’s simple arithmetic: buybacks reduce the number of shares outstanding. To get earnings per share, you divide total earnings by the number of shares outstanding. When you reduce the divisor—because the company has fewer shares outstanding, due to stock buybacks—the calculation gives you a higher number for earnings per share as an answer. On the whole, buyers are willing to pay slightly more for a stock with slightly higher earnings per share.
  2. Second, when the company engages stock buybacks, it bids up the price of the stock.

When you hold a stock in your personal, taxable account and it pays a cash dividend, you have to pay tax on the dividend in the year in which you receive it. If the company instead devotes the cash to a stock buybacks, you have two options:

  • If you need cash, you can sell part of your holding in the stock, presumably at a higher price than you’d get in the absence of stock buybacks. If you do that, you’ll only pay taxes on the sale if the stock has moved up since you bought (outside of an RRSP). If the stock has moved sideways or down, the proceeds of your sale are tax-free.
  • Of course, you’ll always have the option of holding on to your stock until it suits your purposes to sell. That lets you defer taxes on capital gains.

This added opportunity for tax deferral may not seem like much of an advantage in any single year. However, the magic of compound interest applies to that tax deferral. It can add up to a huge advantage over a decade or two.

The advantage of stock buybacks expands all the more if you hold off on selling until you need the money. That holding period may last until you retire, when your income tax rate is likely to be lower.

The funny thing is that, just as investors tend to underestimate the value of a stock buybacks, they overestimate the value of a dividend reinvestment program. They put a high value on the fact that they can reinvest their dividends automatically, without paying brokerage commissions. They fail to recognize that brokerage commissions are now at historic lows. They also overlook the fact that they have to pay taxes on the full dividend, even if they reinvest it. That tax hit and the loss of an opportunity for tax-deferred compounding greatly outweigh what they save on brokerage commissions.

Don’t get us wrong—cash dividends are a definite plus. But you still need to follow the three key guidelines in our Successful Investor approach to sound investing:

Invest mainly in well-established companies, since they are the companies most likely to keep making, if not increasing, those dividend payments each year.

Spread your portfolio out across the five main economic sectors: Manufacturing & Industry, Resources & Commodities,Consumer, Finance and Utilities. That way, you increase your chances of stumbling on a super stock that goes up five to 10 or more times faster than average. A few of these can make an enormous improvement in your long-term investment results.

You also need to limit your exposure to stocks that are in the broker/media limelight. That limelight bloats investor expectations. When stocks fail to live up to those expectations, big downturns often follow, regardless of a company’s dividend history.

DRIPs are increasingly hard to come by. What other factors beyond those programs do you look for when deciding which stock to buy?

This article was first published in 2011 and is updated regularly.

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