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Pros and cons of dividend reinvestment plans (DRPs)

This article appeared in the September 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

DRPs let you receive more shares instead of cash - but beware of the risks.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

I sat for a day in the cavernous CenturyLink Center, Omaha's largest entertainment complex, last year as one of more than 35,000 people there to hear Berkshire Hathaway's CEO, Warren Buffett, field questions from shareholders.

He answered plenty but one stuck firmly in my mind. A concerned shareholder wanted to know why, with more than $30 billion of cash in the bank and the company's share price sitting at $120,000, the board was not prepared to pay a dividend. A reasonable question given the $200-billion company had not paid a dividend for nearly 50 years.

Buffett responded politely as if it was the first time he had been asked the question (it wasn't). He said the share price was $120,000 because of years of profit retention backed up by profitable reinvestment. It meant shareholders had been delivered market-beating returns despite receiving no dividends. Their gains were due solely to the rise in the share price. Buffett concluded by saying that if anyone wanted a dividend they were free to sell some of their stock.

For decades Buffett had been reinvesting the "unpaid" dividends back into the company on behalf of every single shareholder. There's nothing wrong with this as long as management invests the money well, not so good if they don't.

But wouldn't it be nice if the shareholder could make the choice - to either reinvest dividends straight back into the company or take the cash and use it elsewhere? The good news is that there are plenty of companies offering that choice. It's called a dividend reinvestment plan (DRP).

How DRPs operate

An example: Say you own 10,000 shares in a company and have elected for 100 per cent participation in its DRP. The company is due to pay a dividend of 17 cents per share. The shares have a market value of $8.50 each and are offered at a 2 per cent discount through the DRP (i.e. $8.33). Instead of receiving $1700 in cash, you receive 204 shares, which increases your total holding to 10,204 shares.

The cash you have forgone has not equated exactly to the value of the shares you have received so to compensate, a fractional dollar amount is carried forward to the next dividend payment.

How to find companies offering a DRP

Most listed companies do not operate a DRP but there are several ways to find out which do. Check the company's or your broker's website, or Google 'Smart Investor', click on the Share Tables option and scroll down to Dividend Reinvestment Plans. AFR Smart Investor magazine provides an up-to-date list of all ASX companies with a DRP.

How to sign up

If your company is operating a DRP you will be sent a form to fill in when you first become a shareholder. It will ask if you prefer to receive dividends in the form of cash, new shares or a mix of both. If you choose the last option you will be asked to nominate the proportion of the dividend you want to receive as cash and the proportion in new shares.

If you are already a shareholder you can change your DRP preference at any time, and the form can be downloaded from the website of the company's share registry service provider.

You can withdraw at any time up to the books closing date for a particular dividend. Companies also have the right to suspend or close plans on giving appropriate notice to shareholders.

Advantages

  1. Companies see DRPs as useful capital management tools. By paying dividends in the form of shares, rather than cash, companies can retain capital. This can be used either to pay down debt, invest in the company's business or to acquire new businesses. Remember that an advantage to the company is also an advantage to you; as a shareholder you are a part-owner.
  2. New shares acquired under a DRP are bought without brokerage fees, which can take a big bite out of future returns.
  3. Some DRPs offer new shares at a discount to the market price. When DRPs first became popular, discounts of 5 to 10 per cent were offered. More recently this has been reduced to 1 to 5 per cent. Many offer no discount.
  4. DRPs simplify the reinvestment process. They appeal to a set-and-forget investment philosophy because dividends are automatically reinvested for you.
  5. DRPs are a form of forced saving because if you don't see the cash, you are not tempted to spend it.
  6. They provide the benefit of compounding - each time a dividend is issued it will be delivered from a larger number of shares than the previous dividend. Linked to profitable companies, this will lead to growing dividend payments and compounding of your holding over time.

Disadvantages

  1. Those who fancy themselves as value investors will immediately see a drawback with DRPs - discretion regarding the price paid for new shares is relinquished. The purchase has become automatic, with the price established by the prevailing market price at dividend time. Whether or not this is a problem really depends upon how you view things. If you are not a gun at valuing shares, remember that new shares will be purchased at all stages of the market cycle. At times they will be bought cheaply, at other times more expensively. Over time, it should even out.
  2. More onerous record keeping. The Australian Tax Office requires the purchase price of shares be recorded for the purpose of calculating your capital gains tax (CGT) liability (should you sell). If you hold shares in a company for 15 years and it issues dividends twice a year, you would need to keep track of 30 separate transactions for tax purposes - just for one company.
  3. The DRP-associated shareholdings in your portfolio will tend to grow disproportionately compared to other companies you hold. Unless you are justifiably confident in the outlook for these companies it is best not to let them dominate your portfolio. Be conscious of this and periodically rebalance your portfolio as it will allow you to sleep better at night.

How DRPs are taxed

All shares issued under DRPs are treated, for tax purposes, as if a cash dividend had been received. Franking credits are dealt with in exactly the same manner.

When shares issued under a DRP are sold, the cost base for CGT is determined by the market price of the shares at the time of the associated dividend distribution.

If the shares were issued at a discount, the discount does not constitute assessable income at the time of issue. However, it does result in a lower acquisition cost for the new shares and this will result in a correspondingly higher taxable capital gain on any subsequent disposal.

Underwritten DRPs

Companies with a significant need for capital would prefer all shareholders to participate in their DRP. Since this is not practicable, a company can arrange to have its DRP underwritten. Under this arrangement the company issues enough shares to fund the full dividend amount. Those shareholders who choose to participate in the DRP will receive shares as payment. The remaining shares are sold to another party under the terms of the underwriting agreement. The cash the company receives from this sale is used to pay shareholders who chose the cash dividend.

In this sense, the company is declaring a dividend but then not paying one. Essentially it is a futile exercise, a game of musical chairs with the loser being the shareholders, because they are the ones paying the costs of the underwriting. In my view, if the company does not want to pay a dividend the only sensible thing to do is simply not pay one.

So do you DRP or not DRP? It depends. But consider all the pros and cons carefully because ultimately the decision is yours.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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