Topic: Dividend Stocks

The pros and cons of Dividend Reinvestment Plans

June 7, 2016|by Pat McKeough

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You enjoy certain advantages with Dividend Reinvestment Plans, but don’t overrate them—they shouldn’t be the sole reason you invest in a stock.

Dividends are in fashion with investors right now, and that’s always a good thing. As well, some companies provide dividend reinvestment plans, or DRIPs, that let shareholders receive additional shares in lieu of cash dividends. DRIPs don’t require the participation of 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.

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Dividends are typically a sign of investment quality. Some good companies reinvest their profits instead of paying dividends, but fraudulent and failing companies are hardly ever dividend-paying stocks.

Creative accounting can produce false impressions of prosperity and hide financial problems. But accounting can’t create cash for this year’s dividend, let alone conjure up a history of past dividends. Stick to dividend payers and you’ll avoid most of the market’s greatest disasters.

What are dividends? Dividends are typically cash payouts that serve as a way companies share the wealth they’ve accumulated through operating the company. These payouts are drawn from earnings and cash flow and paid to the shareholders of the company. Typically, these dividends are paid quarterly, although they may be paid annually or monthly as well.

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

There are also separate dividend reinvestment plans that are available through most discount brokers (these are called “synthetic DRIPs”). Under these plans, brokers will reinvest dividends on shares that you hold in your account. However, not all your dividend stocks may be eligible for these plans, and you need have a total dividend payment large enough to buy a full share of stock.

Overall, we think that dividend reinvestment plans are okay to participate in. But we think there are a few important points to keep in mind:

1. Many investors make their investment choices solely on the basis of the existence of the DRIP option. We think the availability of Dividend Reinvestment Plans is only a bonus, rather than a reason to invest by itself. Investing only in stocks that offer DRIPs limits both investment choice and opportunity.
2. 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.
3. 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.

4 tips to help you pick the best dividend stocks—including those with Dividend Reinvestment Plans

1. Look for dividends that are paid even during market downturns. For a true measure of stability, focus on companies that have maintained or raised their dividends during economic and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth. The best dividend stocks respond to tough economic times by doing their best to maintain, or even increase, their payouts.
2. Watch out for unusually high dividend yields. When investing in dividend stocks, a high yield can sometimes be a danger sign rather than a bargain. For example, a high growth dividend stock’s yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut. We would be very wary to invest in a stock that had an unusually high dividend yield—including those with Dividend Reinvestment Plans.
3. Watch for a history of paying a dividend. Look for companies that have been paying dividends for at least 5 to 10 years when investing in dividend stocks. Companies can trump up quarterly earnings, issue press releases to appear to be making strong progress, but they cannot fake dividends.
4. Don’t overlook synthetic DRIPs. There are also separate dividend reinvestment plans that are available through most discount brokers (these are called “synthetic DRIPs”). Under these plans, brokers will reinvest dividends on shares that you hold in your account. Not all your dividend stocks may be eligible for these plans.

Dividend reinvestment plans can add additional shares to your portfolio over the long term, and that can boost your investment returns.

Are you invested in any dividend stocks with DRIPs? Have they been profitable for you? Share your experience with us in the comments.