Not everyone who purchases investments wants or needs the income today. Many clients are trying to grow a nestegg to fund a future goal, such as retirement. Investors who are not requiring income may want to invest in growth stocks that pay either no dividend or minimal dividends. It is my opinion that good dividend-paying stocks should be part of nearly every portfolio. The income earned on these stocks can also help build the nestegg.
Many investments have both a growth and income component. Fortunately, most of these same companies offer the dividend reinvestment program — often referred to as a DRIP. Growth is often achieved through price appreciation of the investment and also reinvesting the income.
Stock dividends or cash dividends
Companies have the choice to pay stock dividends, which effectively means shareholders receive stock of the company. The most common type of dividend is a cash dividend. With a cash dividend, the default is for cash to be paid into the account in which the position is held. Once the dividend is paid, the cash sits in the account and unless it is invested right away, will not be earning anything. The DRIP program is perhaps the most efficient way to keep the dividend still growing — income on income.
An investor purchased 400 shares of the common shares of ABC Corporation, currently trading at $100. Total invested would be $40,000 (400 x $100). The current quarterly dividend is set at .45 per share. Based on these values, when the dividend is payable, the investor would receive (400 x .45 / $100) about one share of ABC and $80 cash. After the dividend, the investor would own 401 shares.
The DRIP program has investors acquiring shares at different prices with each dividend being reinvested. For taxable accounts, it is important to keep track of the costs at which the new units were reinvested. The cost of the original purchase plus the total value of the shares reinvested on the date of the DRIP, equals the adjusted cost base.
When a stock has a split, this often means more shares and less cash on the DRIP. Using a two-for-one stock split as an example you will see this is normally good for people who have the DRIP set up.
Let us use the above as an example, in a two-for-one stock split. Before the split, the investor owns 400 shares with a market value per share of $100. Total invested would be $40,000. After the split, the number of shares would double to 800, and the market value per share would decline to $50. Total invested would remain at $40,000. The dividend itself would be lowered to .225 per share.
Based on the new quantity, stock price and dividend amount, the investor would receive ($800 x .225 / $50) three shares of ABC and $30 cash. After the split and dividend the investor would own 803 shares.
Although the investor above may have requested that their dividends be reinvested, the dividend income will still be considered income for taxable accounts in the year the dividend was declared. Investors will receive the applicable taxation slips and should ensure they have sufficient cash on hand at the end of the year to pay any tax liability. DRIPs in an RRSP account are ideal as any income is deferred and is not taxed immediately.
Unlike mutual funds, it is not possible to have fractional shares of common shares. The illustration above highlights that the fractional portion (less than the amount to purchase a whole share) is paid as cash into the investment account. Stock splits are generally a good thing for individuals that have the DRIP program. Share prices are generally reduced resulting in a greater portion of the dividend being reinvested.
Discount to shares
Not all companies pay a DRIP. Of those companies that offer a DRIP, some of those may offer a discount on the share price of the amount reinvested. These discounts typically range from one to five percent. How the discount is calculated can change for each company that offers it. It is not uncommon for a stock to have a discount in the past and then remove the discount. It is often dependent on the corporations need for capital.
Years ago, investors were warned that they may have difficulties selling shares of companies if they had an odd lot. A lot is generally considered 100 shares. One can easily see how the DRIP program would result in an odd-lot situation. Today this is less of a concern for any position that has a moderate volume of shares traded daily. With reorganization, spin-offs and computerized trade execution many investors have odd lot holdings.
Investors should take care to monitor their position sizes. Investors may find over time that certain positions that are set up as a DRIP may become overweight within their overall portfolio. Investors who have charitable intentions may want to consider donating shares or sell a portion of their holdings as a means to rebalance the portfolio.
A DRIP can easily be cancelled. An investor may want to cancel a DRIP when they begin to require income from their investments. Setting up a drip and cancelling a DRIP are very easy.
Growth oriented investors may find the DRIP a low maintenance way of dollar cost averaging while reducing the costs of investing and employing cash that may otherwise be earning a low return in an account. The DRIP allows compounding of investment returns which can enhance total returns.
Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.