Cash goes in, cash comes out, right? Businesses that generate free cash flow, or those that eventually will, are what every investor should seek.
The problem is that not all shareholders need the cash coming out, usually as dividends. That is where dividend reinvestment plans (DRPs) come in.
The idea is that, instead of a dividend - cash coming out - the company issues you additional shares to an equivalent value. The question is whether they are worth it.
Not all shareholders need cash coming out. Photo: Jessica Hromas
There are a few considerations. The first is whether the stock itself is underpriced, one of the golden rules of investing. If so, it may make sense to participate, especially as DRPs often offer stock at a small discount to the traded price and avoid broker commissions. To decide, keep an eye on your DRPs at dividend time and make judgments about the value on offer.
Using a perpetual DRP is a passive investment decision that does not help you improve your skills. Choosing whether to participate at the time of each dividend means you are taking an active role in stock selection, making you a better investor.
The second consideration is whether a DRP is the right option for you regardless of its price. For example, if you want to keep things simple, you could buy a listed investment company with a DRP, allowing you to compound your returns over the very long term. You might also use a DRP if you do not trust yourself with the cash.
But with more than 2000 companies listed on the ASX, it is unlikely that the stocks you already own are the best-value investments on offer. If your portfolio is small or otherwise poorly diversified, why keep adding to existing holdings? Instead, you should accumulate your dividends in a dedicated bank account and invest the proceeds in attractively priced stocks.
After that, if you have established that a DRP does offer value and is the best use of your cash at the time, you need to establish the reason why the company is offering it.
In difficult times, rather than cancelling or reducing the dividend - the sensible course of action - some companies underwrite their DRP (issue shares to a third party to obtain cash to pay the dividend). This is tantamount to not paying a dividend at all.
As a rule, you should avoid companies that deliver regular and substantial increases in the number of shares on issue over time. DRPs, option issues, performance shares, capital raisings and the like all dilute the interests of non-participating shareholders.
There is no real reason why large companies with liquid share registers need to issue shares to satisfy their DRPs. Westpac, for example, buys shares on the market and then transfers them to DRP participants. Other companies buy back shares over time to offset dilution from their DRPs. This is the sort of shareholder-friendly behaviour you should seek out.
Finally, investing in DRPs requires more paperwork. A dividend is assessable income whether you receive it as cash or shares, so put aside some cash from other sources if you'll need to pay tax on the dividend.
Also, dividend reinvestment is a separate share purchase that makes administration more complicated.
For many investors, a DRP is more trouble than it's worth. The decision to participate is less than straightforward. Companies that offer DRPs may have capital-creep issues and may not be the best investments.
But if you can find underpriced stocks with DRPs, by all means participate. Just cancel your election when the stock is no longer obviously underpriced.
This article contains general investment advice only (under AFSL 282288). Nathan Bell is research director of Intelligent Investor Share Advisor. For a 15-day free membership, including 23 buy recommendations, see shares.intelligentinvestor.com.au/smh-free-trial