DRIP InvestingPosted: September 10, 2016
Dividend Reinvestment Plan investing, or “DRIP” investing, is a very cost efficient way of making passive gains in your portfolio. I have been a big fan of this type of investing for years, as it completely removes two types of investment friction: rounding friction, and commission friction. Well, the second one is a bit of a lie: you are exposed to some commission friction, but it is minimal in the grand scheme of things. But, before I get ahead of myself, I’ll explain what DRIP investing entails.
At its core, a company which offers a DRIP allows the shareholder to re-invest dividends issued by the company directly back into additional shares in the company. So if the share price is $5.00, and you received $10.00 in dividends, you will receive 2 shares. In addition to this core functionality, there may be additional benefits and/or constraints:
|Item||Description||Potential Benefts||Potential Constraints|
|DRIP Enrollment||The process of enrolling in the DRIP||May have a minimum number of shares required, e.g. you may need 100 shares to even sign up for the DRIP.|
|OCP/SPP||Optional Cash Purchase or Share Purchase Plan. This is the ability for you to buy additional shares directly from the company.||May offer a discount on additional shares, e.g. 2% off of the current share price.||
|Automatic Contributions||Automatically debit from your bank account on a periodic basis. This allows you to slowly build your position over time, virtually effort-free on your part.||Same as OCP/SPP||Same as OCP/SPP|
So, how does this all work?
With DRIP investing, you normally have a share of stock in certificated form. Classically, this would mean that you have a physical paper certificate for the company in which you are investing. Today, there are alternatives such as the Direct Registration Sytsem (DRS), but the core of the matter is that the share(s) of the company are registered directly in your name. This differs from a typical stock trade through a brokerage where shares are held in street name (more info may also be found here), where the shares are actually in the name of your broker/agent, and not yourself.
This is important, because once an investment is certificated, you can start participating in the DRIP. You cannot participate in the DRIP if the shares are in street form.
Once you have your certificated share, enroling in the DRIP is as easy as filling out the requisite paperwork.
So, how is this a good thing?
As I mentioned above, one form of friction that DRIP investing eliminates is rounding friction. Recap the example ealier:
[i]f the share price is $5.00, and you received $10.00 in dividends, you will receive 2 shares.
I had picked those numbers for convenience, as they gave us a whole number of shares to re-purchase. However, what if the share price was $7.50, and you received $5.00 in dividends? With a normal brokerage, you would receive $5.00 in cash, and no shares, since the share price is greater than the received dividend. With a DRIP however, you can receive fractional shares. So your $5.00 in dividends will purchase you 2/3 of a share (since $5.00 is 2/3 of $7.50).
Let’s look at OCPs. If you have an extra $100 lying around one day, you might decide to purchase some stocks. Moreover, let’s say you own Telus (T.TO) in your DRIP. The current market price (as of business day close on Sep 9, 2016) is $42.03. If you were to buy shares at a typical broker, assuming $9.95 commission, you could only buy 2 shares, and be left with $5.99 in your pocket ($100.00 less $9.95, and purchasing two whole shares at $42.03). But, because Telus offer OCP/SPP, and no commissions, you can buy 2.379252 shares!
These fracitonal elements are important, because you can now take advantage of true compounding. As an example, let’s use Telus again, with the following assumptions:
- Share price grows at 3%/year
- The dividend grows at a rate of $5%/year
At a regular brokerage, after 5 years, here is what you have:
|#||Numbe of Shares||Period Dividend||Dividends Received||Share Price||Dividend Bank||Shares Purchased||Dividend Bank (end)||Net Value|
In the above, the “Dividend Bank” is where you would store all dividends received until you had enough to purchase one share, and “Dividend Bank (end)” is the money left over in the dividend bank after buying a share. But, as you can see above, we were never able to purchase any shares! This is because it would take us forever to save up enough of the dividend income to buy a share, plus we have to save up enough to cover the commissions as well.
Using a DRIP, with the same growth assumptions, here is what you have:
|#||Numbe of Shares||Period Dividend||Dividends Received||Share Price||Shares Purchased||Net Value||% Gain from Without DRIP|
Where the “% Gain from Without DRIP” is the relative difference between a brokerage-based portfolio and our DRIP. Looking at the above, by using the DRIP, over our 5 year example time horizon we have gained 3.42%, all for doing nothing. And, if you throw OCPs into the mix (e.g. setting up regular contributions), your holdings grow even quicker.
Not all companies offer DRIPs. In Canada, two of the major providers are Computershare Canada and CST (the CST link takes you directly to their DRIP page). But even for those companies that offer DRIPs, not all DRIPs are created equal. Not all companies offer OCP/SPP. Some charge for DRIP, OCP/SPP, and/or withdrawals to/from the plan, and some have minimum balance requirements. That said, when I am looking for a company to DRIP with, other than my regular stock analysis, I look for those who offer and OCP/SPP, and as an added bonus, regular automated contributions by deducting from my bank account. Moreover, those that offer discounts on OCP/DRIP (e.g. Emera which offers up to a 5% discount on DRIP) are even better.
And OCP/SPP is key. The reason being, if you have only one share to start, it will take you forever to get to the point where you can take advantage of material growth through DRIPping.
How does one get started?
You only need one share to start a DRIP, and then you can use an OCP/SPP purchase to purchase any additional shares as needed. You can leverage places such as The DRiP Investing Research Centre‘s Share Exchange board to find individuals who are selling individual shares, or you can even post a message asking for a particular share. Typically individuals selling on these forums ask for a $10.00 convenience fee. This is pretty much in line with most discount brokerages, and since you can easily recoup this cost through the DRIP process itself, it is a small price to pay. Alternatively, you can purchase shares through a regular (discount) brokerage, and then ask the brokerage to withdrawal your shares in certificate form. DRIP Primer has a great list of brokerages, and the fees to do so.
One final thing to mention is synthetic DRIPs. With a synthetic DRIP, a brokerage will buy you any whole shares that it can when the dividend is issued, and any money remaining is given to you as cash. Looking back to Telus, if the share price were $42.03, the dividend were $0.46/share, and you had 100 shares, you would receive $46.00 in dividends. Your brokerge would take this $46.00, purchase one share, and leave the balance ($3.94) in your account as cash. The advantage to this is that the brokerage does not charge you a fee (i.e. commission) for the purchase. The disadvantage is that you cannot take advantage of the fractional shares as with a true DRIP; i.e. you are still subject to rounding friction.
- DRIPs offer a great way to build compounding returns, through re-investing dividends and purchasing fractional shares
- Often, companies offer discounts on DRIP and OCP/SPP, but not all DRIPs are created equal; some have better features than others
- DRIPping does not save you from doing your research: as with all investments, only invest in companies after doing a thorough analysis
And some good resources:
- DRIP Primer list of discount brokerages
- The DRiP Investing Resource Centre boards
- List of Canadian DRIPs from DRIPPrimer