Making sense of DRP schemes

Dividend reinvestment plans (DRPs) might be an enforced way of ensuring you don't fritter away your dividend cheque every six months, but it may no longer have broader appeal it once did within less volatile bull markets, when interest rates and brokerage fees were both high.

To the uninitiated, DRPs simply give shareholders the opportunity to purchase additional shares with their dividend payment instead of taking cash.

More often than not, these additional shares can be purchased at a slight discount to market.

The workings

For example, Toni has 10,000 shares in Aussie Wigits Ltd which pays a fully franked dividend of $0.95. Aussie Wigits Ltd offers a 2% discount on shares purchased through a DRP scheme.

Assuming the price of Aussie Wigits Ltd shares was $34 at payment date, Toni would receive 285 shares, and the 2% discount means she has greater exposure to the stock with six additional shares she wouldn't otherwise have.

At face value, that's great a great outcome for Toni. As well as cost-effectively automating the reinvestment of her dividend – without incurring brokerage fees – the power of compounding returns will also contribute directly to her long term wealth.

What's missing?

But what's missing from the above example is the attractiveness of the discount – relative to the value of the share, and market volatility – and the base-case for buying more shares in a stock that she just happens to already own.

The reality is that the current bear market, where daily volatility alone might be higher than a typical 2% discount offered by DRP schemes, plus the low cost of on-line broking means that successfully reinvesting the dividend in more shares is no longer a lay down.

Live example

While banks and financial stocks are more likely to have DRPs running permanently, Woodside Petroleum (ASX: WPL), like a lot of resource stocks, has turned its DRP scheme on or off over the years as part of its capital management strategy. For example, it turned it on in 2007 to help fund the construction of its Pluto LNG project, and off again in February 2013 when it no longer need the extra cash.

In an attempt to preserve its BBB+ credit rating, and have a $2 billion war chest with which to go after acquisitions, the Woodside board reinstated its DRP for the 2015 final dividend.

Shareholders who elect to participate in Woodside's DRP will be issued shares at a price, incorporating a 1.5% discount to its average trading price over the 20-trading days from February 29, free of brokerage or transaction fees.

Is the DRP in your best interests?

But given the how low brokerage fees have become, and current market volatility, it's questionable whether Woodside's DRP scheme really is in the best interest of shareholders.

Within the pre-GFC bull market, when share prices were on a near-permanent upward trajectory, the 1.5% discount would have been a real sweetener.

However, within a market where heightened volatility is the 'new norm', there's every likelihood shareholders who take the dividend as cash will have little difficultly buying on-market following more significant corrections.

It's also worth noting that not all companies operate DRPs that offer discounts – including Telstra (ASX: TLS) and AMP (ASX: AMP), and this only makes the viability of a DRP scheme even more questionable.

At what price?

While having your dividend reinvested may appear to be a 'gift-horse', it's important to remember that you're giving up the opportunity to receive cash instead, and as such there's an opportunity cost. In other words, what else could you have done with the cash..?

One of the biggest downsides to participating in DRPs is you have no control over what price you're given new stock. So simply being issued additional stock at any old price isn't necessarily a winning strategy.

You might find that you're paying well above the stock's intrinsic value or the reasons why you bought the stock in the first place may no longer stack up; and if that's the case – why would you want to buy more?

Being passively forced to buy more stock – through a DRP scheme – might work gangbusters within a bull market. But the bigger question within today's bear market is where could I have better deployed those funds?

DRP tactics

Companies turn their DRP schemes off and on depending on their capital management strategy – and whether they can deploy the cash better elsewhere within the business – rather than through any overt altruism to you the shareholder.

You need to take the same approach, and opt in or out at dividend time depending on whether the share looks over or underpriced.

If the stock looks overpriced or the reasons you bought the stock are no longer valid, then you might want to not only take the cash – and decide what you buy, when and at what price – but also contemplate selling your underlying holding in the company.

Tax issues

Remember, each dividend reinvestment represents a separate share purchase, which means the cost base for CGT is determined by the market price of the shares at the time of each associated dividend distribution.

This complicates the record-keeping required by the ATO on losses and gains on each and every parcel, and based on two dividends annually over 10 years, that's a lot of record-keeping.

So if you're not a good recordkeeper, and are unsure of the benefits of a DRP, and even less sure the company offering the DRP can generate strong future growth, then you're probably better off taking the cash and reinvesting it yourself.