Almost every professional investor will agree that there’s no power in the universe more powerful than the power of compounding. You take a certain growth rate over a certain period and it can create wealth beyond imagination.
When it comes to building wealth, there are three simple elements that can help you – time, capital, and rate of return. On this site, we’re obsessed with the rate of return. Specifically, we talk about dividends and the dividend yield on most stocks.
In my opinion, the point of running a business or owning stock is to receive free cash flows. Whether these cash flows are stored on the company’s books or paid out in dividends makes a difference if you live on the income from your investments. If you need regular cash from your investments to pay your bills and buy groceries, it can be annoying when the company holds the cash back to look pretty on the balance sheet.
The dividend yield plays a key role in your investment portfolio. However, what if you’re not in it for the income? What if the dividend yield on your investments makes little difference to your day-to-day finances?
Most people would consider themselves a part of this group. You’ve probably got a full-time job to take care of the bills and the investments are for your distant retirement. In this case, you don’t need a yield today but wealth tomorrow. The focus is growth, not income.
Luckily, there’s an investment strategy just for these dividend growth investors. It’s called DRIP investing or dividend reinvestment investment plan.
The DRIP Investing Basics
As the name suggests, DRIP investing is all about taking dividends and reinvesting them into the same stocks. This helps you compound wealth faster.
These strategies are so popular that some companies allow their investors to reinvest the dividends before they even get to them. This avoids the commission most investors would have to pay on their additional stock purchases. Some DRIP investing plans offered by companies also lets investors buy the stock at a substantial discount to the current market price.
So, a drip investing strategy can be employed by you, the investor, or the company you invest in. Both investors and the company can benefit from a drip investing plan. Investors can avoid the commission they pay on stock purchases. Instead the money goes into buying more stock. Tax and the effort of putting cash back to work is also avoided. Ultimately, over time the effect will be higher wealth. This effect is further augmented if the company offers stock at a discount as part of this plan.
Meanwhile, the company benefits too. Drip investing plans allow the company to bolster stock capital. Dividend growth seeking investors are more likely to invest with a company that offers such as policy. They are also more likely to stick around for the long term if they believe the dividends will keep growing and building wealth over time. So, the company gets a stable base of capital that can be tapped anytime.
It works out well for everyone. Dividend growth investors should consider DRIP investing as part of their overall strategy to grow wealth through dividends. Here’s what you need to do:
Setting up A DRIP
Setting up a drip investing plan involves a few extra steps. You can either set up the plan directly through the company or through your broker. DRIP investing works through the company’s own reserves and doesn’t involve publicly traded stock, which is why you need to register and perhaps even pay a bit to get access.
However, once the program is set up it’s pretty much automated. The dividends will be reinvested into the company’s stock without you noticing each quarter.
Most blue chip public companies have some form of DRIP investing plan available for shareholders. Shareholders need to make sure they own at least one stock of the company at the time of registration and hold it in their own name (not the broker’s).
Every company has it’s own way of accepting registrations. You might need to read through the fine print on each of these plans to understand how you can set one. You also need to pay attention to the fees involved in setting up a plan like this. If the fees are too high and too frequent, it defeats the purpose of drip investing.
Once you have a drip investing plan set up, you never need to bother with it again. Dividends won’t appear in your bank account. Instead, the money will automatically buy you a proportional number of new shares.
Creating a DRIP Portfolio
To create a viable drip investing portfolio, you need to find high-quality stocks that offer a drip plan. Online services like Computershare are a good bet. The Moneypaper is another great place to start your hunt. This site has more than 1,000 stocks that offer a DRIP plan along with specific instructions and direct links to the enrollment page for most companies. You can apply filters on these sites to discover DRIP stocks of a certain size and criteria. You can also weed out all the companies that charge high fees for setting up a plan.
NetstockDirect is another online service that updates the list of DRIP investing stocks daily. There’s also a dedicated phone line (Direct Stock Purchase Plan Clearinghouse – 800-774-4117) for investors who need to speak to someone and order a prospectus for drip stocks.
There are many well-known companies on these lists, including ones that don’t charge a fee to start a DRIP investing plan. For example, Abbott Labs (NYSE:ABT), Exxon Mobil (NYSE:XOM), and Lockheed Martin (NYSE:LMT) all offer free drip plans to investors who already own stock. Dr. Pepper (NYSE:DPS), meanwhile, takes a negligible one-time fee of $15 to set the plan up.
Things can get a bit more complicated depending on the company’s policies. Johnson & Johnson (NYSE:JNJ), for example, won’t charge anything to set up and run a drip investing plan, so long as the money comes in monthly via cheque. If you apply direct debit, the cost is $1 for every transaction.
Finding out how different companies operate their DRIP investing schemes is essential. Analyze the costs of implementing the plan and the effort involved in picking the stocks and creating a dividend growth plan.
A well executed drip investing plan will help you add back the dividends to fuel capital growth. Because you avoid the temptation to time the market, you’ll benefit dollar-cost averaging. Also, because most of these plans cost nothing and avoid taxes, you can propel the growth even further.
Dividends are rewards for shareholders. But how you use this reward is completely up to you. If you need cash to meet monthly expenses, a high dividend yield probably works to your advantage. However, if you’d rather aim for capital appreciation there are other ways to use the cash from dividends.
Buying up more stock instead of receiving the dividend in cash is a great way to grow wealth over time. In fact, redeploying cash from dividends to buy more stock is such a popular strategy most companies offer a direct plan to investors called DRIPs or dividend reinvestment plans.
A lot of professional investors use dividend reinvestment to buy up more stock. Drip investing is a good strategy to apply if you don’t current income from your investments. If your monthly expenses don’t depend on how much yield your investments make, drip investing is probably the best option for your portfolio.