INVESTMENT OPPORTUNITIES THROUGH DIVIDEND REINVESTMENT PLANS

By J. Richard Williams and Debra Hall Oden, Southwest Missouri State University

Investing in stocks without a broker, creating a personal mutual fund, and building wealth over time are all possible through direct stock-purchase plans and dividend reinvestment plans (DRIPS). There are over 130 companies offering stock directly to the public (see Table 1). An investor can buy stock directly from these companies without using a stockbroker. These stock purchase plans offer the individual investor the opportunity to own stock by making relatively small investments and generally at little or no cost to the investor. In addition, the National Association of Investors Corporation provides investors a means to acquire stock and enroll in DRIPS of over 150 companies (see Table 2) at a low cost. When enrolled in a DRIP, an investor's dividends are automatically reinvested in the company to acquire additional shares of stock, and the plans listed in these tables allow investors to make optional cash investments to acquire additional shares.

Advantages of Dividend Reinvestment Plans

One advantage of DRIPS is the low cost to investors. Many plans charge no fees or only nominal fees to buy stock either when dividends are reinvested or when optional cash investments are made. While many brokerage houses also offer commission-free dividend reinvestments, none offers the opportunity to purchase additional shares without commission.

DRIPS also allow the investor to make relatively small optional cash investments. Minimum initial investments to get started in a plan range from $50 to $1,000 and minimum additional investments generally from $10 to $100. The typical commission on such a small investment makes it prohibitive at brokerage houses since even discount brokers have a minimum commission.

Using DRIPS makes it easier for an investor to diversify and invest in several companies at once. It is generally recommended that an investor buy at least 100 shares of a company through a broker to mitigate the effect of commissions. To purchase a $50 stock requires an investment of $5,000 plus the commission which can range from $20 to $60 at discount brokers. An investment in one company provides no diversification, and many investors simply do not have the means to buy stock in six or eight companies. An investor could use the $5,000 to buy stock directly from several different companies, avoid the commissions, and own a portfolio rather than one stock.

When compared to mutual funds, DRIPS also have advantages. Even though no-load mutual funds are sold without commission, the mutual fund companies do charge investors to manage their money. Fees generally range from one to two percent of the total amount of funds under management. For the investor, these fees reduce the return. The fees are, in a sense, hidden since the net asset value of a mutual fund reflects the value of the investments after deducting any fees. Over a period of time, this one to two percent loss in return can amount to a substantial sum.

Laws require mutual funds to distribute at least 90% of the dividend income and capital gains realized by the fund to investors at least annually. So even though an investor still owns the investment, he or she must pay income tax on his or her share of any capital gains and dividends realized by the mutual fund. Dividends and capital gains are taxable whether the distributions are reinvested or received in cash. Dividends received through a DRIP, although reinvested, are subject to income tax as well. The investor, however, determines when capital gains are realized and thus taxable, by controlling the timing of any sales of the stock. The value of the tax deferral can be very substantial over a long period of time.

The investor also determines which stocks to own through DRIPS. Investing in a mutual fund places all decision making in the hands of the fund manager. Even though mutual fund managers are professional money managers, they do not necessarily do a better job picking stocks than individual investors. The success of many investment clubs, such as the Beardstown Ladies, testifies to the success individuals can have selecting stocks.

Investing in the stocks of individual companies can be fun, educational, and profitable. DRIPS can also be used for custodial accounts for children and are an excellent way to teach a child about the stock market and the importance of investing.

Disadvantages of DRIPS

While DRIPS do offer a convenient method of investing, they are not without some drawbacks. Market timing is not possible with a DRIP. The investor cannot control or dictate the price at which stocks are bought or sold. It generally takes several days from the time a sell order is initiated before the stock is actually sold. The market price could fluctuate during the time lag. Likewise when buying stock, it may be several days after the investor remits funds before the stock is purchased. When dealing with a broker, it is possible to buy and sell stocks instantly. DRIPS are not intended to be used for short-term trades and are not designed for that purpose.

Keeping adequate records of cash investments and dividends takes time. Maintaining accurate records of stock purchases is important for determining cost basis when the stock is sold. An investor participating in a DRIP making periodic cash investments will have numerous purchases during the year, each at a different price. If the investor participates in a number of DRIPS, the number of transactions could be substantial. While the companies do provide statements, it is up to the investor to maintain records of each transaction and the cost of each lot of shares purchased. Accurate records are especially important if the investor sells only part of the stock as determining the cost of the shares sold is necessary to calculate any capital gain or loss.

Investing in individual companies requires a greater time commitment than investing in a mutual fund. Once a mutual fund is selected, the investor essentially lets the fund manager worry about how to invest. An investor participating in DRIPS must make the decisions about how much to invest and in which companies. These decisions require time to study the company before the investment is made and time to follow up on the company to ensure that it is still a good investment.

Not all companies have dividend reinvestment plans. Consequently, an investor does not have access to the stock of the many companies that don't have a DRIP. Many small, fast-growth companies would be excluded from a portfolio of companies with DRIPS. These stocks would be available only through a broker.

Advice for Using DRIPS

Investing through dividend reinvestment plans is an excellent way to build wealth over time. An investor should not, however, enter into such plans blindly. Perhaps one of the most important rules of investing in a company is to know and understand the company. Just because a company has a DRIP and a direct purchase plan does not mean the company is a good investment.

An investor entering a DRIP must make a commitment to make regular investments over time. DRIPS are not for short-term investing purposes and must be viewed as long-term investments. Making regular investments over time allows the investor to take advantage of dollar-cost averaging and avoids the problem of buying all the shares at a market peak. An investor must have patience. DRIPS will not make anyone rich overnight. Short-term price swings must be ignored and the investment plan continued. An investor should not start an investment that he or she plans to discontinue and sell in three months. The stock market has historically provided good returns but it requires a long time horizon to realize those returns. An investor should not invest funds that will be needed for living expenses in the near future.

Examples of DRIPS

Proctor & Gamble, the large consumer products company, offers a direct purchase plan. P&G's plan requires a minimum initial investment of $250. Additional investments of at least $100 may be made weekly. P&G also offers investment by direct debit from a bank account with a minimum of $100. Fees charged by the plan include administrative fees of five percent up to a maximum of $1.00 for dividend reinvestments and direct debit, $2.50 per purchase made with optional cash investments, and $2.50 per sale of shares. Brokerage fees of $0.04 per share are also paid by the investor. P&G's plan allows the investor to determine whether or not dividends are reinvested or received in cash.

Companies in Table 2 participate in the National Association of Investors Corporation's "Low Cost Investment Plan." Some of the companies that participate in the NAIC's plan also have a direct purchase plan as well. The first share of the companies in Table Two can be purchased through the NAIC for a seven dollar fee. Once the initial share is purchased, the investor is enrolled in the company's DRIP and can begin making optional cash investments to buy additional shares. Intel Corporation participates in the NAIC's Low Cost Plan. Intel pays all administrative fees and brokerage fees for purchases made under the plan. The investor pays brokerage fees to sell shares. After the initial purchase, optional cash investments may be made monthly with a $25 minimum.

Organizations for the Individual Investor

Membership in the NAIC is $39 per year for individuals. Membership includes a subscription to Better Investing, access to the low-cost investment plan, and the NAIC's stock selection guide. The NAIC also supports and encourages investment clubs. The NAIC can be contacted by mail at P.O. Box 220, Royal Oak MI, 48068; by telephone at (810) 583-6242; and on the web at http://www.better-investing.org.

In addition to the NAIC, other organizations provide service to individual investors. These organizations include Direct Investor [http://www.netstockdirect.com or (900) 225-8585; $2.50 per call], Direct Stock Purchase Clearinghouse (800) 774-4117, The Money Paper (800) 388-9993, and Drip Investor [(219) 852-3220; 7412 Calumet Ave., Suite 200, Hammond IN 46324-2692]. These organizations are an excellent source of information for investors who are interested in participating in the many dividend reinvestment plans available. *

Editors:
Milton Miller, CPA
Consultant
William Bregman, CPA\PFS

Contributing Editor:
Alan Fogelman, CPA
Clarfield & Company P.C.

JULY 1997 / THE CPA JOURNAL