Looking into dividend reinvestment programs - Column

USA Today (Society for the Advancement of Education), Sept, 1997 by Jeff A. Schnepper

A dividend reinvestment program (DRIP) allows an investor who already owns stock to have his or her dividends automatically invested by the issuer in more shares. These programs, which have been around since the early 1970s, let participants buy additional shares directly from the issuer without paying a broker's commission.

By enrolling in a DRIP, one can buy partial shares with dividends and enjoy the benefits of dollar cost averaging. With dollar cost averaging, additional automatic investments are made at regular intervals. If the price goes up, you buy fewer shares; if it goes down, you buy more shares. In all cases, though, you continue to invest and build up a portfolio.

According to Moneypaper, a DRIP newsletter, about 1,100 companies currently offer these programs. They can be viewed as no-load funds that invest in a limited population of securities. However, there is an entry hurdle to overcome before an investor can participate in most DRIP plans. Since you have to be a shareholder to enroll, you usually have to pay a broker's commission to get started.

Moreover, you have to be a "registered" shareholder -- one carried on the company's books. Most holdings through brokers are held in their street name. You may have to pay extra, at least in time and effort, to have a broker put the stock in your name and send you an old-fashioned stock certificate. Nevertheless, it may well be worth it to open the door to future commissionless trading.

More than 3,000,000 people currently participate in DRIPs by purchasing stock with cash dividends that the company reinvests for them in additional shares. Most DRIPs also let individuals make additional cash payments, in many cases as little as $10-25, directly into the plans to purchase more shares. Companies normally charge little or nothing to purchase stock through their DRIPs.

Recently, more companies have expanded on the concept of no-load DRIPs by allowing direct purchases of their stock without buyers having to be a shareholder prior to participating. This allows one to "play the game" without having to pay the entrance fee of a broker's commission on the initial purchase. In addition, these no-load direct purchase programs are incorporating several attractive user-friendly features on top of the usual DRIP benefits.

For example, many no-load programs allow automatic investments with electronic draws from your checking account. Some will set up individual retirement accounts, and others will permit you to borrow cash against the shares in your account, just as is possible with a margin account at a broker.

Some no-load programs even permit you to purchase additional shares at a discount. This allows you to "print" money through the use of arbitrage. In its purest form, arbitrage is the practice of taking advantage of price discrepancies in different markets for the same security. If you have a DRIP, or a direct optional cash purchase account, which permits the purchase of shares at a discount, you have entered into the wonderful world of investment heaven.

The arbitrage move is simple. Enroll in a DRIP which allows additional optional cash investments or in any program that permits share purchases at a discount. Buy, at the discounted price, the maximum amount of stock allowed under the plan. Then, sell the stock in the open market for the higher current market price and pocket the difference!

Prior to 1994, DRIP discounts were taxed at ordinary income rates. So, for example, if you bought a $100 stock with a five percent discount, your purchase price was $95, and the $5 difference was taxed as ordinary income. In 1994, the rule changed. Now, the discount does not count as income to you, but converts into long-term capital gains if you hold the shares for 12 months.

In the arbitrage scenario, however, you sell your shares immediately, so the gains are taxed as ordinary income. Here, though, there is less concern with the tax rate than the rate of return. As a friend of mine once remarked, "I don't care what the tax rate is. It's real hard to go broke taking profits!"

Why would a company sell stock at a discount? Normally, it would raise additional capital by hiring an investment banking firm that would form a syndicate to sell stock to the public and institutional investors. The company gets the proceeds, less the fees to the investment banking firm (as much as five percent or more of the funds raised), printing costs, legal fees, and the road show expenses of management to promote the investment. With DRIPs and direct sales, these costs are eliminated. In effect, the company acts as its own investment banker and passes some of the savings to the investor.

Historically, companies offering discounts in their DRIPs have been capital-intensive industries such as banks, utilities, and real estate investment trusts. The utilities funded extensive construction projects, and the banks used them to shore up balance sheets in need of repair. What you should look for are companies with minimal price volatility in their shares and the pricing period of the company. The key is to know how much you are paying for the stock and to shorten the time before sale on the open market to minimize the risk of a price decline.