DRIPs or Manual Dividend Reinvestment, Which is Better?

If you agree with me that any currently unneeded cash that you receive from your equity investments should be reinvested, you generally have two options: using a DRIP, or reinvesting your dividends on your own. The two choices are not mutually exclusive (you can use them in conjunction, depending on where and how your stocks are held), but investors usually seem to favor one over the other.


DRIPs, or dividend reinvestment plans, are available through most discount brokers, transfer agents, and directly from some companies. If your account (or some its separate holdings) is enrolled in a DRIP, every time one of its holdings pays out a dividend, that cash is automatically converted into more shares of that holding, at the current market price.

Advantages of a DRIP

1. Dividend reinvestment programs are either free (most discount brokers and companies from which you can buy shares directly) or cost very little (transfer agents and some companies charge a small fee). Paying little to no commissions for regularly buying more shares is advantageous for those accounts that do not receive large dividends and/or regular deposits of fresh money. That is, if you receive $50 worth of dividends per month and you do not deposit more funds with which to invest, reinvesting manually will eat a large chunk of your dividend because of broker fees. With a DRIP, however, you will incur little to no additional expenses.

2. Dividend reinvestment is automatic. You can buy the holding and forget about it. Every time a dividend is paid, you get more shares, increasing your future dividend payments and hopefully compounding your returns.

3. DRIPs give you "investing discipline," as they make you buy additional shares on a regular basis, no matter what the market is doing. You get more shares when they're cheap, and less when they're expensive.

4. DRIPs enable you to buy fractional shares. They allow you to reinvest the full dividend you receive. Suppose you get a $50 dividend payment from a stock that trades for $60 a share. Without fresh money, you generally (excluding scheduled investments with brokers like Sharebuilder and Sogotrade) cannot reinvest that $50 until either the share price goes down, you get another dividend payment, or you deposit more money.

5. Some companies and closed end funds give you a discount for dividend reinvestments that can be a few percentage points lower than the current market price.

Drawbacks of a DRIP

1. You can only reinvest in the company that paid out the dividend. Say company XYZ pays you a dividend. Suppose that at the time your asset allocation would fare better if that money were put into company ABC. You cannot reinvest XYZ's dividend in ABC in a DRIP.

2. Reinvestments are made at market price on the day of the dividend payout. Short of not making a reinvestment, you have no control over what price you pay for additional shares.

3. While using a DRIP over a long period of time can be very rewarding, when the time comes to sell your holding you may have a tax accounting nightmare on your hands. For example, if the stock in your DRIP pays a quarterly dividend, after 20 years you will have 80 DRIP purchases. They will all be at least partially in fractional shares and at different prices. Be sure to save all your account statements to reduce your frustration at tax time. (Note that this type of problem is faced by anyone who makes regular investments in the same holding, so it is not faced solely by users of DRIPs. However, having regular fractional share purchases may pose an additional burden on some investors. Of course, if you already pay an accountant, let him or her worry about it. Additionally, a DRIP in a tax deferred account won't face this problem.)

Reinvesting Dividends By Yourself

Reinvesting dividends on your own can be done in a number of ways. These include, but are not limited to, reinvesting the entire dividend, reinvesting a part of the dividend, and adding the dividend to fresh money for investment in the same or a different holding.


1. By manually reinvesting your dividends, you have full control. You choose

a. when to reinvest and at what price: market timing.

b. how much to reinvest: for example, you might want to keep some of the dividend for use for other things, such as having extra pocket money or buying someone a gift.

c. what holding to reinvest in: your asset allocation may require more money to be placed in another holding.

2. If you make regular investments already, say $x a week or month, if you add your dividends to this amount, you incur no extra fees. That is, if you regularly invest fresh money, you will have paid the commission anyway; adding the dividend to it costs you nothing.

3. If you receive large dividend payments, fees incurred from reinvesting them manually may be negligible. For example, paying a $7 commission for reinvesting a $2,000 dividend payment will have little negative effect on your returns.

Disadvantages of Reinvesting Manually

1. By manually reinvesting your dividends, you have full control. You choose

a. when to reinvest and at what price: most investors are terrible market timers.

b. what holding to reinvest in: you might favor the holdings that have been doing well and might be too expensive while neglecting holdings that would benefit from averaging down.

2. Unless you make automatic scheduled investments at brokers like Sharebuilder and Sogotrade, you can only buy whole shares. As a result, you will most likely be unable to reinvest your entire dividend. Moreover, if your dividend payment is less than the price of one share and you do not deposit fresh funds, you will not be able to reinvest that dividend at all (until your dividends accumulate, which in some cases may take a long time).

3. If you receive small dividend payments and do not regularly deposit fresh money for investing, brokerage commissions will take a large chunk out of your reinvestments.

4. By choosing to reinvest your dividends by yourself you will miss out on the discounts that some companies and closed end funds provide for reinvested dividends.

5. Note the similarity between #1 in the advantages and #1 in the drawbacks. Reinvesting dividends on your own requires self enforced discipline as well as at least moderate monitoring of your holdings. You have to keep track of when dividend payments are received and will have to decide where to put them to work. Many investors end up having dividends pile up in their accounts, often earning little to no interest.


My opinion is that DRIPs are almost certainly the best option for investors with small accounts who do not invest fresh funds on a regular basis.

Reinvesting manually may be advantageous for investors who receive large dividend payments and/or regularly invest new money. Reinvesting on your own requires discipline as well as more frequent account monitoring.

Additional resources

Computershare is a transfer agent that allows investors to buy stock from a number of companies without the use of a broker, with free or low fee additional investments and dividend reinvestments.

While their number is growing fewer due to the expenses involved, some companies still offer direct investment plans with DRIPs. If you are interested in a particular company, visit the investor relations portion of its website. Wall-Street.com lists a few dozen companies that offer direct stock purchases, but I am not sure how accurate or complete the list is.

Zecco is a discount broker that currently gives you 10 free trades per month if your account's value is $2,500 or over. This can make it feasible for those investors who would most benefit from DRIPs to reinvest dividends on their own. I plan to have a Zecco review on this site at some point in the future.

Sharebuilder (review here) and Sogotrade (review here) offer low monthly fee packages that may also make it manageable for investors who receive small dividend payments to reinvest their dividends manually.


Buying vs Renting Part 2

I debated whether buying a home is better than renting recently. Dorian Wales at The Personal Financier has posted on the topic, and provided a link to a New York Times calculator.

I wish I had known about the calculator before, as it would have saved me the time I spent doing calculations. It lets you manipulate a bunch of variables, including monthly rent, cost of house, down payment, mortgage rate, annual rent hikes or cuts, and annual property value appreciation or depreciation.

The scenario I used before was, "you buy a house for $400,000 with an $80,000 down payment. At current rates, 7% in the NYC metro area, for example, you'd pay around $2,128.97 a month in mortgage payments on a 30 year fixed mortgage (on the $320,000 you borrowed). Adding in reasonable property taxes, insurance rates, and your down payment, let's say you pay $2,800 a month."

Using the calculator, this scenario's values are the following:

Monthly rent: ?
Home price: $400,000
Down payment: 20%
Mortgage rate: 7%
Annual property taxes: 2.013%
Rate of property value increase/decrease: ?
Rate of rent increase/decrease: ?

Whether renting or buying is better in this scenario depends on the three factors that have question marks. The NY Times calculator suggests that the monthly rent figure should be $2,165. This is because the national average home price divided by the national average rent is 15.4.

The rates of increase/decrease on home value and rent determine which is better. To be better than renting, the home's value has to increase annually by 4% or more if rent increases 1% annually (these figures are painted with broad strokes, as it were. That is, it might be less than 4%, but the calculator does not let you manipulate the variable on a finer level, such as basis points). If rent increases 2% annually, in this scenario buying the home is better if its value increases 3% or more annually. If rent increases 3% annually, which is the calculator's default value, buying the home will be better (after 29 years) even if it loses 3% of its value annually. (The calculator does not seem to work for greater losses. For example, it says buying is better than renting after 28 years if the house loses 10% annually. This makes no sense.)

Joe Enos mentioned in a comment that timing is important, as are your holding period and risk tolerance. I agree. Americans move every six years on average. Many won't stick around for the time required to make buying worthwhile in those situations where the house loses its value and/or monthly rent does not appreciate as fast as it did in the past.

Here is an excellent article on housing booms and busts posted on the FDIC site in 2005.


Realty Income Corp, The Monthly Dividend Company

Investors looking for monthly income with capital appreciation potential might want to take a closer look at Realty Income Corporation (O).

The real estate investment trust has been around since 1969 and has traded on NYSE since 1994. It raised its dividend, which it pays monthly, every year for the last 11 years. As of writing, the stock yields around 7.5%.

The company has a diversified portfolio. It operates in 49 states and owns 2,375 properties, which it leases to over 100 retail chains spread across 30 industries. Its tenants include Jiffy Lube, Office Max, Staples, and Taco Bell, among many others. No industry accounts for more than 25% of its portfolio. In the most recent quarter, 97.4% of the company's properties were leased out, with an average remaining lease length of 13.2 years.

Over half of the company's properties were acquired from its customers and leased back to them. The firm uses the income from these leases to pay its operating expenses and debts. The rest goes to shareholders (the company limits its dividend payments to around 85% of free cash flow).

Realty Income Corp favors a conservative approach. It prefers long term net lease agreements where its customers pay the taxes and most of the other operating costs of the properties they rent. As a result, the company's gross margins have been close to 100% for at least the last 10 years. Realty Income has employed this strategy with great success since it was founded.

While Realty Income prefers to hold its properties for long periods, generating monthly income, its Crest subsidiary engages in property flipping. Crest engages in less transactions when property values fall. When property values rise, Crest picks up its activity, boosting profits.

There are a few risks that investors should consider carefully.

Because the company leases its properties to retailers, it is sensitive to the economy. As the economy worsens, some of its tenants may not be able to pay rent. Economic conditions may also lower the number of new customers. While the property occupancy rate was an impressive 97.4% in the last quarter, this was a decrease from the 98.8% occupancy rate of the same quarter last year (note, though, that this reflects a number of newly acquired properties).

The company can be hurt by inflation. This would happen if inflation outruns Realty Income's rent increases.

The company grows by acquiring properties. The current credit crunch may limit its acquisition activities in the near term.

Realty Income also can be hurt by declining property values if it decides (or is forced) to sell any of its holdings.

Investors who are interested in monthly income with capital appreciation potential but favor a more diversified approach spread over various asset classes should consider the Claymore/BBD High Income Index ETF (LVL). It is spread out over dividend paying stocks, REITs, MLPs, preferred stocks, and closed end funds. As of writing it yielded 9.14%.

I am interested in buying some Realty Income shares, but will wait until after the bear market rally.


Johnson & Johnson, a Good Defensive Play

Founded in 1886 and traded on the New York Stock Exchange since 1944, Johnson & Johnson (JNJ) is the largest and most diversified health care firm in the world. The company has raised dividends every year for the last 44 years. Its most recent dividend, in June, was 11% higher than its previous quarterly dividend payment.

Just as Procter & Gamble (PG), JNJ seems to be a good stock for those who are looking for safety or have long time horizons.

Johnson & Johnson faces the following headwinds, particularly in its pharmaceutical division, which in 2007 accounted for about 41% of the firm's sales.

1. High margin drug Risperdal had its patent expire at the end of June. Topamax, another high margin drug, will have its patent expire later this year. The two drugs represented nearly 25% of JNJ's drug sales in 2007.

2. JNJ lost its patent on Risperdal recently, sending sales of the antipsychotic drug down around 16%, according to its quarterly report.

3. Procrit, an anemia drug, has slowing sales due to patient side effects, more restrictive labeling, and competition from Amgen's (AMGN) Epogen. In the most recent quarter, sales of the drug fell 14%.

4. Drug coated stents sales declined 6% in the most recent quarter on health and efficacy concerns. Sales are expected to drift lower in the future.

5. In its most recent quarterly report, the company said that drug sales grew 3.1%. The rise is attributed to a weaker dollar. Excluding the declining currency, drug sales fell 1.3%. While its sales rose 17% last quarter, Topamax's patent is set to expire soon, as mentioned. In all, the pharmaceutical division's sales are expected to decline to around a third of JNJ's total sales over the next decade.

6. Higher raw materials and energy costs are putting a strain on margins, as they are with pretty much every other firm.

Despite the above problems, Johnson & Johnson's future looks bright.

1. The FDA recently approved Ustekinumab, a drug that treats plaque psoriasis. Around 37 million people worldwide suffer from plaque psoriasis. While sales are not expected to contribute much to earnings, the drug has potential for treating other ailments. It is currently in phase III for treating Crohn's Disease.

2. The firm has several drugs currently in phase III trials that might become huge sellers.

3. The consumer products division, which accounted for 24% of 2007 sales and has brands such as Band-Aid, Listerine, Neutrogena, Tylenol, and Zyrtec, is growing. In the most recent quarter, sales were up 13%. The consumer products division is expected to continue to grow at a healthy clip.

4. Johnson & Johnson's medical devices division, which accounted for 35% of sales in 2007, is doing well too. Even though drug coated stent sales declined, the division's sales rose 12% in the most recent quarter. The medical devices division is also expected to continue growing.

5. Analysts expect that growth in consumer and medical device sales, as well as new drugs coming on the market, should offset declines from near term patent losses. The firm is expected to post mid single digit sales growth over the next decade. The US's aging baby boomers will need various products, and JNJ holds the leading market position in almost all of them.

6. A stronger dollar could hurt growth, as almost half of JNJ's 2007 sales came from abroad. Nevertheless, the dollar is expected to stay weak against other currencies, at least in the near term. With foreign central banks expected to raise interest rates or keep them steady, the dollar will probably continue its decline.

7. Dividend payments have almost doubled from four years ago. Future dividend increases are likely, as the firm is expected to grow. Its payout ratio is currently under 42% of projected earnings for 2008.


The Power of Investing in Dividend Paying Companies

Suppose 20 years ago, in the middle of the Savings and Loan Crisis, you decided to invest in a basket of dividend paying companies to hold for the long term. Not wanting to do too much research but still interested in buying quality companies, you decided to invest in those Dow Jones Industrial Average components that paid dividends at the time. You cashed the dividend checks, but left your portfolio alone. How would your investment have done until now (as of market close July 11, 2008)?

In July 1988, the 30 companies in the Dow were:

Allied-Signal Incorporated
Aluminum Company of America
American Express Company
Bethlehem Steel
Boeing Company
Du Pont
Eastman Kodak Company
Exxon Corporation
General Electric
General Motors Corporation
International Business Machines
International Paper Company
McDonald’s Corporation
Merck & Company, Inc.
Minnesota Mining & Mfg
Navistar International Corp.
Philip Morris Companies
Procter & Gamble Company
Sears Roebuck & Company
Texaco Incorporated
Union Carbide
United Technologies Corporation
USX Corporation
Westinghouse Electric

Bethlehem Steel, which went out of business in 2001, and Navistar (NAV) did not pay dividends at the time, so let's say you bought the other 28 companies. Suppose you invested $100 in each (total investment of $2,800).

Here's a bit about some of the potentially unfamiliar names.

Allied-Signal is the predecessor of the diversified technology and manufacturing company we now know as Honeywell (HON). It was recently taken out of the DJIA. Aluminum Company of America is called Alcoa (AA) today.

Formerly American Can, Primerica once produced aluminum cans. It shifted its focus to finance in the late 1980s. Primerica became Traveler's Group, and later merged with Citicorp to become Citigroup (C). A record breaker at the time, the deal involved Traveler's paying $70 billion for Citi stock, creating the world's largest bank.

If you think you never heard of International Business Machines, you probably call it IBM. If Minnesota Mining and Manufacturing seems somewhat unfamiliar, that's because today it's called 3M (MMM).

Philip Morris, food and tobacco products maker, became Altria (MO), and has since spun off Kraft (KFT) and Philip Morris International (PM). Altria was recently taken out of the DJIA along with Honeywell.

Texaco, an oil company, was bought by Chevron (CVX) in 2001. Chevron was a DJIA component in 1988, was subsequently taken out, and is now back in. Union Carbide, maker of petrochemicals, was acquired by Dow Chemical (DOW) in 2001.

USX Corp spun off US Steel (X) and changed its name to Marathon Oil (MRO). Westinghouse Electric, a diversified business, became CBS in 1997 and was sold to Viacom (VIA VIA-B) in 1999.

Woolworth sold various consumer goods. After experiencing difficulties, it went by the name Venator for a short time, before adopting the name of its leading store, Foot Locker (FL).

So how did the portfolio do?

First, there are two sets of returns. One includes AT&T (T), and one does not. I found it a bit confusing which AT&T was which, and what the available financial data referred to. Comedian Steven Colbert once expressed his own puzzlement. Here's a link to the video. (I don't know how long it'll work or whether the site has Viacom's permission to post it.)

Second, the results are understated. That is, actual results would have been better than the ones described below. I had trouble finding data on Sears, so for my purposes here, I'm assuming investing in it 20 years ago would have resulted in a total loss (this would not have happened had you actually invested in it).

I also had some trouble finding detailed data on the companies that were acquired (Texaco, Union Carbide, Westinghouse). To figure out their returns, I found the number of shares outstanding in 1988 for each of them by looking at their annual reports, and multiplied this number by their highest share price of the year, determining their highest 1988 market cap. Had you actually bought them in July 1988, you would almost certainly pay less than the price I assume here. Once I had the market cap, I found out how much the companies were purchased for, and determined the return from the difference.

From July 1, 1988 to July 11, 2008, the portfolio's return with AT&T is 430.34%. Without AT&T, the portfolio returned 421.94%. (The return without AT&T assumes that investing in AT&T in 1988 resulted in a total loss. That is, I'm still assuming that 28 stocks were purchased). Your $2,800 portfolio would today be worth almost $14,900 (over $14,600 without AT&T).

Remember, in light of the above, that actual returns would have been greater. Also, these figures do not take into account the dividend payments you would have received over the two decades. Nor do they reflect the extra companies you would now own had you actually invested the $2,800 in 1988.

These returns of 430.34% (a little over 8.68% annually) and 421.94% (a little over 8.59% annually), while not earth shattering by any means, compare very favorably with the market's performance over the same period. From July 1988 to now, the S&P 500 has advanced 356.06% (around 7.86% annually).

But you invested in dividend paying stocks, so how much would your investments be paying you today? With AT&T in the portfolio, you would receive $453.04 in dividends this year. That's over 16% of your original investment this year alone. If dividends remain steady, they will double your original investment around every four and a half years. Without AT&T, you'd get $436.61 this year.

The returns and dividends reflect both terrible performance by some stocks and great performance by others. The portfolio beat the S&P 500 because the winners greatly outpaced the losers. For example, while Goodyear, General Motors, and Woolworth have been lousy, GE, Philip Morris, and Procter & Gamble, to name a few, have been fantastic. On your original $100 investment in Philip Morris, for instance, you'd get over $72 in dividends this year alone (not counting Kraft or Philip Morris International, which also pay dividends). If Altria's dividend remains the same, you will more than double your original investment in Philip Morris every two years. As another example, as long as dividends remain steady, GE will pay you almost $40 on your original $100 investment every year from this point on.

There are a couple of morals we can draw from this story. One is that you can be a lazy investor and still beat the market. A better moral is that great companies (here by virtue of their DJIA membership) that pay dividends can be market beating investments if you hold them for a long time. If you hold them long enough, the dividends alone on some might double your original investment every year.

Another lesson to draw is that diversification pays off. Picking only a few dividend stocks might have given you superior results, but you also could have picked a bunch of losers. By buying a basket of great companies (whatever your criteria for greatness might be, in this example it's DJIA membership), you shield yourself against some inevitable losses.

I don't know how long this blog will be around, but I'll start the same lazy portfolio with today's DJIA stocks. There are a bunch of financials in the Dow today. Who knows how much lower they'll go. On the other hand, they will recover eventually, and over the long term they might be good investments. We'll see. While right now it's pretty much the same as keeping track of the DJIA, the index's components will change in the future while the sample portfolio's holdings will remain the same.

Here are the current DJIA stocks (they all pay dividends) with their prices as of Friday's (7/11/2008) market close:

INTEL CP 20.64
3M COMPANY 68.72
AT&T INC. 32.58

I'll also track a few dividend ETFs (with prices as of market close on 7/11/08), as they also attempt to track the performance of great dividend paying companies.

PowerShares Dividend Achievers Portfolio ETF (PFM)

First Trust Morningstar Dividend Leaders Index Fund ETF (FDL) 14.07

Claymore/Zacks Yield Hog ETF (CVY)

iShares Dow Jones Select Dividend Index Fund ETF (DVY) 47.62

WisdomTree Total Dividend ETF (DTD)

Vanguard High Dividend Yield Index ETF (VYM)

CD Matured, Moved It to Savings

In January, thinking that stocks wouldn't go anywhere for the next two quarters while interest rates would go down, I bought a six month 5.1% CD from Washington Mutual. The CD has matured. As the rate offered for another six month CD is 2% and interest rates are expected to remain steady or rise, I just moved the money into my savings account. The yield there is currently 3.3%.

The S&P 500 is down around 12% since January, so I guess I made the right choice (relatively speaking, of course--an energy stock ETF would've been much better).

I'm not sure how long I'll keep the money in savings. Procter & Gamble looks tempting, as do Johnson & Johnson and Kraft. Pfizer had looked interesting to me six months ago, but I've soured on it a bit.