Sometimes with investment it's the boring little things that make all the difference.
Dividend reinvestment is one of those things. It supercharges investments by using the power of compound interest, which Albert Einstein once described as the eighth wonder of the world.
It's quite simple. You earn interest or dividends and if you add that income to your capital you build up more capital to earn interest from. It's a virtuous circle. By reinvesting the dividends or interest automatically you make more in the long run.
Dividend reinvestment plans (DRPs) allow you to turn your dividends into extra shares through a share purchase plan. They also allow investors to buy shares directly, cutting out broking (adviser) fees. It's a financially efficient way to build up a shareholding.
Dividend reinvestment is a bit like dollar cost averaging where you smooth out market ups and downs by drip feeding your money in.
Sometimes the investors receive just a handful of shares from the DRP. But they all add up. Next time a dividend is declared the investor gets a very slightly higher number of shares thanks to the increased number held because of the last DRP.
Dividend reinvestment is one of the reasons that most people's KiwiSaver accounts have grown much larger than they expect. It's because the earnings on all the investments in the KiwiSaver fund pot are automatically reinvested, benefiting from the magic of compound returns.
Compound interest is something that every child should learn about. Even if they only have bank accounts they can be taught about the concept. I've found that KiwiSaver balances are a great way to start a conversation on this subject.
For a simple example of how DRP works, consider a $10,000 share investment earning 8 per cent a year after tax with no additional money paid in. If you fritter the dividends away, you'll have $26,000 at the end of 20 years - although you will have had the enjoyment of the spending. Reinvest the dividends and your money will be worth more than $46,000 after two decades.
Dividend reinvestment usually happens automatically for managed funds. That is unless you choose an income fund that is designed to pay dividends.
In most cases this suits retired people and those living off the income from their investments. Having said that, some retirees prefer growth investments, withdrawing lumps of capital when needed rather than living off income.
The advantage of a DRP for people who do want to reinvest earnings is that they don't need to track the dividends as they come in and separate them from other income. If it's not automatic, there is an opportunity cost during the lag period - especially if that money is going into a low-interest current account.
DRPs also allow you to invest very small amounts of money straight into the stock market rather than waiting for the money to build up in a bank account at a low rate of interest. Not many people are disciplined enough to invest this money regularly and as one American writer put it: "Procrastination is the natural assassin of opportunity."
Many NZX-listed companies such as Fletcher Building, Westpac and Just Water International allow shareholders to convert their dividends this way into extra shares.
There are two main reasons they do it, says Aaron Jenkins, head of markets at NZX. One is to raise capital. It allows the companies to reinvest the capital into the business. The other is as a shareholder service.
Around 40-45 per cent of NZX companies have DRPs, says Jenkins. Those that don't often do not have capital raising needs. Mighty River Power is an example, although it isn't ruling out starting a DRP in the future. During the past year Mighty River's earnings have been above its IPO (float) forecasts with lower capital expenditure and a $300 million capital bond and a share buyback. This means it's in exactly the opposite phase of a business that needs to retain capital.
All companies that offer DRPs have different terms and conditions, says Link Market Services business development manager Stan Malcolm. So don't assume that they are all the same when signing on the dotted line. It is often possible, for example, to receive some of the dividend entitlement in shares and the remaining portion in cash.
Another example is that each company will have different ways of dealing with residual cash. It may be carried over or rounded up or down.
Sometimes the shares bought may be at a discount to the market price, which makes it a no-brainer to take up the DRP if at all possible. Discounts are not very common in New Zealand, but they have been offered, says Malcolm.
Air New Zealand's DRP is currently suspended, but the company was offering shares at a 1.5 per cent discount. APN News & Media has offered discounts of up to 7.5 per cent, says Malcolm.
Many other companies such as Spark, Fletcher Building and Infratil say in their documentation that they can choose to offer a discount at the board's discretion. This is usually done when they're keen for shareholders to take up the DRP.
Feedback from retail investors indicates they like DRPs, says Fetcher Building general manager of investor relations and capital markets Philip King.
Companies do turn their DRPs on and off. Comvita and Auckland International Airport's DRPs are currently off. Fletcher Building turns its DRP on when it needs to build the balance sheet and off when it doesn't need additional equity.
"Each time we announce a dividend we announce whether the DRP is operative for that dividend," says King.
DRPs do have their detractors. If you sign up to the DRP you can't choose the share price that you're buying at. For example, you might think that the price will be better in a few months after the reporting season or some other event. Having said that, private investors can be notoriously bad at picking highs and lows in the market.
Another concern is that by building up more shares in a particular investment you may be skewing your portfolio, especially if the share price rises in relation to other holdings. Not all private investors rebalance their portfolios.
It could also be argued that you're not making an active decision about how to invest your money. For some people DRPs will tie up a proportion of their income, which may be a problem.
Every company requires its own sign-up, which may be onerous in terms of paperwork and it can be easy to make mistakes when filling in multiple applications. Having said that, if you're a buy-and-hold investor it's just one piece of paper and one letter to post and the DRP is sorted for as long as you hold the shares.
Buying small parcels of shares like this can be confusing when it comes to preparing tax returns. Those investors who are classed as traders and pay tax on their gains must track the cost of every small parcel of shares and then calculate the tax on the gains.
The Inland Revenue Department's foreign investment fund tax makes dividend reinvestment an administrative nightmare for anyone who has more than $50,000 invested overseas. That can include in New Zealand or Australian-based funds that invest in overseas equities or bonds. Investors are usually charged tax on the value of their investment and they need to know how much that has increased over the previous 12 months. If they're buying small parcels of shares here and there it can be time-consuming to unravel the details.
Direct purchase is a related concept. Companies offering direct purchase share plans allow you to buy small parcels of shares directly from them rather than via a financial adviser (stockbroker) at additional cost. Unfortunately only Smartshares provides this in New Zealand.
I've had readers email me who do this with US companies. Buying regular amounts directly without losing some of their investment to brokerage does make sense. Rights issues and initial public offerings are another way to buy shares without brokerage, but they don't have the added advantage of regular small amounts of money building up.