We all know that reinvesting dividends compounds our returns, and we want to compound our dividends as soon as possible, but automatically DRIPping the dividends mean that we can't control what price (i.e. valuation) the shares are purchased at. However, in the long term, this would matter less if we're DRIPping a company with a solid business model that is growing earnings year by year.
If investors choose not to automatically reinvest dividends via a DRIP (Dividend Reinvestment Plan) program, it doesn't necessarily mean that they would deploy those dividends the most efficiently either. (In fact, some investors might decide to spend those dividends!) Furthermore, if it takes awhile for an investor's dividends to accumulate enough so that he or she could buy shares (making the transaction fee worthwhile), those dividends are left sitting there doing nothing. Inflation is eating it up!
So is it better to reinvest the dividends manually or to just let it DRIP?
In reality, there are multiple factors that contribute to the answer of that question. Here are some questions that individual investors can answer for themselves to make that decision:
- Are you in the accumulation phase?
- Does the company of choice have a general trend of steadily growing earnings? (i.e. it's not cyclical)
- Do you have new funds coming in every month?
- What is the valuation of the company we're thinking of DRIPping?
- Do you like simple?
1) Are you in the accumulation phase?
If you are in the accumulation phase, you are trying to obtain as many shares as you can of high-quality companies that are raising their dividends at a rate faster than inflation. In this case, a check mark for DRIP. But more questions need to be answered.
2) Does the company of choice grows earnings steadily?
If it's a company that grows earnings steadily, and this company has a strong balance sheet, then, I would consider dripping. Particular, a company with growing earnings tht has raised the dividends for many years is more likely to continue raising the dividends. Such a company with a low beta also helps as price fluctuation is reduced. An example of a company with steadily growing earnings, with a strong balance sheet, with a low beta, that has increased its dividends for many years is Coca-Cola (NYSE:KO).
Over the past 15 years, Coca-cola's earnings have been steadily growing. Notice the price has been in a somewhat sideways channel, which means that shares owned back in 1998 would be worth much more today. The dividends also reflect that fact. Dividends increased from $0.32 per share in 1998 to $1.02 per share in 2012, which is a compounded annual growth rate of 8.63%. Not bad at all!
For proof of low volatility and high dividend growth lead to high returns, check out Lou Basenese's article.
3) Do you have new funds coming in periodically?
The main source of new funds for investing would most likely be from a job for new investors. Dividend-growth investors who have long been investing in the market may be generating thousands of dollars in dividends per quarter, which is plenty to redeploy to choose a company with the best prospects. In either case, if you have funds coming in periodically, which would make the transaction fee of buying worthwhile, then it may be better not to DRIP for the reason that we cannot control the price (valuation) of the purchase if DRIPped.
One might argue that with the new capital coming in, it may be wise to invest in more shares of your current holdings. Why? You already did research on the company, and concluded that it was a good investment. You can also use the opportunity of having new capital to do a review of your current holdings to see if they're still sound.
4) What is the valuation of the company we're thinking of DRIPping?
If the company I'm already holding is at fair valuation or cheaper, I will still consider automatically DRIPping. After all, if it's not a good company, I wouldn't have bought it in the first place, so why not accumulate more shares if its fundamentals remained strong from when I bought it.
5) Do you like simple?
It's easy to turn on DRIP for a high-quality company and then forget about it. Quick and simple to do. However, if investors want to make sure they're buying at fair value or cheaper on the DRIPs, they'd need to look up the valuations of their holdings around DRIP time. The research time can get out of hand if the investor has say 100+ holdings. (Some investors on Seeking Alpha voiced that they have that many holdings!) Personally, for me, that's too much to handle, and too much to keep up-to-date with.
Food for Thought
How about for a cyclical company which is undervalued? For example, would it be a good idea to DRIP the undervalued Caterpillar (NYSE:CAT) now? It really depends on the individual investor. It depends if the investor has a long enough time horizon to wait for economic growth to pick up again. It depends if the investor can stomach the higher price volatility on the higher beta company. Generally, with a low beta company, investors will be less emotional about their decisions, which is always a good thing.
- I would participating in DRIP for an undervalued, high quality, low beta dividend grower with steadily rising earnings, and a strong balance sheet.
- For a high quality, low beta company with growing earnings, which is at fair value, I would still consider participating the DRIP, especially if historical norms show that the company's price follows its earnings closely.
- For an undervalued, low beta company that has declining earnings, I'd be careful and not DRIP. In fact, I would monitor such a company more closely than others to see if a sale is warranted instead.
Disclosure: I am long KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.