DRIP (Dividend Reinvestment Program) is a popular investment program among retail investors, and there are scores of large, blue-chip companies who offer it including - Exxon Mobil (NYSE:XOM), General Mills (NYSE:GIS), Bank of America (NYSE:BAC), 3M (NYSE:MMM) and many others.
What I am going to describe in this article could be just a statement of the obvious to many, but this might not be so for many others, including some sophisticated investors. Also, I expect some pushback from the stauncher proponents of DRIP, and I welcome the opportunity to debate this in the comments section.
When we buy common stock in a corporation, we generally receive three privileges in return for our money:
a) A claim against the current and future earnings of the company.
b) A claim on any residual assets of the company (after the debtors and other liabilities have been taken care of).
c) The right to vote for directors on the board of the company, who presumably will protect and further our (the shareholders') interests.
Of course, these rights and claims multiply disproportionately depending upon the extent of your shareholding in the enterprise - nevertheless, even a solitary share makes you the factional-owner of the company. And as part owner of an enterprise, it follows that you fully intend to enrich from as much of its earnings as possible.
Dividends and Retained Earnings
Your enterprise is able allocate its earnings in various ways; usually the first priority being reinvestment in its current business - projects that enhance efficiency, penetrate (or create) new markets, introduce new product lines and the like. Any residual earnings after this reinvestment process are made available for distribution to shareholders in the form of dividends (or are used to buy back stock, which is a topic for another time).
And this arrangement works well for you, the shareholder, since the reinvested earnings expand both the future revenue stream as well as the underlying asset base acquired for the purpose of generating those revenues. This makes you, the fractional-owner, very happy as you are receiving part of the company's earnings in cold cash, while the remainder is being retained and compounded at a rate superior to what you can obtain elsewhere.
And there-in lies the rub, dividends are justified only if - a) the shareholder can deploy the earnings elsewhere and obtain returns superior to what the company can from deploying it internally on his behalf, or b) the managers have no attractive projects available for deploying all of its earnings. However, by being respectful to the "bird in the hand" theory, it probably is prudent for shareholders to collect some of their company's earnings in the form of dividends rather than rely entirely on the capital allocation skills of the managers.
The Folly of DRIP
By enrolling in DRIP, the shareholder is violating both of the tenets that justify dividend payments, since he is signaling that - a) he is unable to find superior return on these earning elsewhere, and b) he trusts the managers to reinvest his earnings at a rate of return above the company's cost-of-capital.
There isn't anything wrong with this desire to let your earnings grow at the company, except that DRIP is a highly inefficient means of achieving that goal. DRIP creates two sources of leakage of capital - one, the shareholder will pay income taxes on the dividends he receives, and two, the company will need to issue new stock - which creates frictional costs (underwriting and other fun stuff from investment bankers). Worse, the additional stock received does not materially increase the shareholders' fractional ownership very much - because in addition to the bite taken out by the taxman, the underlying pie hasn't really expanded very much, just cut into additional new pieces and sent the way of the deluded but joyous shareholder.
Now it might seem that the company could just buy these shares from the open market and avoid the deleterious impact of ownership dilution. Alas, matters get even worse in this scenario - since the shares nearly always trade at a multiple to book value (often 2 or 3 times) in the open market. Therefore, when a company is giving up its cash to repurchase these shares for the purpose of sending them your way, the erosion of shareholder value accelerates even more rapidly.
Now, going back to the original goal of DRIP - reinvesting the shareholder's fraction of the company's earnings. Let's assume the company decided to simply redeploy its earnings instead of sending the money out on a roundtrip to you and back - who will be the winners and losers in such a scenario? The losers would include Uncle Sam who loses his 15-40% claim on these phantom dividends and of course the investment bankers who lose underwriting fees. The winner is undoubtedly the shareholder, who is not just able to reinvest more of his share of earnings, but also is able to put them to work at the company's current book value - this is not a trivial advantage. For, unlike retained earnings, the open market only allows an investor to put his money to work at 200-300% percent of book value, resulting in a significant haircut on his "real" return-on-equity.
To further drive home this point, let me introduce a scenario that illustrates the folly of DRIP on a smaller scale. Say you own a carwash, and it earned $100,000 in net income this year on an initial investment of $1,000,000 (this computes to a healthy 10% return-on-equity). Remember that the $100,000 is net income; therefore it was generated after all the expenses including corporate income taxes, your salary, any equipment-maintenance expenses etcetera were accounted for. You decide that installing a dryer at the car wash at a cost of $100,000 will generate an additional $10,000 in earnings for you.
Will you now choose to take $100,000 out as dividends, pay your marginal rate of personal income taxes on it, and then reinvest back the $70,000-$85,000 that remains? That is precisely what DRIP is doing for you - and in a worse way, since in the case of the car wash you don't have the frictional costs that investment bankers add.
The Sage of Omaha
I am yielding this section to quotes from Warren Buffett who characterized the concept of dividend-reinvestment as "the substance of the program is out of Alice in Wonderland." Let's start with his views on the DRIP programs run by utilities:
"In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a Con Ed (ED) reputation.
The more sophisticated utility maintains - perhaps increases - the quarterly dividend and then ask shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in good spirits (particularly the underwriters).
Encouraged by such success, some utilities have devised a further shortcut. In this case, the company declares the dividend, the shareholder pays the tax, and - presto - more shares are issued. No cash changes hands, although the IRS, spoilsport as always, persists in treating the transaction as if it had."
Here is how he follows this up with comments about the DRIP program from AT&T:
"AT&T (T), for example, instituted a dividend-reinvestment program in 1973. This company, in fairness, must be described as very stockholder-minded, and its adoption of this program, considering the folkways of finance, must be regarded as totally understandable. But the substance of the program is out of Alice in Wonderland.
Just for fun, let's assume that all AT&T shareholders ultimately sign up for this program. In that case, no cash at all would be mailed to shareholders - just as when Con Ed passed a dividend. However, each of the 2.9 million owners would be notified that he should pay income taxes on his share of the retained earnings that had that year been called a "dividend." Assuming that "dividends" totaled $2.3 billion, as in 1976, and that shareholders paid an average tax of 30% on these, they would end up, courtesy of this marvelous plan, paying nearly $700 million to the IRS. Imagine the joy of shareholders, in such circumstances, if the directors were then to double the dividend."
I want to be clear - I am not against dividends. As I mentioned earlier, the bird-in-the-hand theory advocates collecting some of your earnings along the way rather than relying entirely on the wisdom of your managers. In fact I limit my stock picking to dividend-paying companies - as long as they that have strong returns of equity, steady book-value growth and a low pay-out ratio. My quarrel is with the DRIP program, and how it is misunderstood by many investors who think of it as akin to money compounding within a certificate of deposit, ignoring the unnecessary loss of capital incurred by the participants.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.