Showing posts with label drips. Show all posts
Showing posts with label drips. Show all posts

Monday, November 24, 2014

How to turbocharge dividend growth

Once an investment is made, and assuming no new money is put to work, there are four levers to help an investor reach dividend income goals:

1) Attractive entry price

The importance of the entry price cannot be overstated. Even the best company in the world is not worth overpaying for. It matters a lot that you can acquire those shares at low valuations, which ensures better entry yields. For example, if you bought Coca-Cola (KO) in 1999 at $23.50/share, you would have paid over 30 times earnings and received an initial yield of about 1.30%. Despite the fact that earnings and dividends increased rapidly, your yield on cost did not go that much higher than 5.20% although you did earn some capital gains in the subsequent 15 years. You would have been better served putting that money in REITs, oil companies or tobacco shares, which were cheap at the time and had better starting yields. Therefore, when you buy shares, it pays to always pick the ones with the cheapest valuations. Quality should never be sacrificed, but if you make a purchase at a cheap enough price, you can earn a decent return even if growth projections turn out to be poor. For example, I bought ED in 2008 – 2009 at really low valuations and entry of 6%. In hindsight, this was a mistake since the dividend was growing slower that inflation. But I still earned a high return despite that, and once I realized the mistake I sold and redeployed capital elsewhere.

2) Dividend growth

Dividend growth is the second important component in turbocharging the dividend income. A company that is cheap, and manages to grow dividends is a must to invest. Even if you spend your dividend income each year, your dividend income still increases. For example in 2004 Coca-Cola sold for 20-21 times earnings and yielded close to 2.50%. Since then the dividend income would have more than doubled by now, rising from 50 cents/share in 2004 to $1.22/share by 2014. Historically, dividends per share on US stocks have grown by 5%- 6%/year. This has beaten inflation, and ensured that the purchasing power of your passive income is maintained.

3) Dividend reinvestment

Another important component to grow income is the power of dividend reinvestment. Let’s assume a scenario where you have a company that yields 3% today, which manages to grow dividends by 7%/year and you spend all your dividend income. In this case, using the rule of 72, you will end up with double the dividend income in a decade. However, if you decided to reinvest those dividends into more shares yielding 3% and growing dividends by 7%/year, your dividend income will double in approximately seven years. It is important to treat reinvestment carefully however, and be mindful of valuations when doing so. In some cases, it might only be cost effective to automatically reinvest dividends, particularly if the position is only a few hundred dollars for example. In other cases however, it might be preferable to accumulate cash dividends for a month, and then put that amount to work in your best ideas at the time. This would work if you generate $600 - $800/month in dividend income.

4) Tax advantaged growth

Two things in life are certain – death and taxes. Investors who receive dividend income and are in the 25% tax bracket have to pay 15% tax on qualified dividend income. This reduces the amount of money one can feed their dividend machine. In order to reduce the effects of this obstacle, many dividend investors place their stocks in tax-advantaged accounts like Roth IRA’s. As a result, their dividends grow tax free, and therefore they could reinvest the whole amount into more dividend paying shares. If you are in the 15% tax bracket however, this means your qualified dividend income is essentially tax free.

The four points discussed above could be best illustrated by a small investment I made in Kinder Morgan Energy Management LLC (KMR) in 2009. This was one of the smartest investments I ever did, and hit the four points perfectly. I was bullish on the Kinder Morgan Partnership (KMP), which was a dividend achiever that offered sustainable current yield, and high distributions growth. I liked the prospect for high distributions growth and high current yields. However, I noticed that KMR was selling at a discount to KMP. KMR was equivalent to KMP in every single economics way, with the only exception being that it paid distributions in additional shares, and not in cash. Some investors disliked this idea, which explained why KMR was always cheaper by 5%-10%. In addition, since the distributions were payable in additional shares of KMR, this meant that IRS saw them as stock splits and considered them tax-free as long as the investor held on to shares. I thought of buying up KMR since I am in the accumulation phase, and then if the gap narrowed to sell and buy the limited partnership units and live off those distributions. For each dollar invested in August 2009, with distributions being reinvested tax-free at KMR that was selling at a massive discount, I ended up with approximately $2.80. Thus, an investment of $1000 back then would have turned into approximately $2800 today. Once the acquisition by Kinder Morgan Inc (KMI) is performed, and each of my shares of KMR is exchanged for 2.4849 shares of Kinder Morgan Inc, this small investment will result in an yield on cost of over 13% at the current rate of $1.76/share. At the $2/share annual dividend that is expected by Kinder Morgan Inc in 2015, that $1,000 investment in 2009 will generate close to $150 or a 15% yield on the amount invested. Not too shabby if you ask me.

As we all know however, Kinder Morgan Management LLC (KMR) is about to stop trading, since its shares will be exchanged for shares in Kinder Morgan Inc (KMI).

A recent example was the purchase of shares in several companies in tax-advantaged accounts such as Roth IRA and Sep IRA. I plan on maxing out the Roth IRA in 2015, and the SEP IRA, along with the 401 (k) and a newly started Health Savings Account. When you get the powers of compounding withing a tax-deferred vehicle, the results are truly spectacular.

Full Disclosure: Long KMR, KMI, KO,

Relevant Articles:

- Kinder Morgan to Merge Partnerships into One Company
Kinder Morgan Limited Partners Could Face Steep Tax Bills
Kinder Morgan Partners – One Company three ways to invest in it
How to buy Kinder Morgan at a discount
Two and a half purchases I made this week

Wednesday, March 25, 2009

Using DRIPs for faster compounding of dividends

Dividends have historically contributed 35% - 40% of annual total returns over the past century. Re-invested dividends however are touted to have provided 97% of S&P 500 total returns between 1871 and 2008.

The main pro of dividend reinvestment is that you get the power of compounding in your favor. If you have also picked a solid stock that tends to increase the payments to stockholders every year you are essentially turbo charging your portfolio for the long run and should expect to receive even faster annual dividend raises.

There is another way to compound your dividends to the third degree using dividends reinvestment plans (DRIPs) which allow participants to reinvest the cash dividends in additional shares of common stock at a discount. Drips are a nice low cost way to purchase dividend stocks and build a stock portfolio. These programs allow investors to purchase shares in two ways either through reinvesting dividends or with optional cash payments that can be sent to the companies you want to invest in. One benefit of drips is that they allow dividend reinvestment in partial shares. Check out my recent review of DRIPs.

The most valuable benefit of drips is that some allow reinvesting your dividends by purchasing shares at a discount to the market price. This is an inexpensive way for these companies to raise capital.

I have provided a sample list of dividend reinvestment plans, which allow participants to reinvest the cash dividends in additional shares of common stock at a discount. It’s not a recommendation to purchase however:

If you are aware of any other drips offering a discount on dividend reinvestment, please add your comment below.

It’s interesting to note that most major companies that offer discount on dividend reinvestment plans are Canadian. Major banks such as Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Toronto-Dominion Bank (TD) and Royal Bank of Canada (RY) dominate the list. Canadian Income Trusts such as Pengrowth Energy Trust (PGH), Penn West Energy Trust (PWE) and Harvest Energy Trust (HTE) also reward shareholders with reinvesting their dividends by purchasing shares at 5% discount to the market price.
Few US companies are currently offering discounts on dividend reinvestment through their DRIPs. With the credit crunch I would expect companies to provide an additional incentive for shareholders to keep reinvesting their dividends through the company’s plan in order to have an easy way to finance operations.

It is important to understand however that these discount prices could be determined differently in different drips. Thus always consult the plan documentation for further details concerning specific DRIPs. Buying stocks just for the dividend reinvestment discount shouldn’t be the main reason behind the purchase. Always analyze each individual stock before investing in it.

Full Disclosure: Long TD

This post was featured on Spring Has Sprung - Carnival of Personal Finance #199.

Relevant Articles:

- Are Drips Worth It?
- Should you re-invest your dividends?
- The Rule of 72
- Why dividends matter?

Friday, October 3, 2008

Are Drips Worth It?

This article originally appeared on The DIV-Net September 26, 2008.

The abbreviation DRIP stands for dividend reinvestment plans. Drips are a nice low cost way to purchase dividend stocks and build a stock portfolio. These programs allow investors to purchase shares in two ways either through reinvesting dividends or with optional cash payments that can be sent to the companies you want to invest in. One benefit of drips is that they allow dividend reinvestment in partial shares. Another benefit of other drips is that some allow reinvesting your dividends by purchasing shares at a discount to the market price. Two such companies that I am aware of that do this are ACAS and NNN. Below you can also check my analysis of ACAS and NNN.

One of the issues with drips is that in order to participate in the DRIP you must already have purchased one share of the company stock. Some companies have overcome that hurdle for shareholders by letting people make a direct purchase in their stock. Stocks like GE or XOM are good examples of direct purchase plans with reinvestment plans.

Another problem with drips however is that you do not have the execution speed like you do when you purchase shares through a broker. If you want to buy or sell shares at the current market price, you can’t do it. In addition to that, despite the fact most drip plans allow charge low or no fees for purchasing additional shares or reinvesting your dividends, most drips have high initial set-up fees.

Another issue that I have with drips is availability. Not all companies offer drips, so you might have to use a stock broker after all.

From a tax perspective drip Investors must track their cost of shares to be used to calculate capital gains tax when shares are sold. In addition to that very few dividend reinvestment plans allow you to hold stocks in an IRA DRIP, which allows for a tax free compounding of your dividends. Examples of non-taxable dividend reinvestment plans include XOM, which offers both traditional and ROTH IRA dividend reinvestment plans.

From a diversification perspective a drip investor has to enroll in as many plans as the number of individual companies he or she plans to invest in. This would a be very inefficient way to keep track of your investments.

The main positive of drips is the fact that one can start with a small amount of money, typically enough to buy one share of stock. DRIPs also allow novice investors to dollar cost average small amounts of money each month without getting killed on the brokerage commissions. The automatic dividend reinvestment comes in handy as if allows you to simply set up your drip with a company and then its all automatically invested into additional shares, while you take full advantage of the power of compounding.

So what is a good alternative to dividend reinvestment plans?

Most brokers allow you to purchase stock in any company that is traded on the NYSE, NASDAQ, AMEX and the OTC markets by charging you a small commission for that. After that however most brokerages do not charge any additional fees if you decide to reinvest your dividends. Some brokers like Sharebuilder allow you to reinvest your dividend by purchasing fractional shares, which accelerates the power of compounding in your favor. In addition to that, I would prefer having my entire dividend portfolio concentrated in one or two places as opposed to having it spread out among thirty different reinvestment plans. Most brokers also keep much more detailed information of your transactions activity in one place, compared to drip plans, which definitely helps during tax time.

And last but not least it is much easier to open a retirement account at a stock broker for a small fee, without being limited to the small number of drips inside an IRA out there.

DivGuy and Get Rich Slowly have both published some insightful articles on DRIPs. Check them out.

Relevant Posts:

- Why dividends?
- Why dividends matter?
- My Dividend Growth Plan - Strategy
- When to sell your dividend stocks? Part 2

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