Dividend Reinvestment Plans
How much do you like paperwork?

by Ann Coleman (TMF AnnC)

Reston, VA (April 28, 1999) -- Another day and the Foolish Four tacks on a few more percentage points. Ho, hum. Even 3M (NYSE: MMM) is moving right along. Just for fun, ever wonder what would happen if the Foolish Four kept up this pace for the rest of the year?

OK, I'll tell you, but keep in mind that this never happens. Right now we are up around 32% (I haven't seen the final figures, but they are right here for you.) By anyone's standards, this would be a good year if we never made another penny. (So, should you sell now or stand pat?) But what if we continued to grow at that rate? Well, if nothing else, this frivolous exercise should serve to illustrate the power of compounding.

Right now we are up around 32% in 4 months, or one-third of a year. You might conclude that since by the end of the year we would have had two more such periods, we would be up by around 96%. Wrong! If the Foolish Four continued to grow at its present rate, by the end of this year we would be up 125%. That's the power of compounding. The money you make makes more money.

Speaking of compounding, I get a fair number of questions from Fools eager to put their dividends to work as soon as possible so that they can take advantage of compounding immediately.

As you may know, we recommend that dividends be held in your brokerage account until the end of the year, at which time they are invested in the next year's stocks along with cash contributions and proceeds from the sale of any stocks that are not being renewed.

But the lure of dividend reinvestment plans exerts a strong pull on some folks. Just letting those dividends sit around idle all year seems to strike them as plumb sinful. Why not reinvest those dividends in the company that paid them and put them right to work?

You can do that. And you would probably improve your returns a bit. But man, oh man, you'd better like paperwork.

There are two ways to accomplish dividend reinvestment. Some brokers will reinvest your dividends for you at no charge. Let's look at them first. Those that I am aware of are the ones that already charge $25 to $40 per trade. If you compare that with a deep discount brokers at $7 to $15 a trade, you can see how they can afford to be so generous. By all means, if you are using such a broker for other reasons, then taking advantage of its dividend reinvestment plan might make sense. Choosing a broker on that basis alone doesn't make sense to me. One other caveat -- it really only makes sense if your account is tax sheltered. More about that in a minute.

The second way to reinvest your dividends is to sign up with various companies' Dividend Reinvestment Plans. You buy a share or a thousand, and the company automatically reinvests your dividends AND lets you buy additional shares (or sell some) for free or for a very modest fee. This is a wonderful idea -- such a wonderful idea that we created a Drip Portfolio to illustrate just how the process works.

But how does it work for the Foolish Four?

Not very well.

For one thing, the Foolish Four strategy assumes that you run your numbers and select your stocks then buy them before the prices change very much. With most DRPs, that is just not possible.

Starting from scratch, it takes a good six weeks to set up a DRP. By then, at least some of the stocks you have targeted are likely to be off the list. Even if you have DRPs set up in advance with most Dow companies, the plans usually only buy stocks one or two times a month. You have essentially no control over your purchase price. The only way that makes any sense at all is to set the DRP up after you buy your Foolish Four stocks. But then you've paid both commission on the purchase and the fees to set up the account. Bummer.

Then there is the tax question. Most DRPs do not provide IRA custodial service, so the accounts are subject to capital gains taxes. Imagine this: You buy a Foolish Four stock in a DRP and hold it for (let's make it easy for you) two years. During that time, you dividends have been faithfully reinvested in the stock. Now you sell. Your initial purchase and the first year's worth of dividends are long-term capital gains, but the dividends from the second year are short-term gains. Not only do you have to pay higher taxes on them, you have to account for each type of purchase separately.

But it gets worse. Suppose the stock splits. Now, when you sell, you will have to calculate the cost basis for the pre-split shares and the post-split shares. And heaven help you if you don't have all your records!

Remember that the Foolish Four strategy does reinvest dividends. They are only held in your account as cash for 6 months or so. If you have a huge account, it might make sense to reinvest them immediately, but for $20 worth of dividends, I really don't see it.

Outside of your Foolish Four portfolio, DRPs may make sense, especially those that offer stock at a discount -- as long as you don't mind the paperwork.

Some naturally organized people are very happy to do all the paper pushing that dividend reinvestment requires. (Not me personally -- as you may have guessed.) If you are looking to build up a stake gradually in a solid company, perhaps the one you are working for, DRPs can't be beat. But I don't see much room for them within your Foolish Four portfolio.

Fool on and prosper!

The Fool is hiring. Answer the call.

 Recent Foolish Four Portfolio Headlines
  12/28/00  Modifying Mechanical Strategies
  12/27/00  Beating the S&P Year 2000 Recap
  12/26/00  After-Hours Quotes
  12/22/00  Why Include the Foolish 4 Port?
  12/21/00  The Value of Community Input
Foolish Four Portfolio Archives »  

Today's Stock Lists | 1999 Dow Returns

04/28/99 Close
Stock  Change   Last
CAT  +1        64.56
JPM  -1 15/16  135.81
MMM  +3 11/16  84.50
IP   +1  5/8   57.38

                Day   Month    Year   History
        FOOL-4   +1.81%  26.35%  29.94%  31.87%
        DJIA     +0.13%  10.82%  18.51%  18.04%
        S&P 500  -0.87%   5.02%  10.22%  10.48%
        NASDAQ   -2.00%   3.60%  16.31%  17.90%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     64.56    49.87%
 12/24/98   22 Int'l Paper   43.55     57.38    31.75%
 12/24/98    9 JP Morgan    105.51    135.81    28.72%
 12/24/98   14 3M            73.57     84.50    14.86%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1549.50   $515.50
 12/24/98   22 Int'l Paper  958.12   1262.25   $304.13
 12/24/98    9 JP Morgan    949.62   1222.31   $272.69
 12/24/98   14 3M          1030.00   1183.00   $153.00

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5274.77