Last week, I discussed the fact that most investors who purchase dividend-paying stocks don't actually need the income but simply invest in these companies for the low-risk yet market-beating potential that they provide.
Indeed, investors who don't need to tap into their dividend dollars are in a position to reap tremendous rewards from dividend reinvestment. Though dividends themselves can certainly add a sizable boost to your total returns, using your dividends to accumulate additional shares can lead to downright phenomenal growth.
Compound your compounding
Consider this: As I've mentioned before, dividends have accounted for a substantial 42% of the S&P 500's total return since 1926. However, for those who chose to funnel their checks right back into additional shares, dividends accounted for nearly two-thirds of their total return.
Need more? Over the past 30 years, the cumulative return of the S&P 500 has been about 675% excluding dividends. Would you like to hazard a guess as to the cumulative return for the same period assuming dividends were reinvested? Try a touch more than 2,000%. That's nearly three times the return, and you received it simply by investing in dividend payers and reinvesting those payouts.
As subscribers of my dividend-oriented investment newsletter, Motley Fool Income Investor, can attest, I try to close each stock recommendation by sharing the details of its respective dividend reinvestment plan or direct stock purchase plan -- if it has one.
So, how can you transform the return figures mentioned above into reality for your portfolio? Let's jump into the pros and cons of dividend reinvestment plans -- often called Drips -- and find out.
The lowdown
Drip plans constitute the closest thing to getting your shares "straight from the tap." There are basically two types: dividend reinvestment plans (DRPs) and direct stock purchase plans (DSPs). They are often virtually identical except for one notable feature: Whereas DRPs typically require that you already be a shareholder in order to participate, DSPs allow you to purchase your first shares directly through the plan. This feature can save you quite a bit of time and hassle, as the DRP process often entails buying your shares through a broker, having the stock certificate issued, and then mailing the certificate to the DRP administrator.
Both plans are designed to allow investors to begin investing relatively small initial sums. You then have the option to amass a more significant position over time via low- or no-cost optional cash payments, which can typically be made monthly or as often as you can afford.
Though these accounts can be a desirable choice for any investor, they tend to be ideal especially for those just getting started. If you'd like to introduce your children or grandchildren to the benefits of investing in, say, Disney (NYSE:DIS) or McDonald's (NYSE:MCD), you'd be hard-pressed to find a better way.
They're also perfect for college students. Indeed, I started my first Drip plan as a student living off croutons and ramen noodles. Dividend reinvestment and regular cash purchases allowed me to build a position slowly and steadily over the years -- of course, as broke as I was, the emphasis there is on slowly.
Making the call
Plans have increased in number and have improved quite a bit since those bygone days. However, the number of plans that charge fees I consider prohibitive has also grown.
So, what to consider when evaluating a plan? Beyond choosing a stock you're comfortable investing in for a very long time, there are three things to mull over when choosing which Drip is right for you: fees and commissions, breadth of services provided, and fees and commissions. Oh, wait. You should also pay close attention to fees and commissions. (I guess that makes four things -- my mistake.)
I think you get the idea. Drips used to be a no-brainer back when the fees and commissions charged by full-service brokers virtually guaranteed you'd be saving money. However, the proliferation of discount brokerages - and the free dividend reinvestment many of them provide -- has made this a much closer race.
Consequently, if you're looking at a Drip that charges a $5 service fee for optional cash payments plus a 2% fee for dividend reinvestment -- and you're paying only $8 per trade at your discount broker that also offers free dividend reinvestment -- you may be better off avoiding the Drip.
Remember that you don't get to choose your price when investing via this plan. Rather, you receive the aggregate price of all shares purchased by the plan during the given time period. If there's only a modest difference in cost, many investors will opt to stick with their discount broker, which allows them to maintain control over their purchase price and avoid the need to open multiple accounts with various companies.
Cream of the crop
Still, there are some situations where Drips continue to win hands down. Out of the approximate 1,500 companies that now offer Drips, about 200 give you the option of making regular cash contributions via automatic bank draft and, even better, more than 100 plans allow participants to purchase additional shares at a discount to the market price -- ranging from 1% to 10%. That benefit allows you to achieve considerable gains over what could be accomplished by investing through a traditional broker.
The Foolish bottom line
Ideally, your favorite companies will offer DSPs with no fees or commissions, and possibly even discounted purchases. But even if they don't quite reach that level of excellence, you should be fine as long as you keep an eye on those fees.
Basically, we're looking at a two-step process here. First, you have to find a company that you're going to be comfortable investing in for what's likely to be a very long time period. Second, you have to do your homework and make sure the firm's Drip doesn't droop. It sounds simple enough, but be sure you treat these as separate steps because there are plenty of great companies with mediocre Drips out there.
Take PepsiCo (NYSE:PEP), for instance -- a great company with excellent long-term growth prospects and a solid 1.8% dividend yield. However, though it's certainly not the worst I've seen, I expected more from Pepsi on the Drip front. Here's a company that's on the cutting edge of innovation in nearly everything it does, yet its Drip can't handle automated bank drafts (i.e., you have to write a check and lick a stamp in order to make optional cash payments). A vanguard firm with a Stone Age Drip is always a bummer.
Even if you're not looking for that quarterly paycheck, don't underestimate the power of dividend reinvestment. Harness this key growth enhancer for your portfolio, and start compounding your compound returns.
Fool on!
In addition to picking market-beating dividend stocks, Mathew Emmert can make 20-minute brownies in 10 minutes. He is the editor and chief analyst of Motley Fool Income Investor, and he owns shares of Disney and PepsiCo. The Fool has an ironcladdisclosure policy.
