Dividend Re-Investment Plans are an excellent program for an investor to build up a nominal position in a company over time. They allow an investor to opt out of cash dividends in favour of distributions that are composed of more stock. If the stock is expected to rise more over the longer term, this arguably increases the value of the dividend to the investor, as it provides a form of time value.
Additionally, it is a cheaper dividend for the company to issue, which therefore results in a better cash position for the company to invest in continued growth, as opposed to having to spend money on cash dividends. However, while DRIP programs are fantastic in bull markets, they have the ability to be self-destructive if left unchecked.
As a DRIP program issues more and more shares for a company, it incrementally dilutes the value of the non-participating positions by increasing the total float of equity outstanding. While this is not really an issue if every investor is participating in the DRIP program, and therefore increasing their holdings at an equal rate to the rate of growth of the total float, it creates a bubble-like situation with the outstanding equity issued. Think about it, you’ve got every single shareholder geometrically increasing the value of their positions against all of the other holdings in their portfolios. What happens when some of these investors start taking chips off the table?
The biggest draw-back to a DRIP program is that it starts to fall apart once the expectations for growth with a company begin to decline. Investors accept equity dividends because they believe that they value of the positions will increase. However, once the value of the stock is expected to decline, investors will immediately begin to opt for the cash dividend option. Since a cash dividend has a greater impact on a company’s ability to grow, it has a detrimental impact on the expectations associated with the equity itself. See where this is going?
Investors will suddenly jump to the cash dividend, further diluting their capital positions. The end result is very similar to capital flight. Investors switch to cash dividends, and slowly become diluted out by larger holders like funds and insiders. As they are diluted out, they lose more confidence in the holding and begin to sell, causing the price to drop further, and thus further reduce the expectations associated with the company.
Most unfortunate of all, is that not much of this volatility actually has much to do with the actual ability of the company to perform. Instead, it has to do with an over-dilution of equity holdings, and an unrealistic market expectation of technical performance that has been supported by the dilution itself.
That being said, DRIPs aren’t necessarily a bad thing. In fact, under proper supervision, they are an excellent venue for generating yields above 5%, and to build into a position over time without having to spend lots of money. In the next article, I’ll go into detail about a couple of tips you can use to manage DRIP-friendly positions.