Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part IV. Investment Strategies and Tactics

Chapter 19. Getting a Handle on DPPs, DRPs, and DCA ... PDQ

IN THIS CHAPTER

Buying stock directly from a company

Looking at dividend reinvestment plans

Using dollar cost averaging

Who says you must buy 100 shares of a stock to invest? And who says that you must buy your stock only from a broker? (There goes that little voice in my head… .) Can you buy direct instead? What if you only want to put your toe in the water and buy just one share for starters? Can you do that without paying through the nose for transaction costs, such as commissions?

The answer to these questions is that you can buy stocks directly (without a broker) and save money in the process. That’s what this chapter is about. In this chapter, I show you how direct purchase programs (DPPs) and dividend reinvestment plans (DRPs) make a lot of sense for long-term stock investors, and I show how you can do them on your own — no broker necessary. I also show you how to use the method of dollar cost averaging (DCA) to acquire stock, a technique that works especially well with DRPs. All these programs are well-suited for people who like to invest small sums of money and plan on doing so consistently in the same stock (or stocks) over a long period of time.

Don’t invest in a company just because it has a DPP or DRP. DPPs and DRPs are simply a means for getting into a particular stock with very little money. They shouldn’t be a substitute for doing diligent research and analysis on a particular stock.

Going Straight to Direct Purchase Programs

If you’re going to buy a stock anyway, why not buy it directly from the company and bypass the broker (and commissions) altogether? Several hundred companies now offer direct purchase programs (DPPs), also called direct investment programs (DIPs), which give investors an opportunity to buy stock directly from these companies. In the following sections, I explain the steps required for investing in a DPP, describe alternatives to DPPs, and warn you of a few minor DPP drawbacks.

DPPs give investors the opportunity to buy stock with little upfront money (usually enough to cover the purchase of one share) and usually no commissions. Why do companies give investors this opportunity? For their sake, they want to encourage more attention and participation from investors. For your purposes, however, a DPP gives you what you may need most: a low-cost entry into that particular company’s dividend reinvestment plan, or DRP (which you can read more about in the section “Delving into Dividend Reinvestment Plans,” later in this chapter).

Investing in a DPP

If you have your sights set on a particular company and have only a few bucks to start out, a DPP is probably the best way to make your initial investment. The following steps guide you toward your first stock purchase using a DPP:

1. Decide what stock you want to invest in (I explain how to do so in Parts 2 and 3) and find the company’s contact information.

Say that you do your homework and decide to invest in Yumpin Yimminy Corp. (YYC). You can get YYC’s contact information through the stock exchange YYC trades on (or at the company’s website). For example, if YYC trades on the New York Stock Exchange, you can call the NYSE and ask for YYC’s contact information, or you can visit the NYSE’s website (www.nyse.com). So, you can contact the NYSE to reach YYC for its DPP ASAP. OK?

2. Find out whether the company has a DPP (before it’s DOA!).

Call YYC’s shareholder services department and ask whether it has a DPP. If it does, great; if it doesn’t, ask whether it plans to start one. At the very least, it may have a DRP. If you prefer, you can check out the company’s website because most corporate websites have plenty of information on their stock purchase programs.

3. Look into enrolling.

The company will send you an application along with a prospectus — the program document that serves as a brochure and, hopefully, answers your basic questions. Usually, the enrollment forms are downloadable from the company’s website.

The processing is typically handled by an organization that the company designates (known as the plan administrator). From this point forward, you’re in the dividend reinvestment plan. The DPP acts as the entry point to the DRP so that you make future purchases through the DRP.

Finding DPP alternatives

Although several hundred companies offer DPPs, the majority of companies don’t. What if you want to invest in a company directly and it doesn’t have a DPP? The following sections present some alternatives.

Buying your first share through a broker to qualify for a DRP

Yes, buying your first share through a broker costs you a commission; however, after you make the purchase, you can contact that company’s shareholder services department and ask about its DRP. After you’re an existing stockholder, qualifying for the DRP is a piece of cake.

To qualify for the DRP, you must be on the book of record with the transfer agent. A book of record is simply the database the company uses to track every single outstanding share of stock and the stock’s owner. The transfer agent is the organization responsible for maintaining the database. Whenever stock is bought or sold, the transfer agent must implement the change and update the records. In many cases, you must have the broker issue a stock certificate in your name after you own the stock. Getting a stock certificate is the most common way to get your name on the book of record, hence qualifying you for the DRP.

Sometimes, simply buying the stock isn’t enough to get your name on the book of record. Although you technically and legally own the stock, brokers, for ease of transaction, often keep the stock in your account under what’s referred to as a street name. (For instance, your name may be Jane Smith, but the street name can be the broker’s firm name, such as Jones & Co., simply for administrative purposes.) Having the stock in a street name really doesn’t mean much to you until you want to qualify for the company’s DRP. Be sure to address this point with your broker. (Flip to Chapter 7 for more details on brokers.)

Getting started in a DRP directly through a broker

These days, more brokers offer the features of the DRP (like compounding interest) right in the brokerage account itself, which is more convenient than going to the trouble of setting up a DRP with the company directly. This service is most likely a response to the growing number of long-term investors who have fled traditional brokerage accounts for the benefits of direct investing that DPPs and DRPs offer.

The main drawback of a broker-run DRP is that it doesn’t usually allow you to make stock purchases through optional cash payments without commission charges (a big negative!). See the section “Building wealth with optional cash payments,” later in this chapter, for more on this topic.

Purchasing shares via alternate buying services

Organizations have set up services to help small investors buy stock in small quantities. The primary drawback to these middlemen is that you’ll probably pay more in transaction costs than you would if you approached the companies directly. Check out the most prominent services, which include the following:

· DRIP Central at www.dripcentral.com

· First Share at www.firstshare.com

· National Association of Investors Corporation at www.betterinvesting.org

· ShareBuilder at www.sharebuilder.com

Recognizing the drawbacks

As beneficial as DPPs are, they do have some minor drawbacks (doesn’t everything?). Keep the following points in mind when considering DPPs as part of your stock portfolio:

· Although more and more companies are starting to offer DPPs, relatively few (approximately 600) companies have them.

· Some DPPs require a high initial amount to invest (as much as $250 or more) or a commitment of monthly investments. In any case, ask the plan administrator about the investing requirements.

· A growing number of DPPs have some type of service charge. This charge is usually very modest and lower than typical brokerage commissions. Ask about all the incidentals — such as getting into the plan, getting out, and so on — that may trigger a service charge.

Delving into Dividend Reinvestment Plans

Sometimes, dividend reinvestment plans (DRPs) are called “DRIPs,” which makes me scratch my head. “Reinvestment” is one word, not two, so where does that “I” come from? But I digress. Whether you call them DRIPs or DRPs, they’re great for small investors and people who are truly long-term investors in a particular stock. A company may offer a DRP to allow investors to accumulate more shares of its stock without paying commissions.

A DRP has two primary advantages:

· Compounding: The dividends (cash payments to shareholders) get reinvested and give you the opportunity to buy more stock.

· Optional cash payments (OCPs): Most DRPs give participants the ability to make investments through the plan for the purpose of purchasing more stock, usually with no commissions. The OCP minimum for some DRPs is as little as $25 (or even nothing).

Here are the requirements to be in a DRP:

· You must already be a stockholder of that particular stock.

· The stock must be paying dividends (you had to guess this one!).

In the following sections, I go into more detail on compounding and OCPs, explain the cost advantages of using DRPs, and warn you of a few drawbacks.

As technology (the Internet and so on) changes and improves, it becomes easier to participate in programs like DRPs because most brokerage firms now make it easier to participate right inside your brokerage account.

Getting a clue about compounding

Dividends are reinvested, offering a form of compounding for the small investor. Dividends buy more shares, in turn generating more dividends. Usually, the dividends don’t buy entire shares but fractional ones.

For example, say that you own 20 shares of Fraction Corp. at $10 per share for a total value of $200. Fraction Corp.’s annual dividend is $1, meaning that a quarterly dividend of 25 cents is issued every three months. What happens if this stock is in the DRP? The 20 shares generate a $5 dividend payout in the first quarter (20 shares multiplied by 25 cents), and this amount is applied to the stock purchase as soon as it’s credited to the DRP account (buying you half of a share). If you presume for this example that the stock price doesn’t change, the DRP has 20.5 total shares valued at $205 (20.5 shares multiplied by $10 per share). The dividend payout isn’t enough to buy an entire share, so it buys a fractional share and credits that to the account.

Now say that three months pass and that no other shares have been acquired since your prior dividend payout. Fraction Corp. issues another quarterly dividend for 25 cents per share. Now what?

· The original 20 shares generate a $5 dividend payout.

· The 0.5, or half share, in the account generates a 12.5-cent dividend (half the dividend of a full share because it’s only half a share).

· The total dividend payout is $5.125 (rounded to $5.13), and the new total of shares in the account is 21.01 (the former 20.5 shares plus 0.513 share purchased by the dividend payout and rounded off; the 0.513 fraction was gained by the cash from the dividends). Full shares generate full dividends, and fractional shares generate fractional dividends.

To illustrate my point easily, the preceding example uses a price that doesn’t fluctuate. In reality, stock in a DRP acts like any other stock — the share price changes constantly. Every time the DRP makes a stock purchase, whether it’s monthly or quarterly, the purchase price will likely be different.

Building wealth with optional cash payments

Most DRPs (unless they’re run by a broker) give the participant the opportunity to make optional cash payments (OCPs), which are payments you send in to purchase more stock in the DRP. DRPs usually establish a minimum and a maximum payment. The minimum is typically very modest, such as $25 or $50. A few plans even have no minimum. This feature makes it very affordable to regularly invest modest amounts and build up a sizable portfolio of stock in a short period of time, unencumbered by commissions.

DRPs also have a maximum investment limitation, such as specifying that DRP participants can’t invest more than $10,000 per year. For most investors, the maximum isn’t a problem because few would typically invest that much anyway. However, consult with the plan’s administrator because all plans are a little different.

OCPs are probably the most advantageous aspect of a DRP. If you can invest $25 to $50 per month consistently, year after year, at no (or little) cost, you may find that doing so is a superb way to build wealth.

OCPs work well with dollar cost averaging (DCA). Find out more in the upcoming section “The One-Two Punch: Dollar Cost Averaging and DRPs.”

Checking out the cost advantages

In spite of the fact that more and more DRPs are charging service fees, DRPs are still an economical way to invest, especially for small investors. The big savings come from not paying commissions. Although many DPPs and DRPs do have charges, they tend to be relatively small (but keep track of them because the costs can add up).

Some DRPs actually offer a discount of between 2 and 5 percent (a few are higher) when buying stock through the plan. Others offer special programs and discounts on the company’s products and services. Some companies offer the service of debiting your checking account or paycheck to invest in the DRP. One company offered its shareholders significant discounts to its restaurant subsidiary. In any case, ask the plan administrator because any plus is, well, a plus.

Weighing the pros with the cons

When you’re in a DRP, you reap all the benefits of stock investing. You get an annual report, and you qualify for stock splits, dividend increases, and so on. But you must be aware of the risks and responsibilities.

So before you start to salivate over all the goodies that come with DRPs, be clear-eyed about some of their negative aspects as well. Those negative aspects include the following:

· You need to get that first share. You have to buy that initial share in order to get the DRP started (but you knew that).

· Even small fees cut into your profits. More and more DRP administrators have added small fees to cover administrative costs. Find out how much they are and how they’re transacted to minimize your DRP costs. The more costs you incur, of course, the more your net profit will be diminished over time.

· Many DRPs may not have added services that you may need. For example, you may want to have your DRP in a vehicle such as an Individual Retirement Account (IRA). (Chapter 21 offers more information on IRAs.) Many investors understand that a DRP is a long-term commitment, so having it in an IRA is an appropriate strategy. Some administrators have the ability to set up your DRP as an IRA, but some don’t, so you need to inquire about this.

· DRPs are designed for long-term investing. Although getting in and out of the plan is easy, the transactions may take weeks to process because stock purchases and sales are typically done all at once on a certain day of the month (or quarter).

· You need to read the prospectus. You may not consider this a negative point, but for some people, reading a prospectus is not unlike giving blood by using leeches. Even if that’s your opinion, you need to read the prospectus to avoid any surprises, such as hidden fees or unreasonable terms.

· You must understand the tax issues. There, ya see? I knew I’d ruin it for you. Just know that dividends, whether or not they occur in a DRP, are usually taxable (unless the DRP is in an IRA, which is a different matter). I cover tax issues in detail in Chapter 21.

· You need to keep good records. Keep all your statements together and use a good spreadsheet program or accounting program if you plan on doing a lot of DRP investing. These records are especially important at tax time, when you have to report any subsequent gains or losses from stock sales. Because capital gains taxes can be complicated as you sort out short-term versus long-term capital gains on your investments, DRP calculations can be a nightmare without good record-keeping.

MOVING MONEY OUT OF DRPS TO PAY OFF DEBT

DRPs are a great way to accumulate a large stock holding over an extended period of time. Moreover, think about what you can do with this stock. Say that you accumulate 110 shares of stock, valued at $50 per share, in your DRP. You can, for example, take out $5,000 worth of stock (100 shares at $50 per share) and place those 100 shares in your brokerage account. The remaining 10 shares can stay in your account to keep the DRP and continue with dividend reinvestment to keep your wealth growing. Why remove those shares?

All things being equal, you’re better off keeping the stock in the DRP, but what if you have $2,500 in credit card debt and don’t have extra cash to pay off that debt? Brokerage accounts still have plenty of advantages, such as, in this example, the use of margin (a topic I discuss in detail in Chapter 17). If your situation merits it, you can borrow up to 50 percent of the $5,000, or $2,500, as a margin loan and use it to pay off that credit card debt. Because you’re replacing unsecured debt (credit card debt that may be charging 15 percent, 18 percent, or more) with secured debt, you can save a lot of money (borrowing against stock in a brokerage account is usually cheaper than credit card debt). Another benefit is that the margin loan with your broker doesn’t require monthly payments, as do the credit card balances. Additionally, ask your tax consultant about potential tax benefits — investment interest expense is deductible, but consumer credit card debt is not.

The One-Two Punch: Dollar Cost Averaging and DRPs

Dollar cost averaging (DCA) is a splendid technique for buying stock and lowering your cost for doing so. The example in Table 19-1 shows that it’s not uncommon for investors to see a total cost that reflects a discount to the market value. DCA works especially well with DRPs.

Table 19-1 Dollar Cost Averaging (AE)

DCA is a simple method for acquiring stock. It rests on the idea that you invest a fixed amount of money at regular intervals (monthly, usually) over a long period of time in a particular stock. Because a fixed amount (say, $50 per month) is going into a fluctuating investment, you end up buying less of that stock when it goes up in price and more of it when it goes down in price. Your average cost per share is usually lower than if you were to buy all the shares at once.

DCA is best presented with an example. Say you decide to get into the DRP of the company Acme Elevator, Inc. (AE). On your first day in the DRP, AE’s stock is at $25, and the plan allows you to invest a minimum of $25 through its optional cash purchase (OCP) program. You decide to invest $25 per month and assess how well (hopefully) you’re doing six months from now. Table 19-1 shows how this technique works.

To assess the wisdom of your decision to invest in the DRP, ask yourself some questions:

· How much did you invest over the entire six months? Your total investment is $150. So far, so good.

· What’s the first share price for AE, and what’s the last share price? The first share price is $25, but the last share price is $20.

· What’s the market value of your investment at the end of six months? You can easily calculate the value of your investment. Just multiply the number of shares you now own (8.03 shares) by the most recent share price ($20). The total value of your investment is $160.60.

· What’s the average share price you bought at? The average share price is also easy to calculate. Take the total amount of your purchases ($150) and divide it by the number of shares you acquired (8.03 shares). Your average cost per share is $18.68.

Be sure to take note of the following:

· Even though the last share price ($20) is lower than the original share price ($25), your total investment’s market value is still higher than your purchase amount ($160.60 compared to $150)! How can that be? You can thank dollar cost averaging. Your disciplined approach (using DCA) overcame the fluctuations in the stock price to help you gain more shares at the lower prices of $17.50 and $15.

· Your average cost per share is only $18.68. The DCA method helped you buy more shares at a lower cost, which ultimately helped you make money when the stock price made a modest rebound.

DCA not only helps you invest with small sums but also helps you smooth out the volatility in stock prices. These benefits help you make more money in your wealth-building program over the long haul. The bottom line for long-term stock investors is that DCA is a solid investing technique, and DRPs are a great stock investment vehicle for building wealth. Can you visualize that retirement hammock yet?

Dollar cost averaging is a fantastic technique in a bull market and an okay technique in a flat or sideways market, but it’s really not a good consideration during bear markets because the stock you’re buying is going down in price, and the market value can very easily be lower than your total investment. If you plan on holding on to the stock long term, then simply cease your DCA approach until times improve for the stock (and its industry, and the economy).