For decades, the best option for growing returns from investments – especially shares – was to take part in the company’s dividend reinvestment plan (DRP). Many people still swear by this form of passive investment. But while it is enforced saving, it does not guarantee success.
The problem with DRP
Recently the goal posts have changed, and the hunt for ‘yield’ has resulted in most blue-chip stocks being bid up beyond fair value in the month leading to their dividend record dates – in most ASX-listed companies, this dividend pay date occurs twice a year.
There are specific funds and stockbroker strategies now set up to deliberately buy in to stocks before the dividend dates, enabling these people to access the dividends and franking credits. These strategies are clever enough that they also employ protective measures to ensure they are not exposed to holding the stock for longer than needed – this is in order to meet the 45-day holding rule to benefit from franking credits.
It has always been the case that a share price would drop by near the equivalent of the dividend payout once declared ex-dividend. However, it is no longer strange to see a share drop even further as the ‘yield hunters’ sell out and move on to their next target. This is especially true in pension-phase SMSFs or other low-tax investment structures that are willing to give up share value for the added franking credit benefit, which is otherwise not available to (or not as attractive for) the normal marginal taxpayer.
Combine this with the fact that many companies now offer little or no discount on their dividend reinvestment plans and investors are finding that by buying in on the DRP, they are paying an inflated price for that reinvested income.
What is the prudent strategy going forward?
I recommend that people store up cash from dividends in a high interest savings account and seek buying opportunities that help diversify their portfolio. If at the same time you are putting aside regular savings from employment income, you will quickly build a decent additional investment sum.
In the period since the global financial crisis, we have seen numerous occasions where good companies have had short-term issues and, as a result, stock was sold down by panicked day traders. This, however, created the perfect opportunity for long-term investors who could pick up solid stocks at very attractive prices.
I recommend that people store up cash from dividends in a high interest savings account Of late, good news is treated as expected of blue chips, while any bad news has been jumped on and good stocks shorted or sold down. Take advantage of these short-term overreactions and see them as entry points to good stocks long term.
Don’t follow the money… get there before it arrives
An alternative strategy is to research the stocks that will be the target of SMSF pensioners in the future. SMSF investors make up 16 per cent of our total market and are reasonably conservative and herd-like in their behaviour – they love dividends. If you can identify and invest now in mid-cap stocks that will deliver sustainable dividends in the future, you may be able to benefit from better yield and growth in the future as the herd catches up.
So forget about the old adage of passive reinvestment. Instead, build your cash reserve, do your research and be ready to take advantage of opportunities.
Disclaimer: The views expressed, and any advice given, in the above article are those of the author, and do not necessarily reflect the views of RaboDirect. We recommend that you seek professional advice before making any decisions relating to the matters discussed in the article.