Clearly, a lot of investors like companies that pay dividends, so there is incentive for companies to pay high dividends, and there is also a strong incentive for companies to get franking credits out into the hands of the people to whom they are most valuable – the shareholders.
Five to ten years ago DRPs were commonly offered at a discount of 5%–10% (see tables below) off the market price, which made them very attractive to small investors. More recently, companies have wound the discounts back to the 1%–3% range, or dispensed with the discount altogether.
The purpose
Companies want to encourage shareholders to reinvest their dividends automatically, but they are also keen to husband cash. Having a DRP helps them out in this respect, because if they can get 10%–20% of their investors to reinvest, then the company is paying out less. The investor gets the franking credit benefits – particularly if the investor is a self managed super fund (SMSF) – but the company gets almost free capital. Although it is not really getting the cash back, but by paying less out in the first place, it is essentially the same.
However, the reality is that a DRP is dilutive. The investors who reinvest get more shares, the number of shares goes up, and there is a dilution – minor, but still a dilution. And if the DRP shares get a discount, the dilution gets bigger. Some institutional investors do not like DRPs for this reason – especially discounted issues – because it dilutes other shareholders.
On the other hand, the company gets cash (or recovers cash) for expansion at a modest administrative cost, while giving its investors a bit of love. Being a semi-automatic capital raising, the DRP can often suit the company better than doing a small share placement or borrowing more money – both of which situations can put pressure on the share price.
The dilemma
It’s a constant dilemma for the corporate treasury, and it’s neatly summed up by the situation ANZ is in. UBS analysts say ANZ needs to strengthen its balance sheet, and that reintroducing a discount to its DRP may be the best way to go about it.
ANZ currently has a tier one capital ratio of 8.33%, and UBS would like to see it improved to 9%. There is a range of measures the bank could take – selling down Asian Partnerships, restricting risk-weighted asset growth in Asia, rationing credit growth in Australia, and cutting the dividend payout ratio to the lower end of its 60-70% band. There are potential problems with each of these, but
UBS says ANZ could give its shareholders a DRP discount for the next few dividends – a method used successfully through the credit crisis. UBS says ANZ generally has a DRP participation rate of about 20%. However, when a discount of 1.5% was offered between the second half of 2009 and the second half of 2011, the DRP participation ratio doubled – which gave the bank’s capital generation a significant boost. UBS says it expects a 1.5% DRP discount for at least the next two ANZ dividends.
The benefits
For investors, the advantage of a DRP is that shareholders do not have to pay brokerage when reinvesting their dividends. That means shareholders can build up their stake in a company at no additional cost, and get compounding to work in their favour. (Although they must use a good portfolio monitoring system that aggregates all the DRP information in one place and recalculates the tax position of each relevant ‘parcel’, or the DRP can rapidly give rise to a tax-lot nightmare.)
As with all investing options, though, investors should always be thinking about whether they should actually be buying the stock – because that is all the DRP is, just a low-cost way of buying more stock. If you think the stock is overvalued, perhaps you should avoid reinvesting, and use the dividend cash some other way.
There is not much point in having a nicely discounted DRP if the stock does not perform – you still need to ensure the company is a good performer before you buy more through the DRP. The market’s only current 10% discounted DRP, Mirrabooka Investments Limited, a listed investment company specialising in small and medium-sized companies located with Australia and New Zealand, certainly fits that bill. Here is its performance data, on total return (all dividends reinvested), ranked by 5-year performance:
Of the companies with a 5% discount on their DRP, the best long-term performers are:
There is only one company with a 3.5% discount on its DRP:
Of the companies with a 3% discount on their DRP, the best long-term performers are:
Of the companies with a 2.5% discount on their DRP, the best long-term performers are:
Of the companies with a 2% discount on their DRP, the best performers are:
Of the companies with a 1.5% discount on their DRP, the best performers are:
Of the companies with a 1% discount on their DRP, the best performers are:
All performance figures are from Stock Doctor as at close of play, 27 June.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Follow the Switzer Super Report [1] on Twitter
Also in the Switzer Super Report:
- Peter Switzer: Uncomfortable market optimism [2]
- Paul Rickard: Why your LIC could be a cashbox in disguise [3]
- Rudi Filapek-Vandyck: Buy, Sell, Hold – what the brokers say [4]
- Penny Pryor: Shortlisted – The perfect yield portfolio [5]
- Gary Stone: NYSE Composite Index breaks out [6]
- Greg Fraser: Tatts Group comes out winner [7]
- Staff Reporter: Property powers on [8]