More investors 'snowball' their dividends

PUBLISHED : Sunday, 20 February, 2005, 12:00am
UPDATED : Sunday, 20 February, 2005, 12:00am

They call it the snowball effect. A growing number of people investing in the stock market in the United States choose dividend reinvestment plans, known as Drips.

More than 1,000 companies offer them, including General Motors and Exxon-Mobile, as well as a host of little-known smaller firms.

Dividend cheques come frequently and because the amounts often seem insignificant most investors simply cash them or put the money in the bank.

If they buy more shares in the traditional way through a broker they have to pay more transaction fees, and these add up over time.

With Drips, they see their holdings increase incrementally like a snowball - small at first and greater as time goes by.

Apart from tax deferment reasons, Drips have several advantages. For one thing, they enable an investor to take advantage of the compounding effect. Recycling the dividends back into shares means you are essentially reinvesting the interest on the principal.

An investor holding 250 shares of General Motors stock in 1999 would now hold more than 300 shares.

Without having spent a cent, the number of shares would have increased by 20 per cent.

Had the investor received those cheques for about US$150 in the mail four times a year, there is a good chance the money would have been spent.

Needless to say, the value of shares can swing wildly. So additional shares don't necessarily mean the value of your holdings has increased.

Drips have other advantages. Most of the companies offering them allow you to purchase additional shares and the fees are either negligible or non-existent. Exxon-Mobile, for example, requires a minimum investment of US$50 and a maximum of US$200,000.

You can do this by sending off the occasional cheque or automatically making direct purchases on a regular basis.

Whether you simply let your dividends accumulate or you make additional investments, you benefit from what investors call dollar-cost averaging, which means you acquire fewer shares when prices are high and more shares when prices are down. This results in lowering the average cost per share.

If you need cash, you can usually withdraw funds on a one-off, occasional or automatic basis.

Drips, of course, have their disadvantages.

First, you have no control over exact purchase prices. Dividends declared quarterly or half-yearly rarely correspond to cyclical lows in the stock price - meaning you may be acquiring new shares are at less than bargain rates.

Another problem is that opting for stock instead of cash amounts to shareholder dilution.

In effect future company earnings will be divided among a greater number of shares, which can weigh on the stock price.

Some argue that by accepting shares instead of cash, investors are inadvertently cutting their own throats.

And you don't have the advantage of professional guidance as to when you should acquire or offload shares. You are pretty much left to your own devices.

Considering the many benefits of Drips - especially for non-professional investors - why haven't they caught on in Hong Kong? Some insiders believe they work best in the US, where odd-lot trading is the norm.

But there are other reasons, as well.

'In Hong Kong, people just take the cash and reinvest it as there are no tax concerns,' said Gloria Siu, director and general manager at Gain Miles Assurance Consultants, which specialises in pension funds and retirement planning.

'Whether they reinvest it in the same company depends on the nature of the stock and the quality of the company.

'Many people reinvest it in alternate investment vehicles such as mutual funds, retirement funds, or Tracker.'

Despite Hong Kong's reputation as a tech-savvy city, online investing isn't as popular here as it is in the US, and people are driven more by emotion than research.

'They don't do a detailed study of a company's background,' Ms Siu said.

'People just react to what they hear on the radio and read in the newspaper.'

HSBC Holdings is one of the companies that offers investors a scrip dividend scheme under which new shares are issued in lieu of cash. There are no fees. Shareholders are notified of the dividend amount and given the option of taking the payment or taking the scrip.

'Retired people may prefer the cash dividend,' HSBC spokesman Gareth Hewett said. 'People interested in capital appreciation, who believe the share or financial sector prospects are good, may want to take the scrip.'

Many investors do not even know that reinvestment options exist in Hong Kong. Many companies do not advertise them and brokers do not always volunteer the information. Take the initiative by calling the company or your broker to find out if they offer reinvestment options.