A Simple Way to Supersize Your Returns from the Market

With a market yield double that of the MSCI world index, it’s not surprising that so much international money is funnelling its way into the Australian market.

Add in the fact that our government bonds are currently yielding around 1.8% — roughly 2% higher than the negative rates on offer in over a dozen developed economies around the world — and there’s even more reason for that money flow to turn into a torrent.

It certainly hasn’t allowed the RBA Governor to take it easy in his last few months on the job. All that money coming here has put upwards pressure on the currency, forcing the RBA to once again lower rates last month.

While those juicy dividends are a godsend to savers trying to tough it out in a low interest rate environment, they’re also allowing another type of investor to build an asset base that could pay them a much bigger income in the future.

And while this strategy is well known to most investors, far fewer put it into practice.

A great way to spruce up your returns

Seeing a dividend hit your account is always a nice feeling. Especially if you’re more accustomed to watching the money head the other way.

But if you don’t need the income from dividends now, you can opt to take part in a dividend reinvestment plan (DRP). Under a DRP, they can choose to take some (or all) of the dividend amount in shares, instead of cash.

Not all companies offer a DRP — usually it’s the bigger companies inside the ASX 200. For those that do, they’ll quite often issue these additional shares at a discount to the market. And as you don’t need to pay brokerage to take part, it’s cheaper than buying the shares on the market instead.

If you want to find out if a company offers a DRP, it won’t take you long. The quickest way is to go to its website and check under the investor centre section. If a company operates a DRP, it will include the price the DRP shares were issued at, alongside the previous dividends.

As companies are also required to lodge dividend announcements with the ASX, you’ll also find that information on the ASX site. The announcement will include the dividend amount, the ex-dividend and payment date, along with the date by which a shareholder must nominate if they wish to take part in the DRP.

Well that covers the ‘how’. Let’s now look at ‘why’ a DRP can be such a useful tool to help supersize investment returns.

It’s a game changer

If an investor were looking through the different rates on offer from term deposits, their eyes would focus on two key things. First the rates, and second, how long they have to lock in their money to receive that rate.

The thing about a term deposit is that unless they roll it over, all you’ll ever receive is that headline interest rate — less any fees, and the tax they’ll pay on the income (if applicable). It provides some income now, but not any capital growth.

Dividend-paying shares offer the ability to generate income, but also capital appreciation. Of course, markets never head anywhere in a straight line — shares can take a tumble too.

But as I wrote in yesterday’s Money Morning, investing in companies with a history of growing profits and dividends should stack the odds in your favour. That being said, while the dividends might grow, you’ll only receive those dividends over the same number of shares.

The great value of a DRP is that it’s a game changer — it continually grows the number of shares that you hold, so that when you later elect to start receiving cash instead of shares, it will be over a much bigger share holding.

It’s maybe not something that reaps an immediate and obvious return. But if you can implement a DRP for just a few years, you’ll start to understand how powerful it is.

An ever growing asset base

Let’s take a company that trades on a current yield of 6% and pays out a dividend every six months. An investor holds 5,000 shares which are trading at $1. If they elect to receive the dividends, they’re likely to receive $150, twice a year (or $300 in total).

If however they elect to take part in the DRP, they’ll receive 150 additional shares instead of the cash after the first dividend. However, the second dividend will be calculated on the 5,150 shares, not the 5,000 if they just took the cash.

For the second dividend, they’ll pick up 154 shares based on their larger holding, whereas they’d still only get $150 if they took the cash. So far, not a big deal. But after 3 years (and six dividend payments), this shareholding would grow to 5,970 — a near 20% increase.

Do this for a decade and you’d be staggered at how big this holding could become.

So what’s the catch? You guessed it…tax!

Some pain now for rewards later

Always get advice from your accountant. But the brief version is that the ATO treats shares that were acquired via a DRP as though the investor took the cash from the dividend and used it to buy shares in the company (at the DRP issue price).

Because of this, dividends reinvested under a DRP are assessed the same as cash dividends. Meaning, you’ll still need to pay tax on the newly issued shares.

For some investors, that just might not work for them. But for others, it’s a way of paying tax (and taking pain) in the meantime, while building an ever growing asset base.

The secret weapon

If you’re prepared to take some pain now by paying tax, a DRP can be a great way to build your asset base. While income investors often tend to just focus on yield, a DRP can allow them to generate larger amounts of income later (based on a higher number of shares), even if a stock’s yield was to never increase.

A DRP also helps take the timing issue out of buying shares. That is, trying to pick the best time to buy them. By receiving new shares every six months, it lessens the chance of overpaying — when the share price is low, they’ll receive more shares, and less when it’s higher. But overall, it should even itself out.

And don’t forget you can always choose to opt out of a DRP if you no longer want to participate. But for those that can forgo cash now to take part, a DRP is one of the great wealth building tools.

Matt Hibbard

Money Morning Australia