What is Dividend Reinvestment Plan and Why to prefer it in one's portfolio?

Dividend reinvestment plans are plans offered by companies to existing shareholders to purchase the shares of the company directly from the company in lieu of dividends. The benefit of the above is that the investors do not have to go through the hassle of going through a brokerage house and paying brokerage charges on their purchases. The advantage to the company is that it will not have to part with any cash when it needs it the most and still reward investors, who are likely to keep confidence in the company and stay invested.

Investing in such a plan would add significant value to one's portfolio who is not able to actively allocate time and effort to churn his portfolio in order to take advantage of market inefficiencies. For allocation of stocks to one's portfolio, which is subscribed to a reinvestment plan, the principal strategy is to invest in stocks which have a consistent dividend track record like that of well-established companies with robust financial performance records. The second strategy is to look for those companies that still have the potential for significant growth opportunities. The reason why such companies offer dividend reinvestment plans is in part to sustain investor interest in the company and partly to take advantage of business opportunities that will increase its return on capital employed rather than the management giving away a portion of its earnings as cash dividends. Given these characteristics of such companies, it is also apparent that they face limited business risks as well as are least effected by macroeconomic headwinds. The biggest advantage of investing in such stocks and adding them in one's portfolio is that they do not add any element of risk to the portfolio over and above that is already present and can also be utilized for creating a fairly defensive portfolio from scratch.

Investing in such stocks and portfolios bearing such stocks is popular with investors who have a moderate risk profile and a very long-term investment horizon. These investors tend to reinvest their earnings from the portfolio in the short term to medium term in order to increase the size of their investments so that they may earn a substantial capital gain in the long run when they actually need it. These characteristics of such a type of portfolio having the features of both a  mixed growth and income dividend portfolio are not available with a purely defensive dividend portfolio strategy, and in the long run, an investor making an investment in such a portfolio could get a hefty return which may even surpass the earnings from a growth portfolio.

Other tertiary factors that go into the building of such a portfolio are the selection of the individual stocks, and for that one needs to look at the sectors to choose them from. The debt-equity profile of the company, the cash-generating profile of its business model and the geographical spread or extent to which its business is expanding and at what rate. The second factor to be considered is the proportion of the portfolio that can be allocated to such stocks. Since such stocks take away some of the portfolio’s current earnings, they come with a risk element that is higher to that of a pure defensive portfolio; hence an investor or a fund manager has to decide of much of safety and current earnings he is willing to part with. The third component is the tentative time horizon before the portfolio requires any churning to reflect any changed circumstances. The performance of these portfolios is usually linked to representative earnings of a similarly managed passive dividend income portfolio, with the investor consistently trying to keep a tab of how the other portfolio is performing so that a change in strategy may be adopted if his portfolio starts to underperform.

The investors in these stocks are rewarded in the medium to long term. The companies which adopt these policies are facing sustained growth opportunities, which necessitates the adoption between cash dividend payout and dividend reinvestment. This policy is, however, inferior in some ways to the stock dividends given out by companies. In stock dividends, the investor many of the times have the option to reject the offer and ask for cash dividends, and the stock issued in these cases are usually at a discount to the prevailing market prices. In the case of dividend reinvestment plan, an agreement is generally entered into between the investor and the company detailing the terms of the plan. Second, such shares are also less liquid compared to stocks that are bought or sold in a stock exchange and can only be redeemed by selling it back to the company. Hence investors with short term time horizon would desist from investing in such stocks. These plans ensure significant controls remain in the hands of the management who wouldn't have to worry about any event influencing highly volatile stock price movements in stock exchanges; Plus there is a lesser chance of a takeover risk even when the management has less than majority shareholding.

The other benefits of the dividend reinvestment plan are that new equity may be issued by the company without any practical dilution of control as the transfer of these shares are restricted. The cost of raising capital is at the least if a dividend reinvestment plan is adopted as it will only involve allocating new shares to existing investors. Dividend reinvestment plans also ensure better investor relations as the investors in question are long term loyal investors, making takeover bids on the company more difficult. Companies that offer dividend reinvestment plan often have a lower investor base requiring less expenditure on investor relations while maintaining better investor services. This also ensures better investor participation in the company’s’ annual general meetings and voting processes.

The disadvantage, however, for the investors in this plan is that they still have to pay taxes on these newly acquired shares whenever they are issued by the company, which means a cash outgo from the hands of the investors while they are earning none. Whereas, if they were to accept cash dividends, they would receive a sum which is net of the taxes paid.