Dividend stocks will help you grow your portfolio in the long-term. Some companies offer dividend reinvestment plans that will automatically reinvest your dividends into more shares of the same company. Here is how you can pick the right DRIP stocks for your portfolio.
How To Pick The Right DRIP Stock For You
Some stocks pay out quarterly or annual dividends. Picking stocks with high dividends helps you generate predictable revenues. There are two options available if you want dividend stocks. You can either invest in stocks with cash payouts or choose DRIP stocks.
What Is A DRIP Stock?
DRIP stands from Dividend Reinvestment Plan. DRIP stocks pay out dividends, but instead of getting a cash payment, you will receive more stocks from the same company.
You can typically get lower fees since these additional stocks come from the company’s stock reserve rather than the secondary market. Over time, your ownership in the company’s stock will increase. The DRIP model allows you to own a percentage of a share, which means you won’t have to wait until you qualify for an entire share to invest more in the same company.
Different DRIP Options
A reinvestment plan can be offered by different entities. You can invest in DRIP stocks issued and managed by the company itself.
You can also invest in a reinvestment plan that is offered by a broker. These plans require the broker to establish a partnership with the company you invest in.
If possible, invest in DRIP stocks managed and issued by the company since you will avoid brokers’ fees. These stocks will come from the company’s stock reserve while investing in a plan managed by a broker means you will automatically purchase more stocks available on the secondary market.
The main advantage of investing in a dividend reinvestment plan managed by a broker is that the shares you own were originally issued on the secondary market. This means you can sell these shares on the secondary market at any time.
On the other hand, if the plan is managed by the company, you won’t be able to sell your shares on the secondary market. You will be able to sell the shares back to the company at the current market value.
The Benefits Of DRIP Stocks
There are several benefits associated with DRIP stocks. Saving on fees is one of the main advantages of investing in company-managed reinvestment plans.
Stock pricing is another interesting advantage. When a dividend is automatically reinvested in more shares of a company, you won’t be purchasing shares at the current market value.
Instead, a model called dollar-cost averaging is used. The dividend will be reinvested to buy shares at a price that corresponds to a long-term stock price average. Market fluctuations won’t affect this price on the short-term.
Some companies also offer discounted stocks to DRIP stocks holders. This is a benefit to take into consideration when picking a DRIP stock since it can help you grow your portfolio on a small budget.
The Downside Of DRIP Stocks
If you are interested in DRIP stocks, you should know that this type of dividend is treated as a cash dividend for tax purposes. You will be taxed at a 15 percent rate on the money that is automatically reinvested.
The other downside of reinvestment plans is that this model isn’t flexible. The dividend is automatically reinvested in the same company on a quarterly or yearly basis. Opting for a stock that pays out cash dividends would make more sense if you want flexibility since you will be able to choose where you want to reinvest the cash.
Some companies require you to purchase a minimum number of shares to participate in their reinvestment plan.
In spite of a few drawbacks, DRIP stocks are still very advantageous. These products help you build a strong portfolio in the long-term, and it makes capital easy to access for the companies you invest in, which creates a huge potential for growth.
What To Consider When Picking A DRIP Stock
Check the recent pricing history for the stock to make sure now is the right time to invest. A DRIP stock is a long-term investment, and it might be wise to wait a few weeks before investing. Check the pricing history over the past year to get an idea of the average price of the stock.
You should also look at the price to earnings ratio and at the stock’s earnings. If the price of a stock is much higher than its earnings, the stock is currently overvalued and might not be a good buy, even in the context of a reinvestment plan.
A stock’s earnings will give you a good idea of how the company is performing. Check the earnings history to find out how the company has been performing. A stock with a strong earnings history is typically a sign that the capital generated via the dividend reinvestment program is used efficiently.
Do as much research as possible about the company you want to invest in. Negative headlines and high turnover among a company’s board of directors are red flags.
Look For High-Quality And Low-Risk Stocks
It is important to favor high-quality and low-risk stocks if you want to invest in one of these plans. DRIP stocks allow you to take a hands-off approach when it comes to managing your portfolio, which is why you want to avoid stocks that will require you to constantly assess and re-evaluate your position.
Blue Chip Companies
Blue chip companies are an obvious choice. These large well-established corporations tend to yield profits in the long-term and carry few risks thanks to their existing market shares.
A blue chip company would be perfect for a long-term DRIP investment since automatically reinvesting your dividends in the same company will still make sense ten years from now since the company is likely to remain an industry leader.
ESG stands for Environmental, Social, and Governance. Taking ESG factors into consideration when building a portfolio is a growing trend.
The ESG scorecard of a company provides you with insights that can’t be extracted from a company’s balance sheet.
A company with a good ESG scorecard is likely to keep growing thanks to a board of directors that has a well-defined strategy for the future of the company. It is also likely to avoid PR crisis linked to pollution, and far less likely to run into conflicts with local communities or with its workforce.
Assess Industry Risks
You can pick a DRIP stock issued by a blue chip company with a great ESG scorecard and still end up making a bad investment due to external risks.
You need to carefully assess the risks linked to the industry you want to invest in. An entire industry can become obsolete, or a business model can become outdated.
Choose a company that has a history of adapting to a changing environment, or look for a promising industry that isn’t likely to become obsolete.
How Quickly Will Your Shares Increase?
Reinvestment programs vary from one company to another. You need to compare your options and find out how quickly you will be able to acquire new shares of a company. The same thing applies if you decide to invest in a program offered by a broker.
A company with high dividend yields and low stock value would be a good choice since your shares will add up at a faster pace.
You should also look for companies that offer additional shares at a discounted rate. It is important to build a diversified portfolio, but this perk would allow you to invest more in the same company at an interesting price.
A Long-Term Strategy
DRIP stocks are a long-term investment strategy. The main risk associated with these products is that you could purchase a DRIP stock and see the company fail several years after your dividends have been automatically reinvested in the same company.
Investing in a DRIP stock makes sense if you can find a high-quality stock with low risks. A blue chip stock would be an excellent choice, but you can also invest in smaller companies with excellent ESG factors in promising industries.
The best way to mitigate your risks is to diversify your portfolio. You could purchase more DRIP stocks in other industries, diversify across company sizes, and add other financial products to your portfolio.
There are two questions to ask yourself when picking a DRIP stock:
- Will automatically purchasing more shares of this company still make sense ten or twenty years from now?
- Will paying the 15 percent tax on this dividend be worth it in the future?
Think of purchasing a DRIP stock as a long-term commitment. Look for stocks you will still want to own years from now and that you can justify purchasing more of in the future.
Adding DRIP stocks to your portfolio is a great way to generate predictable returns and to keep growing your portfolio. The downside of this model is that you have to pay taxes on dividends and that your money is automatically reinvested in the same company. Make sure you pick a high-quality DRIP stock issued by a company that carries few risks!