Dividend reinvestment program (DRIP)

Recently, one of my invested real estate investment trust (REIT) has announced a dividend reinvestment program (DRIP). This triggers the question as to whether DRIP is a good thing and should investors take up the DRIP. Before we delve into the advantages and disadvantages of such a program, we can look at what is a DRIP.

DRIP is a way for investors to receive the dividends from an invested company in the form of new shares or units (in the case of REITs). In a DRIP, an investor can choose to participate in it fully or partially. When an investor chooses to participate fully in DRIP, he is opting to receive fully all his cash dividends in the form of new shares/ units. When an investor chooses to participate partially in DRIP, he will elect to receive only part of the cash dividends in the form of new shares/ units while the remaining dividends is still disbursed to him in cash.

In calculating the number of shares or units an investor will receive, he will need to know the exercise price per share/ unit under the DRIP. For example, ABC company has announced a DRIP in which new shares are issued at the price of $1.95 per share. If an investor is receiving a cash dividend of $1950, he can opt to participate fully to receive approximately 1000 new shares in place of his cash dividend of $1950. Of course, he may also opt to receive partially his dividends in new shares and remaining dividends as cash. He may even choose not to participate in the DRIP in which case, he will still receive his dividends fully in the form of cash.

Advantages of a DRIP

1. It allows an investor to reinvest his dividends directly in a company as he is opting to receive new shares/ units in the company instead of cash dividends. By doing so, an investor can save on brokerage fees as he will need to pay brokerage fees should he buy new shares in the same company through a brokerage firm instead of participating in DRIP to receive new shares equivalent to the amount of his cash dividends.

2. A DRIP encourages investors to have a long term investment mindset towards a company. By giving investors a chance to participate in DRIP, some investors (especially those who choose to participate in DRIP) may stay invested with the company for longer term. This encourages price stability in the share price of a company when more investors are holding the shares of the company for longer term instead of actively trading the shares of the company.

3. A DRIP benefits the company as it can conserve its cash earnings to use it to further the growth and expansion of the company since some dividends are disbursed in the form of new shares instead of cash. Warren Buffet's Berkshire Hathaway Inc. has been known not to give out dividends to its investors but instead conserve its cash earnings to keep investing in growing and expanding its businesses. By doing so, it is able to expand its businesses and future earnings. In return, long term investors in Berkshire are rewarded by the capital gain from their shares which comes up to a substantial amount of returns over a few decades which will not be possible had Berkshire disbursed part of its earnings in dividends to its investors instead of using its earnings to grow and expand its businesses.

Disadvantages of a DRIP

1. A DRIP has its disadvantage as sometimes, an investor may not receive his amount of dividends fully for an equivalent amount of new shares/ units of the company. This is because any fractional new shares/ units under the DRIP are rounded down and disregarded. For example, the exercise price of a DRIP is $1.943 and an investor is opting to receive fully his dividends of $1950 in the form of new shares in a company. His amount of new shares equivalent to the amount of cash dividends of $1950 is approximately 1003.6 new shares. In this situation, he will only receive 1003 new shares instead of 1003.6 new shares as fractional shares are disregarded. However, this is only an insignificant amount as he only loses around $1.16 of cash dividends for that puny 0.6 fractional new share he lost.

2. Another disadvantage of DRIP is that an investor usually lands up with odd number of shares. In the above case, an investor opting fully for the DRIP will land himself with 1003 new shares. Assuming he has existing 11000 shares in the same company, he will now have 12003 shares after the DRIP. When he decides to exit fully his shareholding in the company in future, he will have difficulty selling the extra 3 shares on top of the 12000 shares. In order to do so, he will need to sell his odd number of shares through his brokerage firm on a different market catering to odd lot shares which will incur higher brokerage charges compared to selling the usual number of shares on the normal market.

3. The exercise price of a DRIP may not be attractively priced compared to current traded share price in open market and intrinsic value per share. If the existing shares of the company participating in a DRIP is traded at $2.00 per share in the open market and the exercise price of the DRIP is at $1.98 per share. As such, an investor will be better off with receiving the dividends in cash and wait until the traded share price is below $1.98 to buy new shares in the open market at a lower price than the exercise price of the DRIP. If the traded share price of this company should become lower for example at $1.93 per share in the open market, the investor may even save some money (after factoring in brokerage costs) if he purchases new shares in the open market instead of participating in the DRIP at a higher exercise price of $1.98 per share. Such swings in traded share price is not unusual within a short term period given the volatility in the stock market. Also, if the exercise price of the DRIP is higher than estimated intrinsic value per share determined by the investor, there is no margin of safety in participating in the DRIP as an investor will be receiving new shares through the DRIP which are not attractively priced. Thus, does one wait to buy at lower share price or participate in the DRIP? Let the investor decides for himself since the exercise price of the DRIP is not attractively priced.

Conclusion

In considering whether to take up a DRIP, one has to look beyond the advantages and disadvantages of a DRIP. As Benjamin Graham, the father of value investing puts it, "Investing is most prudent when it is most business-like". How an investor should approach DRIP is from assessing the business behind the listed company. 

Questions to ask include:

1. Does this company have a competitive moat?  

2. What is the future growth prospects of the company?

3. How is the management of the company? Are they trustworthy and capable?

4. How is the financial track record of the company? How are its performance in growing its revenue, managing its expenses, profit margins, cashflows, debt levels (is it precariously over leveraged) and short term/ long term liquidity?

As one can see, the focus is not whether a DRIP is good or bad for the company or its investors. A DRIP actually brings one back to investigating the fundamentals of the business behind the listed company. DRIP for a gem or DRIP for a rock. Let the investor decides whether the fundamentals of the business behind a company offering DRIP points to the company being a gem or a rock. As always, one should seek to purchase shares at undervalued or fair valuations. That includes reinvesting in new shares through DRIP only at fair valuations.

Water the right plants (participate in reinvesting in good companies through DRIP) that will grow to produce much better yield through time. A caveat to note that not all companies are even good to invest in, much more consider their DRIP.

Have you bought insurance for your shares?

We insure ourselves for a lot of things in life from our home, our belongings, our car, our medical expenses to even our lives. Insurance is just a way to protect ourselves from the uncertainties in life. In an unexpected event, we are still able to carry on surviving through life in the case of all types of insurance coverage which allow a financial payout secured through an insurance company to tide through life crisis except in the event of death which already cost us our lives. In this case, our loved ones who are still around are able to carry on life based on the insurance payout to tide them over the crisis of losing a loved one (especially if the lost one is the breadwinner of the family). 

In stock investment, one can consider buying insurance for his investment. By this, I do not mean literally buying insurance, but "buying insurance" in the sense of preparing for the wild swings of the volatile stock market. Stock investing is volatile in the short-term, but profitable in the long-term. To protect against the wild swings of the volatile stock market, one has to "buy insurance" by having an adequate amount of emergency fund and opportunity fund to capitalise on any wild swings in the stock market.

There is no hard and fast rule to how much emergency fund and opportunity fund one should hold on to in preparation for investment opportunities when the occasions arise. It depends on the investor. A conservative investor will hold more emergency fund and opportunity fund in proportion to the amount of his investments. An agressive investor will likely invest almost all of his available cash leaving little cash reserves each time to capitalise on any opportunities which may arise occasionally.

A general guide is to have an emergency fund which is equivalent to three to six months of expenses to tide through any emergency such as retrenchment from work or inability to work due to circumstances like disability, illness or sudden change in family situation (e.g. sudden death of a family member). Having both emergency and investment opportunity fund will mean that one has "bought insurance" for his stock investment. In the event of any emergency in the life of an investor, he need not liquidate his shares at a wrong time (especially in a down market) to raise fund to meet the emergency. When a down market is presented, an investor having opportunity fund will be able to invest upon such down market opportunity buying undervalued stocks and will not miss it and thus be subjected to the volatility of the stock market playing out on him.

Thus, an investor has to ensure he has "bought insurance for his investment" by setting aside an emergency fund and also an opportunity fund. I found out that there are approximately three to five profitable chances in any year based on compiled statistics of historical stock market behaviours to invest in stocks yielding good reasonable returns. The more times one invests in a year in excess of five times may not guarantee good profits. This means that an investor has to be very patient to observe the stock market every year to invest for only up to a maximum of five times in any year. The rest of the time in any year is spent observing for a good moment to invest.

This is pretty much like fishing, waiting for the fish to bite the bait. In this case, the bait is the amount of opportunity fund one has set aside while the fish is the valuable stock one is eyeing for to purchase at an undervalued or reasonably valued price in any year. There may be only one good opportunity to invest in any year to catch a stock at its undervalued or reasonably valued price. There may be a few more opportunities to catch the same stock at an undervalued or reasonably valued price in any year. However, there is no such thing as a great value every day for the same stock. Even if one is a trader, he also knows his boundaries to stick to his trading signals and trade only when opportunities arise.

Since there is so much uncertainty in the stock market due to the European debt crisis, slow recovery of the US economy and slow down in China's economy, one must be ready with opportunity fund which will be his insurance to protect against any potential swings due to the volatility of the stock market which is affected by a myraid of economic events worldwide. When a down market does arise, he will be able to exercise his insurance (opportunity fund) to buy up undervalued stocks. Even if such down market does not arise any time soon, the investor can sleep well every night knowing that he is insured and will be able to purchase into undervaled stocks with an adequate opportunity fund set aside whenever the down market arises.

The stock market will always continue to be volatile due to the different sentiments of many stock market investors. There will be highs as well as lows. With insurance (an opportunity fund) set aside, an investor just need to be a fisherman patiently waiting for his fishes (stocks) to bite the bait (to become undervalued) so that he can reap a harvest of fishes (buy into undervalued shares of companies). This opportunity will surely come a few times in a year. Just be patient to have an adequate opportunity fund ready to insure against such down markets and exercise this insurance (opportunity fund) to purchase undervalued shares without feeling the stress of having to face a down market while not being able to invest into undervalued shares.

Not having insurance creates uncertainty. However, it is also no good to be over insured. Cash on hand depreciates in value with time. Thus, one has to have an adequate amount of opportuntity fund but not in excess so that one is over insured and under invested. Cash can only grow in value while being invested. The value in holding cash is for emergency use, opportunity fund for investment or some personal immediate uses. Holding too much cash is not going to act as insurance but on the contrary is depreciating one's networth by the day.

Have you bought insurance today against the volatility of the stock market by having enough emergency fund and opportunity fund (to capitalise into investment opportunities when presented), but not in excess (being over insured and under invested)?

There will be "rainy days" (stock market lows) in the stock market in any year. Having enough insurance (adequate amount of  emergency fund and opportunity fund) will allow one to capitalise on that few investment oppotunities (during stock market lows) in any year and to sleep well every night while waiting for that rare few investment opportunities to be presented.

Pricing strategy.

For everyone, we have definitely encountered times when we need to sell anything, be it selling our products or services for a business, or selling our own personal items. How do we price the products, services or even our very own personal items we sell? I have always held the opinion that it is never good to compete to sell anything based on prices alone. Even if an item is a commodity which does not differentiate itself from another same commodity being sold by a competitor, one can still adopt a creative selling approach to make the item of commodity become unique in the eyes of the buyer. This involves creating added value to the buyer so that he will not be just buying the same item which he can easily buy elsewhere from another competitor. It does not take much thinking to appreciate that the same Coca Cola can drink can be sold at different prices at different venues. A can of coke sold off the shelf of a supermarket in Singapore costs approximately $0.70. The same coke sold off a vending machine costs approximately $1.20 while the price of this same coke sold in a restaurant costs approximately $2.80.

Why is there such a disparity in the prices of the same item, a can of coke? I consider this creative selling which involves creating added value. The same coke sold off vending machines bring convenience to the buyers as they can go to any nearby machine to buy a can of coke at anytime of the day including wee hours when everyone is sleeping when a particular buyer has a sudden craving for this soda. A restaurant offers a comfortable dinning environment to enjoy this can of coke. So, the price of coke is sold higher for the consumer not only to drink coke, but also to drink it at a very comfortable environment. This creation of unique added value makes the selling of coke becomes uniquely different commanding different selling prices. For the vending machine, it targets consumers who want the added value of convenience. For the restaurant, it targets consumers who wants the added value of comfort to enjoy this soda.

Well, do people still pay much higher prices for a can of coke sold off a vending machine or in a restaurant? Your guess is as much as mine. Yes. People do pay for higher prices. The difference is that coke sold in a restaurant only attracts a certain target consumer group, those going for added value of comfort while vending machines attract another group of consumers, those going for convenience. As to coke sold off the supermarket, it does attract peope who are price sensitive and do not need any added value to their purchase of the coke (placing their only buying consideration on price alone and nothing else that can move their hearts to pay more). Thus, by focusing on the creation of value even when selling the same item, higher selling prices can be commanded and the product or service can be sold to a relevant target group of consumers who see the added value they are paying more for.

There are 5 different ways by which most businesses priced their products namely:

1. Making wild guesses.

2. Following industry norm.

3. Clients dictate their prices.

4. Cost plus pricing.

5. Target return pricing.

1. Making wild guesses

This needs no explaining. The seller prices his products and services according to what he thinks buyers are willing to pay. There is no survey and research done. Neither is there any history to base the pricing on. The pricing is based on luck mentality. If the product can sell at this price, it sells. Otherwise, it will not.

2. Following industry norm

This way of pricing looks into what prices the other competitors are selling the same or comparable product or service. Usually, an average selling price in the middle is derived by considering the highest price and lowest price other competitors are selling comparable products or services. This works on the assumption that other competitors in the industry must be doing the right thing since they are able to sell their products and services.

However, assumptions may not always be a good thing. What is applicable for other competitors may not be applicable for oneself as their situation is uniquely different from each other as well as different from oneself. For example, a larger competitor may be able to sell their products or services at lower prices based on their economies of scale without eroding their profit margin. A weaker competitor may find it hard to follow suit with low pricing as this will mean a much lower profit margin or even making a loss resulting in the inability to sustain itself. In the long term, even if the weaker competitor is able to barely survive, there will be very slow growth (if any) as without profits, growth will slow down. Thus, a pricing which works for a competitor may not necessarily work for oneself.

3. Clients dictate their prices.

This way of pricing places priority in the clients to dictate what maximum prices they are willing to accept to buy one's products or services. This is done by running surveys, focus group discussions or causal talks with clients to know what maximum prices they are only willing to accept when buying one's products or services. It is good to always listen to the needs of one's clients. However, if one decides on the selling price solely on the clients' wish, it may mean lower profit margin thus resulting in unsustainability or lethargic growth in a business.

A business exists to serve the needs of its clients. However, also as important is the need to be profitable so as to continue in existence to serve the needs of its clients and even serve it better. If a business is not making profits, how can it grow and improve its products and services to continue serving its clients with better products and services. So, profitability of a business and its great meaning and purpose to serve through providing relevant products and services to clients go hand in hand. Greater value offering comes at higher prices. Higher prices fuel profitability to further improve value offering.

By not allowing clients to solely dictate the selling price, one is also training its clients not to focus on price alone but consider the value in the product and service offering of a business.

4. Cost plus pricing

This way of pricing considers the cost of producing a product or service, and the selling price is derived by adding a desired amount of return based on cost. This way of pricing has some inherent flaws. By using this way of pricing, one is not considering whether the clients can accept the selling price. Clients generally do not care about how much it cost to produce one's products or services and also the amount of desired return one requires when pricing the product or service. What they generally do care is whether they need or want the product or service and whether they want to pay or can afford to pay at a particular selling price.  

In this way of pricing, one may also need to carefully consider the true cost of producing a product or service. Sometimes, it may suddenly require a large increase in cost to acquire a machine or more manpower cost and delivery cost to sell products or services to the clients. Thus, costs do fluctuate significantly sometimes. Also, there may be seasonal demand for one's products or services. Is a business going to sell at a much significant lower price when the cost of producing a product or service has gone down due to slower demand for some periods of the year? Can one really fix a suitable selling price based on cost plus way of pricing?

Furthermore, pricing of a particular product or service may influence sales of other different product lines or service lines in a business. If pricing a product A at a certain price results in more of the product sold and less of another product B being sold, the loss incurred on product B has to be amortized and accounted for as a cost added to product A. Thus, there will be changes to costs of individual product or service lines.  

Also, there may be differential costs in selling the same product through different people or different means. For example, it may cost more to deliver the same product overseas than locally. It may also involve different costs to sell the same product by different salespersons.

Thus, this way of cost plus pricing is a difficult way to determine the selling price of a product or service as one will need to know the actual true cost of producing the product or service.

5. Target return

 

This way of pricing looks at a business and its prices as an investment. A target return on the capital invested in a venture is set. This is one's required return on investment. This way of pricing is more focused on profits, but it can also ignore the realities of the market similar to cost plus pricing, by focusing on unrealistic return on investment.

What is the purpose of pricing?

 

As one can see, no matter which way of pricing one chooses, the purpose of pricing is still to make profits for a business to ensure growth and sustainability. Even if one is taking a loss by lowering prices for example in giving discounts, it must still serve the purpose of taking a loss today in order to make a greater profit tomorrow.

 

Price skimming

 

One way of ensuring high pricing is to adopt a price skimming method. The objective of price skimming is to serve clients who are not price sensitive and are willing to pay higher prices for the exclusive value they can get from one's products or services. This is similar to the analogy of skimming off the top cream of the milk much like skimming off the top level of clients who are willing to pay higher prices for the exclusive value they get. This ensures high profit margins.

 

Sequential skimming

 

Another method related to price skimming is sequential skimming. For this method, clients who are willing to pay higher prices for premium value they get from a product or service is secured first. When demand for the product or service drops, the price of the product is lowered to increase demand for the product serving the next level of buyers. The price is again lowered when demand further drops after sometime thus attracting the next lower level of buyers. This method of sequential skimming is evidently seen in the sale of many electronics such as computers. When a new computer product is newly introduced in the market, it is priced at a premium attracting the first level of buyers who are not price sensitive but are focused on the immediate value they get from their purchase. When demand drops, the selling price is decreased to attract the next level of buyers and so on. 

 

Penetration pricing

 

This method of pricing involve lowering prices below the competitors to quickly attract more clients thus seeking to increase market share. Penetration method works on the assumption that people are always attracted by lower prices. This method may be useful to increase market share quickly, but it can also become damaging to profit margins. Thus, this method is a short-lived method to penetrate one's market to gain market share and should be carefully used. In order to sustain long term growth and profitability, other methods of pricing such as skimming are better. One should not only consider the market share for his products or services, but more importantly the profits. For without profits, a business cannot sustain itself.

 

 

Conclusion

 

Pricing of product or service is an important part of a business. Purpose of pricing is to make profits without which a business can not sustain itself or see long term growth. There will always be people who are not price sensitive and willing to pay premium prices for premium value they can get from their purchase. This requires the business to adopt creative ways of offering premium value in their products or services in order to charge higher prices to attract their top level buyers. Sequential skimming is a method which can help to maximise the prices at each levels one can sell sequentially to different levels of buyers. Profits should be also considered in addition to gaining market share when using price penetration. For what good is there in gaining market share when a business is selling products or services at low prices which does not sustain profitability and results in causing long term irreparable damage and loss to the business.

 

Pricing is an important part of a business. The purpose of pricing is to make profits which results in long term growth and sustainability of a business.