Dividend bonanza, high yield stocks – these are the catch cries ringing in investors ears right now.
And it's not really surprising, with so many ASX listed companies raising their dividends as they play to the wishes of shareholders.
But there is a major issue that investors need to be aware of. While companies are increasing their dividends, many are clawing them back in the way of issuing new shares through dividend reinvestment plans (DRP).
If you're not sure what that means, instead of receiving cash dividends, shareholders can elect to receive shares of the equivalent value. You still have to declare them in your tax return just like a dividend, and you still get the franking credits.
Commonwealth Bank (ASX: CBA) may raise as much as $873 million in new shares, and has refused to offset them through buying the shares back on market.
In other words, more than ten million new shares could be issued to existing investors.
So what you may think. After all, CBA has more than 1.6 billion shares on issue. 10 million is a mere drop in the ocean.
But it also means that if you take the cash dividend instead of opting for shares in the DRP, your holding will be diluted.
Think of it this way. A company has 100 shares. It's share price is $1.00 and decides to pay a dividend of $1.00 (very generous I know) and under the DRP, 30% of shareholders opt to receive new shares. That means another 30 shares will be issued.
If you held 10 shares, your holding in the company would have been 10% prior to the DRP. But afterwards, you hold 10 out of 130 shares, or 7.7%.
Your 10 shares are worth less, since you only own 7.7% of the company now.
So shareholders have two options, both with a downside. Take the dividend in cash and be diluted, or take up shares under the DRP. In the second scenario, the share price may well be very expensive, and you receive less shares that you would if the company was trading at more reasonable levels.
What's worse news for bank shareholders, is that the effect is hardly noticeable. After all you are still receiving dividends, and you still hold the same amount of shares.
What should be a concern is that now the company has more shares on issue, and either has to increase its dividend payout ratio to keep paying dividends at previous years' levels, or lower the dividend.
When you think about it, if the company hadn't issued any new shares and other things being equal, your dividends in future years would be much higher.
As an example, say Commonwealth Bank will pay $3.00 in dividends this year. Next year, thanks to the issue of new shares, the dividend rises to $3.15. Nice you say. But had it not issued new shares under the DRP, your dividend may have been $3.20. Now imagine this goes on every six months for years and you can see how the issue becomes a huge concern.
To illustrate the point even further, 20 years ago, Commonwealth Bank had 886.7 million shares on issue, nearly half the current number.
As Simon Marias, managing director of fund manager Allan Grey has told the Australian Financial Review,
"I can see why you do a DRP for small investors, I would say it almost makes sense . . . but a dividend is supposed to be the extra money you have in a company. To pay a dividend then claw it back . . . that is just stupid."
Foolish Takeaway
With very few investors understanding the effects of dilution, companies are taking advantage of that fact. CBA is unlikely to be the only one, with the AFR suggesting the other banks ANZ Bank (ASX: ANZ), National Australia Bank (ASX: NAB) and Westpac Banking Corporation (ASX: WBC) will follow the lead and also decline to offset new equity issued under the DRP with on market share purchases.
