By Joshua Kennon. Investing for Beginners Expert
Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.
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I wanted to take a few minutes to explain what DRS is, why so many people are excited about it, and how it can make your life easier.
The Basics: What Is the Direct Registration System or DRS?
If you are like most new investors, you invest in stocks through a brokerage account. When you buy a stock, this means your stock is registered in a street name. That is, if you own 1,000 shares of Wal-Mart Stores through Charles Schwab & Company, your stock is pooled with all of the other brokerage clients who own shares of Wal-Mart Stores and reported on the books of Wal-Mart's transfer agent as "Charles Schwab & Company".
You are the beneficial owner of your 1,000 shares, but Schwab is the owner of record. Schwab then breaks down, in its own accounting, which client owns which shares, providing trade confirmations. brokerage statements. and tax records.
If the brokerage firm goes bankrupt, you are left holding the bag with a general claim against the firm. In almost all cases, this is not a problem because client assets are segregated from firm assets. Still, if there is a shortfall, you may may find yourself relying on SIPC insurance. which has limits.
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Between these two guardrails, it is exceedingly rare for a brokerage customer to fail to receive his or her portfolio back, in full, in the event of a brokerage bankruptcy but for those chronic worriers, the Direct Registration System provides a safeguard.
In 1996, the Direct Registration System was created for people who didn't want their stock held by the brokerage firm. Sometimes, these investors buy and sell directly from the transfer agent. Other times, they work with their favorite stock broker to arrange trades registered through the DRS. Personally, my family has used a combination of street names and DRS registrations depending on the situation. For example, the shares of Coca-Cola we gave my younger sister are an example of direct registration coupled with a dividend reinvestment plan .
The Advantages of Using the Direct Registration System When Holding Your Stocks
There are several major advantages to using DRS for your stockholdings. These include:
- Protection Against Counter Party Risk: If your stock broker goes bankrupt. and your shares were held in a street name, you are going to have to go through the claims process. and possibly get reimbursed, if eligible, from SIPC insurance. In contrast, if your stock is held through the DRS, it shouldn't matter because your claim is with the company you own itself, not the intermediary.
- Correspondence Directly from the Company Itself: Stock brokers can be notoriously slow when it comes to delivering annual reports. 10k filings. proxy statements. and other materials from the companies you own. When you are registered directly with the transfer agent through DRS, the papers are mailed to your address of record, often promptly.
- There Are No Paper Stock Certificates to Lose When You Use DRS: If you've ever owned a paper stock certificate,
you know they can be misplaced. With the Direct Registration System, this a problem you will never have to face. This can save you money, as well. Whenever you mail stock certificates, you are highly encouraged to insure them for 2% of the market value, which comes out of your pocket. (Why 2%? That is the cost estimate of what the transfer agent will charge to replace your certificate.)
- Stocks Held Through DRS Cannot Be Lent to Short-Sellers: When you hold stock in a street name. your broker lends your shares to short sellers. who can drive down the price by selling short the stock. The shares they borrow probably come from your account! This can sometimes lead to an interesting tax problem when the dividends you receive, which would otherwise meet the qualified dividend requirements to gain the 15% favorable tax rate, technically are taken away from you because the short-sellers reimburse you with something known as a Payment in Liu of a dividend, or PIL.
- Using DRS Makes It Easier To Take Advantage of DRIPs: Many companies offer dividend reinvestment programs. or DRIPs. These are great for investors who want to pour their dividends back into purchasing more shares of stock with little or no commission fees. Over time, reinvesting your dividends can have a massive influence in your ultimate wealth. When you use the Direct Registration System, you can make a phone call or send in a signature and enroll in the DRIP.
- Making Gift Transfers to Friends or Family Can Be Easier with the DRS: As an added bonus of using the Direct Registration System, you can often gift shares to family or friends by having the transfer agent setup a DRIP account for them, funded with a transfer of shares from your account into their account. This can be a great option for an investor who has built up a large position in a particular company and wants to give his or her children shares up to the gift tax limit exclusion each year. I know of one family that held hundreds of thousands of shares of General Electric, built up over a lifetime of disciplined investing, who used this method to pass down ownership to subsequent generations. The eldest generation would fill out some paperwork once a year and the children and grandchildren would see deposits of new shares added to their account statements every twelve months.
The Disadvantages of Using the Direct Registration System When Holding Your Stocks
The biggest disadvantage to using DRS is that you can't sell your stock immediately. You have to submit instructions directly to the transfer agent, who then pools your sell orders with other sellers, and executes the trade on a predetermined schedule. That would make it impossible to sell off in the midst of a panic as the world fell apart or if you needed money quickly. At best, you are going to allow for a minimum of several business days to access your cash.
Another option for faster liquidations is to have the transfer agent managing your DRS entry in a particular company move your shares to the brokerage firm so the stock broker can sell quickly. This would take at least a few business days to achieve, perhaps longer.
The Ideal DRS Investor
The investor who should seriously consider the Direct Registration System is one who:
- Plans on buying large amounts of stock in a particular business,
- Plans on holding those shares for the next few years at a minimum,
- Doesn't want to lose sleep over the possibility of his broker or financial institution going bankrupt
- Prefers to receive annual reports and other documents as quickly as possible
- Wants to setup automatic reinvestment of dividends or electronic deposit of dividends in a bank account
- Doesn't want the hassle and physical security risk of holding paper stock certificates
Only you will know whether DRS is right for your situation. For some of you, it warrants a closer examination.