The Profound Logic of Dividend Investing

In the realm of investment strategies, simplifying the current wave of dividend investments to mere "dividends" and focusing only on the dividend yield misses the crucial essence of the market's dynamicsThe modern market landscape differs significantly from that of the past due to the emergence of a cohort of "returning middle-aged" investorsThis group is navigating industries and companies that have undergone approximately a decade of structural adjustments, leading to diminished valuations and insufficient market analysisThis scenario presents a considerable "expectation gap," representing a unique opportunity forged through years of industry recalibration.

Since the latter half of 2023, dividend investing has shown strong performance; yet, participation from market players remains surprisingly subdued

Objective data indicates that, whether in institutional allocations or trading turnover of these dividend-focused stocks, we cannot yet speak of a fervent “herd mentality” or overheated market conditionsThis phenomenon raises eyebrows, especially when considering that for the past three years, assets characterized by lower valuations and higher dividends have demonstrated distinct relative returns, with projections for 2024 suggesting further opportunities for absolute returnsNonetheless, the mainstream investment community continues to oscillate between acknowledgment and inaction.

Examining only the dividend yield is insufficient to grasp the full narrative.

A common understanding surrounding dividend investments posits that the slowing growth of the Chinese economy, coupled with the declining yield of ten-year government bonds—the benchmark for a risk-free interest rate—makes high-dividend strategies particularly appealing

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This reasoning forms a closed loop, suggesting that if the Chinese economy rebounds to high growth or if risk-free rates rise, then these high-dividend strategies may falterHowever, an investigation into the historical correlation from 2005 onwards between the yields of ten-year government bonds and the dividend yield of the CSI 300 Index reveals a lack of significant relationship, undermining the logic that underpins this reasoning.

In the A-share market, there always seems to be a penchant for encapsulating the entirety of market sentiments into catchy phrases, but many of these terms fail to encapsulate the reality accurately.

When we began to allocate towards undervalued assets in 2021, phrases like "dividend investing," "special state valuation," "defensive market," and "falling government bond yields" weren’t part of the narrative

Our approach was rooted in the intrinsic perspectives of industry dynamics and valuations, leading us to recognize the immense cost-effectiveness of these assets.

Thus, to reduce the current wave of investments merely to "dividends" and dwell solely on the yield is to overlook the profound subtleties embedded within this market movement.

When assessing dividend yield, it breaks down into the formula of dividends divided by stock priceFurther dissected, it translates to earnings per share multiplied by the dividend payout ratio divided by stock price, offering a different perspective when understood as dividend payout ratio divided by price-to-earnings (P/E). Hence, for an industry or stock to boast a high dividend yield, two significant conditions must be met: First, it must maintain low valuations without prolonged negative earnings growth, ensuring stable performance; second, the dividend payout must be high and consistently reliable

However, achieving both conditions simultaneously poses challenges, as stable, high-dividend firms are typically from industries perceived as utility-based, warranting decent market valuations, thus contradicting the low valuation prerequisite.

Consider the two primary sectors in dividend investment: coal and bankingAs observed since 2005, the current price-to-book (PB) valuation of these sectors stands at a mere fraction—approximately one-tenth—of their peak valuationsIn essence, the valuations of these sectors, viewed through a historical lens, are significantly depressed, although the market has grown accustomed to this status quo and tends to regard these sectors as inherently undervaluedWe contend that such a state is not sustainable or healthy.

Industries experiencing low valuations often do so for various reasons; this can include inherently low prosperity, yielding poor performance, resulting in inevitable undervaluation

Conversely, sometimes prevailing market biases also contribute to such scenarios.

Analyzing three flagship companies—Kweichow Moutai, SANY Heavy Industry, and China Shenhua Energy—across the distinct sectors of liquor, construction machinery, and coal from 2012 to 2022, we observe that these firms hit their respective valuation troughs around 2015 to 2016 during the supply-side structural reformMarket perceptions varied immensely despite their cyclical turning points appearing closely around the same timeframeFor instance, Kweichow Moutai’s valuation lows occurred in early 2014, following which fundamental improvements weren’t recognized until two years later, in early 2016, when its batch prices plummeted to around 800 RMBMeanwhile, SANY’s valuation and fundamental turnaround coincided closely, but China Shenhua’s fundamental improvements came around 2016, with market valuation lows not reflected until 2020, underscoring a persistent valuation disconnect despite better fundamentals.

This illustration reveals that market biases differ across sectors; the market is often quick to pardon the liquor industry, rewarding it even if cyclical improvements may only manifest in the future

In contrast, the construction machinery industry sees evaluations move synchronously, while the coal sector, despite witnessing substantial profitable shifts supported by a decade-long decline’s end, remains largely undervalued.

The reasons for the otherwise low valuations in traditional sectors stem not only from poor fundamentals but perhaps an oversight by investors who, over the past decade, directed their focus toward growth stocks, tech shares, and certain consumer stocks, often dismissing cyclicals as irrelevantSuch biases have engendered a trend of low valuations, and within these expectations lies the silver lining of investment opportunities.

Next, we should examine the aspect of dividend payoutBank stocks typically maintain a steady dividend payout ratio ranging between 20-30%, while coal companies have seen their payout ratios surge beyond 50% since 2016-2017. The rise in dividend payouts stems from an overall decline in capital expenditures across the industry, which, while presenting the sector as lacking vast future prospects, also indicates a transition toward maturity, allowing more capital to be returned to investors.

Ultimately, the most significant differentiation between the current market landscape and its predecessors is the influx of returning middle-aged investors

This demographic, shaped by over a decade of industrial adjustments, continues to experience low valuations and insufficient market studies, contributing to a pronounced "expectation gap." This situation offers opportunities that have emerged from lengthy periods of adjustment, embodying the intricacies of new investment prospects that transcend mere dividend yields.

Currently, the undervalued dividend valuations remain stagnant; for instance, the PB ratio of the leading dividend index has stabilized at around 0.69 since early 2021. Following a possible resurgence beginning in late 2022, many institutional investors and funds remain hesitant about fully committing to dividend assets.

Investment strategies must evolve as well.

The approaches suited for "middle-aged" investments differ markedly from those tailored for "youthful" strategies

The latter may not display growth potential or expansive horizons, yet their inherent value remains significantMany remain puzzled as to why stocks with "ordinary" fundamentals—represented by companies like PetroChina, Sinopec, and Bank of Communications—have experienced notable price surges in recent years.

This conundrum boils down to a decade-long norm within the mainstream investment community cultivating a preference for "youthful" investment methodologiesThe A-share market holds growth investing in high esteem, with a tendency toward metrics like penetration rates and market capacities, emphasizing valuation less than market capitalizationsFrom the small appliance sub-sector between 1996-1997 to cyclical segments from 2005-2007, through the internet boom from 2013-2015, to the recent prominence of renewable energy from 2019-2021, these phases exhibit a distinct focus on growth investment strategies.

Prior to 2016, all sectors within the A-share market were primarily classified as emerging industries, necessitating growth investment tactics

However, after 2016, numerous previously declining sectors, such as liquor, construction machinery, shipping, shipbuilding, and coal, began their resurgence post-adjustment, demonstrating resilience through cycles, albeit without the expansive growth opportunities of their earlier days.

Indeed, established industries’ cyclical investments offer greater stability compared to growth-focused strategies, which, while expansive, often incur lower success rates and demand exceptional foresight regarding future trajectoriesBy merely concentrating on cyclical investments in matured industries, individuals can navigate the predictable peaks and valleys of these markets, capitalizing on declines without the anxiety associated with emergent industries, where leaders may remain unclear amidst inevitable disruptions.

This stability allows for earlier heavy investments, with anticipated yields tied to initial tactical selections rather than long-term speculative growth expectations