In recent years, the investment strategy centered around high dividend yields has gained considerable traction among investorsThis approach essentially embodies the principles of medium to long-term investing and value investing, prioritizing robust future dividends over short-term fluctuations in secondary market stock pricesThe crux of this strategy lies in the challenge of forecasting a company’s future profitability accurately.

In the previous two years, stocks with high dividend yields have notably outperformed the A-share index of ChinaThis leads to a pertinent question: at what point will these stocks reach their peak? Furthermore, is there a limit to the effectiveness of the high dividend strategy?

In navigating these questions, it's crucial to consider the specific conditions of different industries and individual companies, as well as the nature of the purchasing power behind these investments.

Different Industry Categories

To begin, consider companies that are anticipated to face downturns, where future dividends might decline

Even a dividend yield of 7%-8% might not justify an investment if the underlying business is unstableIn such scenarios, a substantial current dividend could very well turn into negligible returns the following year, showcasing a lack of sustainabilityIt’s misleading to anchor long-term investments merely on high dividend yields.

A striking example of this phenomenon is seen in a leading real estate enterprise in China, which previously demonstrated a solid record of dividend distributionFrom 2018 to 2022, its dividends per share amounted to 1.045 yuan, 1.017 yuan, 1.25 yuan, 0.976 yuan, and 0.68 yuan respectivelyHowever, this downward trend culminated in a shocking zero dividend in 2023. This fluctuation highlights the cyclical nature of the domestic real estate market, intricately linked to prices of land and housing salesIf an investor purchased shares of this company in 2022 based solely on a perceived 5% dividend yield, they would now face considerable losses

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At its peak in 2022, the stock traded at 19 yuan, a stark contrast to its current valuation of roughly 8 yuan.

On the other hand, for companies that exhibit healthy competitive dynamics, stable profit expectations, manageable debt levels, and robust operating cash flow—along with promising future prospects—a dividend yield between 3%-5% can be deemed acceptableHowever, looking ahead three to five years, with a further decline in interest rates, the market might aggressively pursue such stocks until the yield dwindles to around 2%-3%.

A relevant case study here is Changjiang PowerThe company, under the auspices of the State-owned China Three Gorges Corporation, has a substantial portfolio of hydropower assets that have been listed publiclyWhile the future growth potential of hydropower appears limited due to its vast installed capacity, the stability of revenue positions the firm favorably in the market

Between 2021 and 2023, its dividends were reported at 0.815 yuan, 0.853 yuan, and 0.82 yuan per share—with minimal growth recordedSince the end of 2022, however, its stock price has surged approximately 40%, primarily driven by dropping interest rates and an evolving expectation or tolerance within the market for Changjiang Power's dividend yield—from just above 4% to near 3% today.

Moreover, for stocks projected to have stable growth, positive market outlooks, and robust competitiveness, alongside reasonable capital expenditures and new ventures, a forecasted annual net profit growth of 5%-10% justifies a current dividend yield of 2%-3%. A prime illustration of this category is Tencent HoldingsAlthough the taxation on dividends in Hong Kong poses significant challenges, Tencent maintains a post-tax dividend yield of around 2.5%. Despite its massive scale, the company’s dominance in the WeChat ecosystem positions it for favorable performance, with optimistic growth forecasts for the coming years.

That said, smaller companies and growth stocks often exhibit lower dividend yields due to substantial capital requirements and expenditures

As such, investments in these areas necessitate an entirely different strategy, one that is not primarily motivated by high dividend yields.

Understanding the nuances surrounding high dividend investment strategies requires an appreciation of both the stability in various industries, such as hydropower, water supply, and essential consumer goods, as opposed to more volatile sectors like coal, oil, and gas, which are subject to fluctuations in commodity prices.

Moreover, bank stocks provide an interesting exception to the typical categorizationsWhile they may seem cyclical, banks possess multiple profit adjustment mechanisms, allowing them to maintain relative stability in annual dividendsCurrently, bank stocks exhibit high overall dividend yieldsNonetheless, there is considerable divergence among high dividend investors regarding future profitability expectations for bank stocks

This has prevented them from experiencing continuous price appreciation akin to that of Changjiang Power, thereby constraining yields to around 3%.

Despite the bleak profitability outlook for 2023 and potential negative growth for several banks in 2024, it’s crucial to recognize that dividends may not necessarily decrease in responsePresently, the subdued demand for loans is likely to result in diminishing loan growth rates annuallyHowever, this muted risk asset increase would lessen capital depletion, stabilizing capital adequacy ratios and allowing for sustained annual dividends—typically within a general range of 30%

Hypothetically, if a bank were to see profitability decrease by 30% over the next five years, yet its dividend payout ratio increased to 60%, this could translate to a 40% growth in annual dividends

Provided investors maintain consistent expectations regarding dividend yields, bank stock prices could rise by 60%-70% over this five-year horizon—accounting for a 40% increase in dividends and an additional annual yield of 4%-6%. Given the relatively low price-to-book (PB) ratios of domestic banks, often ranging from 0.4 to 0.8, there's substantial potential for meaningful returns if ROE remains consistently at 5%-10%.

This suggests that, should the domestic financial landscape avoid systemic risks and enhance regulatory measures to optimize loan quality, banks could become key players in igniting a new bull market, akin to previous “Golden 50” or “Sister Seven” movements.

Preferred Investment Allocations

Currently, the market foresees possible reductions in China’s deposit and loan interest rates in the latter half of the year, and a potential interest rate cut in the US by year-end, forecasting additional space for price increases in high-dividend stocks

Insurance companies are increasingly compelled to seek alternatives beyond high-grade bonds to cover mid-to-long term policy costs, given that current 10-year national treasury rates hover around 2.3% and are expected to dip below 1.5%-2% in subsequent yearsHigh-grade bonds offer yields in the range of 2.5%-3%, while the implied costs for various insurance policies often hover around 3%-4%.

Consequently, conservative investors, as well as institutions such as pension funds looking for bond alternatives, have begun allocating more capital towards high dividend yield stocksThe declining interest rates create a scarcity in fixed income products, necessitating a pivot towards high dividend yielding equities.

Conversely, publicly managed mutual funds have historically shied away from investing in high dividend yield stocks, typically perceiving them as having lackluster growth potential and insufficient projected annual returns without speculative market activity to stimulate interest

A historical tendency among Chinese investors to seek significant returns—often expecting upwards of 20%-30% in six months to a year—poses a challenge for convincing them to invest in high dividend yield stocks, which generally promise returns only marginally above dividend payouts.

In line with these higher return expectations, active stock funds in China tend to focus heavily on growth or thematic stocksHowever, performances in this arena over the past couple of years have been somewhat disappointing, primarily due to the absence of significant market buy-insConversely, funds oriented towards dividend yields have thrived thanks to the prevailing trends of declining interest rates and a shift towards defensive investment strategies among institutional investors.

Drawing parallels, Japan’s stock market has experienced favorable outcomes from a high dividend strategy since the early 2000s