Huatai Securities: Middle East tensions disrupt market risk appetite; dividends still hold core position value

Haitong Securities research reports that in recent years, as global macro uncertainty has risen and domestic residents’ asset allocation demand has grown, alongside a downward shift in the all-society broad investment return rate’s central level, the dividend/bonus (dividend yield) strategy has attracted increasing attention from capital. At present, the dividend/bonus strategy’s relatively growth-neutral valuation is at a low level; disturbances from the Middle East situation have shaken market risk appetite. Still, dividend/bonus remains to have bottom-position value. Haitong Securities optimizes the dividend/bonus strategy from two aspects: stock selection and market timing: 1) From the stock selection angle, based on dividend stability, earnings quality, and industry neutrality optimization, it builds a Haitong Strategy high-dividend, industry-neutral portfolio. Based on free cash flow combined with growth and the capital expenditure relative strength factor, it builds the Haitong Strategy free cash flow growth, stable portfolio; 2) From the market timing angle, it focuses on three types of excess-return environments: falling risk appetite, rising inflation, and the “rising volatility” phase in volatile markets. Combined with the Haitong Quantitative Engineering (金工) team’s quantitative market timing model, the current outlook is bullish on dividend/bonus.

Full text as follows

Haitong | Strategy: Stock Selection and Market Timing Optimization for the Dividend/Bonus Strategy

Key Viewpoints

Re-breaking down the long-term and short-term logic behind the outperformance of the dividend/bonus strategy

Considering dividend reinvestment returns, the dividend/bonus strategy has been effective both overseas and domestically over the long term. Its sources of excess returns can be summarized as dividend reinvestment returns, low valuation and low volatility, and the “coupon run-up (filling the ex-rights gap)” effect. Over the long term, the environments favorable to the outperformance of the dividend/bonus strategy include: 1) rising global macro uncertainty, increasing investors’ demand for “safe assets” such as gold and dividends; 2) a downward interest-rate trend or a prolonged low interest-rate environment, where from an asset-allocation perspective the return spread between dividend stocks and stocks/bonds either rises or stays at a high level, and funds flow into dividend/bonus assets through channels such as insurance, pension funds, and ETFs. In the short term, the dividend/bonus also has both defensive and cyclical characteristics: 1) dividend/bonus as a short-duration asset is relatively insensitive to risks premia on the denominator side and changes in discount rates, and therefore is more resilient during valuation-contraction phases; 2) cyclical dividend/bonus tends to be relatively advantageous during inflation upswings.

Stock selection #1: Optimize dividend/bonus portfolios based on dividend stability, earnings quality, and industry neutrality

We can enhance the dividend/bonus strategy through methods such as multi-factor composites, more refined factor processing, and weight optimization. Traditional dividend/bonus strategies face issues such as value traps, low growth potential, and overly concentrated industry distributions. To “prescribe the right medicine” for the above problems, on 2023.3.30 in “High Dividend Strategy: Excess Return Environments and Stock Selection Thinking,” we constructed a Haitong Strategy high-dividend, industry-neutral portfolio, and further optimized it as follows:

1) The sample universe is all A-shares, rebalanced on May 1 each year; 2) Remove ST stocks and stocks with market value less than 10B yuan; 3) Continuous dividend payments for the past three years, and the average dividend yield over the past five years is higher than the median, while the coefficient of variation is lower than the median; 4) Calculate the forecast dividend yield based on consensus forecast net profit (if unavailable, use net profit TTM instead) and the average dividend payout ratio over the past 5 years; after removing outliers, the forecast dividend yield is not less than 2.5%; 5) Compute a composite score by weighting based on forecast dividend yield and ROA percentile ranks, then rank; 6) Select the top two stocks in each Shenwan first-level industry by score (if fewer, ignore them) and construct an equal-weighted portfolio.

Within the backtest period (from May 1, 2016 to March 26, 2026), the portfolio’s annualized return is 11.7%, with an annualized excess of 7.2% versus the CSI Dividend/Bonus Total Return Index; annualized volatility is 17.0%, maximum drawdown 23.1%, and Sharpe ratio 0.69, all outperforming the CSI Dividend/Bonus Total Return Index. From a performance review, the portfolio only significantly underperforms the CSI Dividend/Bonus Total Return Index in 22 Feb–8 months and 25 Jun–9 months. While maintaining defensive characteristics and also accounting for portfolio elasticity, it loses on the degree of exposure to the dividend/bonus factor, and the portfolio’s dividend yield is clearly lower than that of the CSI Dividend/Bonus.

Stock selection #2: From high dividend to high cash flow, build a free cash flow enhanced portfolio

From the perspective of valuation models, the essence of the dividend/bonus factor is the DDM model, while the essence of the free cash flow factor is the DCF model, which is closer to first principles. Compared with the traditional dividend/bonus factor, the cash-flow factor (free cash flow yield, FCFF/EV) can better reflect a company’s ability to continuously and stably distribute dividends. The selected stocks not only have strong profitability, healthy financial conditions, and higher shareholder return capabilities (buybacks and dividends), but also maintain a certain expansion ability. This corresponds to earlier positioning in the industrial life cycle, balancing stability and growth. The free cash flow strategy has already become relatively mature in overseas markets. In China’s A-share market, similar index products have gradually become more diverse as well. Since the base date, the risk-return ratio of the main free cash flow indexes has improved significantly versus the CSI Dividend/Bonus index; among them, the China Securities (国证) free cash flow index has a relatively superior risk-return ratio. We enhance it in two ways:

1) Combine with a growth factor to build the Haitong Strategy free cash flow growth portfolio: use free cash flow after smoothing (TTM), combine with a growth factor (rolling 2-year free cash flow CAGR), and after excluding outliers and ranking, select the top 100 stocks. Weight by free cash flow yield, with an individual stock weight cap of 10%. Within the sample (from January 2, 2014 to March 26, 2026), the annualized return is 18.0%, annualized volatility 22.4%, Sharpe ratio 0.83, all outperforming the China Securities Free Cash Flow Index;

2) Combine capital expenditure relative strength to build the Haitong Strategy free cash flow stable portfolio: use free cash flow after smoothing (TTM), and exclude stocks with capital expenditure / operating cash flow greater than 0.4. Select the top 100 stocks. Weight by free cash flow yield, with an individual stock weight cap of 10%. Within the sample (from January 2, 2014 to March 26, 2026), the annualized return is 19.8%, annualized volatility 20.7%, Sharpe ratio 0.96, all outperforming the China Securities Free Cash Flow Index.

The above portfolios’ annualized turnover rates are both around 125%; industry distribution is relatively balanced. Looking at changes in the industry mix of holdings since 2020, the approach can capture some clues about improvements in the state of business conditions or the supply-demand pattern.

Market timing: Three types of excess-return environments and a quantitative market timing system

From a strategy perspective, dividend/bonus assets have three typical excess-return environments: 1) when risk appetite declines, the excess return window generally starts within 1–3 months after the peak in the all-A market, and ends after liquidity widens or the economy weakens; stable dividend/bonus is relatively advantageous; 2) when inflation rises, the timing signal is the upward movement of the US-China PPI year-on-year average, and cyclical dividend/bonus is relatively advantageous; 3) during the upswing phase of rising volatility in a choppy market, from a portfolio management perspective, when trends are unclear, or downside risks are greater than upside risks, investors typically use a “barbell” strategy to deal with the rise in volatility, and dividend/bonus can also generate excess returns. From a quantitative perspective, in the Haitong Quantitative Engineering (金工) team’s research dated 2025.1.7, “Dividend Factor Market Timing and 2025Q1 Sector ETF Investment Recommendations — ETF Smart Investing Series Research III,” it constructs a market timing model using the dividend/bonus factor’s own trend, term spread, and interbank market trading volume. From 2017 to this year, the annualized return is 16.5%, and the annualized excess versus the benchmark (50% CSI All Shares + 50% CSI Dividend/Bonus) is 9.9%. Currently, with PPI year-on-year rising and risk appetite under periodic pressure due to geopolitical developments, the quantitative market timing model signals also turn bullish on dividend/bonus. Dividend/bonus assets show relatively attractive valuation versus risk when measured by the stock-to-bond return spread, mutual fund allocation coefficient, transaction value share, and turnover rate.

Risk warning: risk of model failure; fundamentals at home and abroad underperforming expectations; liquidity underperforming expectations.

（Source: Caixin/CS（财联社））