This says that you don't get owt for nowt. A high yield should therefore be either a sign that a stock is riskier than average, or that it has worse growth prospects and so a higher yield will be offset by lower price rises.
So, who's right: income investors or common sense?
Income investors, mostly. My chart shows the point. It plots annualised price changes for 28 main FTSE sectors in the past 20 years against their dividend yields 20 years ago. If common sense were right, we'd expect to see a negative relationship between the two, with higher yields leading to lower price performance. If income investors were right, we'd see a positive relationship.
And it's income investors who have been right. There's been a positive correlation between the two - of 0.36 if we want to be precise.
In part, this is because income investors got lucky. Twenty years ago, some stocks were on good yields because investors regarded them as risky, in the sense of being more heavily exposed than others to the risk of recession. Because this risk only materialised once in those 20 years (albeit greatly so) these stocks have done well on average. This is true for construction, miners and chemicals. If we consider only the past 10 years, which gives a greater weight to the 2008-09 slump, we see a different picture. In this sample, there has been a slightly negative correlation between yield and price performance - albeit largely due to banks having a high yield in 2007 and catastrophic subsequent performance.
That, though, isn't the whole story. Some high-income sectors have done well even though they are not obviously risky, such as tobacco, utilities, beverages and food producers.
This happened because investors' expectations for growth have been wrong. Years ago, they thought these sectors offered little growth and so they required high yields as compensation for holding them. Such pessimism, however, proved to be mistaken.
Whether income investing will continue to pay off depends on how we interpret this fact.
One possibility is that it was a mistake that investors have since corrected. Years ago, investors under-rated the importance for earnings growth of what Warren Buffett calls economic moats - barriers to entry that allow a company to fight off competition and so expand earnings by maintaining a stable market share: a constant share of a slowly growing market is better than a shrinking share of a growing one. Today, though, investors have wised up to this: stocks with strong brands, such as Diageo, Unilever and Reckitt Benckiser, are all on low yields. Granted, telecoms and utilities are still on high yields. But this might reflect the risk that new entrants will eventually undermine their oligopoly power; the sort of price war we're seeing in the Indian telecoms market could come to the UK.
If this is the case, then the days of income investing are over. It paid off because investors were mistaken, but they've now corrected that error.
But there's another possibility. Alex Coad at Sussex University has pointed out that corporate growth is largely unpredictable. To the extent that this is the case then we should be income investors on the basis that a bird in the hand is worth two in the bush; we can't rely on expected growth actually materialising, so we should trust a nice dividend instead.
In this sense, the case for income investing rests on your view about knowledge of the future. If the future's unknowable, then income investing is sensible because the expectations of growth that cause low yields are not reliable. If, by contrast, you think growth can be predicted, then higher yields exist for a good reason, in which case income investing comes at a price. Personally, my sympathies are with income investors.
