The wisdom of buy and hold

The basic assertion made by Mr Bogle is that while equity valuations can fluctuate quite wildly in the short-term, "over the long haul, investment fundamentals, not market valuations, are the piper that calls the tune". Indeed, Mr Bogle picks apart 40 years of US performance data in his book to illustrate how market returns revert to what he terms "investment returns" - earnings growth plus dividend.

According to Mr Bogle's numbers, between 1970 and 2010 the annual rate of investment return of 9 per cent was very close to the 9.3 per cent market return. However, this masks 7.5 per cent of underperformance by the market in the 1970s as PEs fell from 15.8 to 7.3, followed by two decades of serious outperformance (7.7 per cent followed by 7.2 per cent) as PEs surged from to a dot-com induced 30.6, then 3.2 per cent underperformance in the first decade of the millennium as PEs moderated to 22.

What's more, for investors with holding periods of 25 years, Mr Bogle finds that market returns rarely differ significantly from investment returns. Measuring returns on a rolling 25-year basis over the last 125 years, Mr Bogle found the difference between market and investment returns never exceeded 4 percentage points and only exceeded 2 percentage points 25 times.

While Mr Bogle's ultimate conclusion about investment is to buy and regularly rebalance a small portfolio of low-cost index funds ("buy the haystack not the needle"), for buy-and-hold equity investors his conclusions about RTM nevertheless provide encouraging affirmation that buying stocks with undervalued fundamentals will reap rewards in the long term. Helpfully, there is another legendary US investor whose clear and concise approach to stock picking embodies the RTM principle exposed by Mr Bogle, and it is possible to find stocks that may benefit from RTM with a simple stock screen based on the approach.

From Bogle to Neff

John Neff earned his reputation as an investment legend at the helm of a fund which is now managed by Mr Bogle’s own firm, the Vanguard Windsor fund. Mr Neff produced annual returns of 13.7 per cent compared with 10.6 per cent from the S&P 500 during the 31 years he managed the Windsor fund. While he is often characterised as a value investor, probably due to his liking for overlooked stocks that are perceived as dull by the wider market, his approach is much more agnostic than the "value" tag suggests. Indeed, his key valuation tool is based on "investment return", of which EPS growth plays a large part. Like Mr Bogle, he also advocates long holding periods. ("Time is your friend" is another one of Mr Bogle's axioms). So we've run a Neff screen to find stocks with investment fundamentals that don't appear to be reflected in price and could therefore benefit from the RTM effect.

The first part of Mr Neff's approach to stock picking is to weed out stocks at valuation extremes, which helps avoid the risks associated with RTM. So any stocks that have forecast PEs among the highest quarter of all stocks - those most likely to see ratings fall sharply - are rejected. Nor is he interested in the quarter of companies with the lowest forecast PEs as these are likely to carry very high investment risk. Applying this process to our screen of the UK market (which also eliminated all companies with no EPS forecasts or negative forecast PEs at the outset) we were left with 369 stocks with forecast PEs ranging from 8.6 to 16.3 times.

The same RTM-aware approach is applied by Mr Neff to EPS growth. Mr Neff likes stocks to display healthy levels of growth (over 7 per cent) but not excessive levels of growth (over 20 per cent) that are likely to prove unsustainable.

While Mr Neff was sceptical about he market's ability to forecast the future, he did want to see expectations of EPS growth broadly in line with past growth rates. He also put emphasis on the consistency of earnings growth, and we have found a satisfactory way to build this into our screen. Considerations of RTM are also applied to margin growth by Mr Neff. He wants stocks to demonstrate that EPS growth is based on solid turnover growth as EPS fuelled by margin expansion will ultimately hit a limit.

Perhaps the biggest parallel between the approaches of Mr Bogel and Mr Neff, though is the ratio used by the latter to try to identify value in a stock. Mr Neff uses a ratio that compares a stock’s PE to its total return (TR). We’ve based our TRs on the average of forecast EPS growth and the 5-year EPS CAGR plus the historic dividend yield. We’ve also reversed the numerator and denominator from Neff's original formulation of the ratio to give a PE/TR ratio, which expresses value in a similar way to the familiar PEG ratio – ie the lower the number the better. From the 369 stocks we screened, the median PE/TR ratio was 0.93, and we've highlighted all the stocks with valuations lower than this in the table below. If the fundamental performance holds up, these are the stocks one would expect the market to rerate as RTM exerts its influence.

Stocks to buy and hold

Source: S&P CapitalIQ

Lowest PE/TR

A business specialising in seals, life science equipment and controls distribution certainly fits with Mr Neff's love of dull stocks. But the unglamorous nature of Diploma's business is not the only reason for it being the cheapest stock on the list based on its PE/TR ratio. Tough economic conditions in Europe and elsewhere means organic growth has been slowing, although last month's trading update reported the growth rate was still a healthy 5 per cent in the final quarter of Diploma’s financial year. The business is reasonably defensive compared with other distributors due to the diversity of the niche markets it serves and also its geographic spread. The performance of the seals business has been particularly impressive recently. The company also boasts impressive cash generation and has a good record of using this money to make useful bolt-on acquisitions.

Last IC View: Buy, 447p, 14 May 2012

Highest yield

Shares in motor insurer Admiral came a cropper last year as the market got wind the brakes were about to be put on its formidable growth record, and yield is not the stock's principal attraction. Indeed, while forecast growth still looks attractive in the year ahead, things appear to be slowing fast. Broker Espirito Santo believes consensus forecasts are actually too high and predicts profit growth of 7 per cent in 2012, falling to 3 per cent in 2013, then 1 per cent in 2014. Espirito also believes that the float of Direct Line may cause short term selling of Admiral as investors in the sector try to rebalance their holdings between an increased number of big players. Behind Admiral’s slowing growth outlook is the fact that motor insurance rates have gone into decline at the same time as it has slowed volume growth target and referral revenues have fallen away due to a ban on the practice. Still the yield, which is forecast by Espirito to rise to a thinly covered 7.7 per cent this year, is attractive.

Last IC View: Hold, 1,163p, 30 Aug 2012

Lowest PE

Rigid plastic products manufacturer RPC faces tough trading conditions at the moment but the group nevertheless continues to make encouraging progress. Among the challenges faced by RPC are the torrid economic conditions, its heavy exposure to the euro and yo-yoing raw material prices. Some restructuring action has been taken to help mitigate these difficulties, such as the closure of a plastics cup operation last year, but the main progress has come from RPC’s use of its enviably strong balance sheet to invest in high-margin growth areas. Indeed, capital expenditure nearly doubled last year as the group invested heavily in product development and RPC has seen encouraging growth in areas such as coffee capsules and pharmaceuticals. The company also continues to benefit from the integration of its €240m Superflos acquisition which was made in February 2011.

Last IC View: Buy, 366p, 13 Jun 2012

Highest EPS Growth

Given the fact that the UK consumers have faced declining real incomes, it may seem surprising to find a UK consumer-focused company emerging as the fastest growing of our "common sense" Neff stock picks. However consumers have shown a dogged determination to continue treating themselves. What's more, while independents have struggled, large dining-out firms have shown a flair for offering consumers value for money while retaining margin. And few businesses can claim to be slicker operators than Restaurant Group which has won many plaudits for its impressive, long-term, self-financing growth strategy. In fact, growth prospects could be improving for Restaurant Group, which has reined in investment over recent years due to the uncertain outlook. The company has developed a new restaurant brand called Coast to Coast which it is starting to roll out and which broker Canaccord Genuity believes could add £11m to operating profits by 2015/16. Canaccord believes the profit rise would be equivalent to 26 per cent equity upside and it estimates there would still be enough cash sloshing around the business to encourage management to return some of it to shareholders.

Last IC View: Buy, 331p, 3 Sep 2012

Most consistent EPS Growth

Mr Neff emphasised the importance of stability of earnings growth. Building maintenance firm MITIE offers by far the most stable past and future earnings growth profile of all the stocks making it through our screen. This is despite a slowdown in orders around the time of the last election. The company may also have spruced up future growth prospects with its recent £111m acquisition of the UK's fourth largest home-care provider Enara. While some eyebrows have been raised at the price paid for the business, which is equivalent to 11 times cash profit, there is no denying that the home-care market has significant potential. The main thing holding back the development of home-care outsourcing is wrangles over how the burden of caring for the elderly should be spread. There has been a lot of talk on the subject but pressing demographic concerns means at some point a tough decision is going to have to be made following which there could prove to be a lot of excitement about the opportunities for businesses such as Enara.

Last IC View: Buy, 297p, 9 Oct 2012