The idea behind the Plowback screen is to invest in large-cap companies with strong price growth momentum that also have a high return on equity. The logic behind the screen is that return on equity is to growth stocks as dividends are to value stocks. Dividends in value stocks are an indication of cash the company has available to disperse to shareholders. Return on equity is an indicator of how much of a company's retained earnings (profits) is reinvested in (or plowed back into) the company, and of how well that investment is paying off. Specifically it looks at the ratio between retained earnings and the company's common equity. (Think of common equity as net worth. It's the total assets minus the total liabilities.)
This isn't a year-by-year measure, by the way. Retained earnings accumulate from year to year and are a component of common equity, so the Plowback Ratio looks at the history of the company, not just how it did last year. Being able to finance growth internally from retained earnings means companies can borrow less, and it means that they are generating healthy amounts of cash in the first place.
While the large market cap and strong momentum criteria are similar to Keystone, Plowback differs from Keystone in that it does not rely on Value Line's Timeliness ratings and in that it adds the "high return on equity" criteria to the screen. The lack of the Timeliness ranking makes it unique to all the other screens of the workshop.
Here are the steps for determining the Plowback Screen using Value Line Investment Survey for Windows:
With these numbers looking so good you may ask, Why is the Plowback so controversial? Let's look more closely at the returns. Below is a graph of the average return of each position (i.e., the average return of all stocks that were in the first position, then the average return of all stocks that were in the second position, etc.) for a January portfolio that ran from the beginning of 1986 through the end of 1998.
Position CAGR SD
1 45.4 44.7
2 14.1 61.1
3 34.7 47.4
4 9.2 58.0
5 11.7 44.0
6 16.9 43.0
7 -3.8 55.6
8 30.2 38.4
9 23.0 37.7
10 0.1 51.2
You can see that only the first, third, eighth, and ninth positions have market-beating returns. You can also see that each of the positions have huge standard deviations. For many, including myself, these numbers are a big concern. This screen looks too much like a hit-and-miss approach. In this respect, it doesn't meet my criteria for a sound stocks screen. Therefore, when looking downstream, I am concerned about how well this screen will hold up. For me, I'd rather stick to some of the other large-cap screens such as Keystone, Key100, and Spark.
Others disagree. They look at the strong returns of the top few positions and go with the numbers that say, "Buy the top three." Others say that the average of the first five positions look great, so they aren't worried about individual positions. They also just like the idea of investing in large companies that are plowing back money into the business. It's certainly a philosophically attractive attribute.
Which side of this argument is right? Only time will tell, but if you have an opinion one way or the other, feel free to express it on the Foolish Workshop message board. I look forward to hearing what you think.
Until next time, Fool on!
For more on the Plowback strategy see:
Workshop August 5, 1999
Workshop May 19, 1998
For more on the company accounting numbers that make up the Plowback Ratio, see:
How to Read a Balance Sheet