Workshop Portfolio The Plowback Strategy: Does It Work?

By Moe Chernick (Moebruin)

EL SEGUNDO, CA (Dec. 16, 1999) -- One of the new screens that will be followed by the Workshop next year is also one of the most controversial. Folks either love of loathe the Plowback strategy.

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:

  1. Select all stocks covered by Value Line Investment Survey for Windows (1700-stock edition) that have a "% Retained to Common Equity" value greater than 25%. This is the Plowback ratio.
  2. Select the 20 with the highest market cap.
  3. Sort by 26-Week Total Return.
  4. Select the number of stocks you want to buy from the top of the list.
How has this screen performed? According to Jamie Gritton's tester, a five-stock version from 1986 to 1998 has a CAGR of 30.5% with a standard deviation of 18.0%. A 10-stock version has a CAGR of 24.2% with a standard deviation of 20.7%. Looking at 13-year portfolios starting in various months, we see a range of returns between 19% and 33%, which is reasonable. February was the highest.

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

Workshop Portfolio


9/28/01 as of ~5:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AETAETNA INC NEW0.943.36%28.94
BABOEING CO(1.04)(3.02%)33.36
CATCATERPILLAR INC1.112.53%44.91
COGCABOT OIL & GAS 'A'0.693.59%19.90
DDDU PONT (EI) DE NEMOURS0.992.74%37.14
DGXQUEST DIAGNOSTICS(0.45)(0.73%)61.42
EKEASTMAN KODAK0.421.31%32.49
GMGENERAL MOTORS1.393.38%42.55
LHLABORATORY CORP AMER HLDG(NEW)1.141.42%81.21
MOPHILIP MORRIS COS(0.76)(1.55%)48.24
NEWPNEWPORT CORP0.261.90%13.97
NVRNVR INC(0.54)(0.38%)140.41
PKXPOHANG IRON & STEEL ADS1.097.51%15.61
PVNPROVIDIAN FINANCIAL1.075.64%20.04
QCOMQUALCOMM INC(0.40)(0.84%)47.16
RJRRJ REYNOLDS TOBACCO HLDGS(0.69)(1.19%)57.31
SLESARA LEE CORPUnchg.Unchg.21.09
UNFIUNITED NATURAL FOODS0.563.18%18.15
WMIWASTE MANAGEMENT(0.01)(0.04%)26.74

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(12/24/1998)
Workshop1.30%7.32%(12.02%)(20.66%)(18.91%)
Comparable S&P 500n/an/an/an/a(19.07%)
S&P 500 (DA)1.95%7.48%(8.33%)(21.22%)(14.88%)
NASDAQ2.02%4.71%(17.46%)(39.68%)(31.41%)
DJIA (DA)1.68%7.07%(11.07%)(17.86%)(2.22%)

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (12/24/1998)
Workshop(17.62%)
vs. S&P 500(17.63%)

Trade Date # Shares Ticker Cost/Share Price Total % Ret
1/8/0126MO40.9448.2417.82%
1/8/0122RJR50.1057.3114.39%
1/8/0167UNFI16.4518.1510.34%
12/24/9824CAT43.0844.914.24%
1/8/018NVR136.63140.412.77%
1/8/0140WMI27.4426.74(2.54%)
1/8/0150SLE22.5421.09(6.42%)
1/8/0161PKX17.8315.61(12.46%)
1/8/0115DD48.8337.14(23.95%)
1/8/0129AET38.1728.94(24.19%)
1/8/0139COG28.7519.90(30.79%)
1/8/0114QCOM75.5447.16(37.57%)
1/8/018LH134.6981.21(39.70%)
12/27/9918GM73.2642.55(41.92%)
1/8/0118BA59.5333.36(43.96%)
1/8/019DGX114.4961.42(46.35%)
12/27/9920EK65.0932.49(50.08%)
1/8/0120PVN55.5020.04(63.89%)
1/8/0115NEWP74.9613.97(81.36%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
1/8/0126MO$1,064.50$1,254.24$189.74
1/8/0122RJR$1,102.25$1,260.82$158.57
1/8/0167UNFI$1,102.12$1,216.05$113.93
12/24/9824CAT$1,034.00$1,077.84$43.84
1/8/018NVR$1,093.00$1,123.28$30.28
1/8/0140WMI$1,097.50$1,069.60($27.90)
1/8/0150SLE$1,126.88$1,054.50($72.38)
1/8/0161PKX$1,087.75$952.21($135.54)
1/8/0115DD$732.50$557.10($175.40)
1/8/0129AET$1,107.00$839.26($267.74)
1/8/0139COG$1,121.37$776.10($345.28)
1/8/0114QCOM$1,057.62$660.24($397.39)
1/8/018LH$1,077.50$649.68($427.82)
1/8/0118BA$1,071.50$600.48($471.02)
1/8/019DGX$1,030.44$552.78($477.66)
12/27/9918GM$1,318.62$765.90($552.73)
12/27/9920EK$1,301.75$649.80($651.95)
1/8/0120PVN$1,110.00$400.80($709.20)
1/8/0115NEWP$1,124.37$209.55($914.83)
 
Cash: 
Total: 
$10.80
$15,681.03
 

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

Note
Note: The Workshop Portfolio was launched on December 24, 1998, with $4,000 which was invested in the Foolish Four strategy. Approximately $15,000 was added on January 8, 2001, to support five additional mechanical strategies. At that time approximately $1000 was transfered out of the Foolish Four strategy to bring the Foolish Four into balance with the other strategies. (That's why the Foolish Four's overall return is not consistent with stock values.) Such rebalancing will take place each year among the strategies so that each will start out with approximately the same value at the begining of the year. No more cash additions are planned. The first four tables above show the overall performance of the portfolio. Below that we also track the performance of each component strategy. All transactions are announced publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen using strategies developed by the Workshop community.