Beacon Street Capital believes that a portfolio of stocks with superior business fundamentals and improving internal growth potential will generate greater returns than the market over a three-to-five year period. Purchasing these stocks when mispriced by the market adds to the returns without adding market risk. Furthermore, using a mechanical trading system to capture these pricing anomalies makes the investment results both consistent and repeatable.
Accounting-based Anomaly: Beacon Street Capital has developed a unique insight into the impact balance sheet changes have on a company's growth potential and stock price appreciation. We believe, and academic research supports the belief, that growth potential is created by management's decisions regarding the allocation of capital, which is first reflected in sequential quarterly changes in key variables in the company's balance sheet. Consequently, these balance sheet variables have predictive characteristics regarding future earnings and value ("The Prediction of Stock Returns Using Financial Statement Information," Journal of Accounting and Economics, 13 (1990)) and the market may not react instantaneously to such changes. To capture these accounting based anomalies (growth premiums) before a stock's price realigns with the fundamentals we use a sophisticated algorithm that combines these predictive variables into a highly efficient quantitative definition of internal growth potential. The result is a strict, disciplined framework for buy/sell decisions which yields consistent added value with less volatility as measured by the standard deviation of returns.
Earnings-based Anomaly: Post-earnings announcement drift is another well documented phenomenon where stock prices continue to drift in the direction of the initial price response to earnings announcements. This "drift" is exaggerated or mitigated based on the level of growth premium embedded within the earnings surprise. Therefore, positive annual excess returns from the accounting-based anomaly are even more pronounced when combined with this post-earnings announcement drift.
Fundamental: High performing companies have certain fundamental characteristics that separate them from the average company. They typically have a unique product or service that is in strong demand by the consuming public, they generate above average earnings on a consistent basis, and they have a management team that works to benefit shareholders. These qualities are reflected in fundamental measurements of financial strength, profitability, and cash flow. Therefore, stock selection first requires screening the Standard & Poor's 500-Stock Index and the Dow Jones Industrial Average to identify those companies that meet these fundamental requirements. While finding such stocks is not difficult, knowing when to buy them and how long to hold them is.
Quantitative: Our process does not involve making assumptions about business valuations or earnings expectations. We believe external factors affecting these criteria are already priced into the market. Nor do we consider price ratios, or price changes, which we believe have little to do with value. Instead we use our sophisticated accounting based definition of internal growth potential, which we call the Q.E.P. (Quantitative Earnings Power) Index, to identify inefficient anomalies in an otherwise efficient market. When applied to the 200 or so companies that remain from the screening it raises the bar in terms of what is accepted as suitable for our portfolios. This helps reduce risk and improves portfolio performance by concentrating in high quality stocks where growth potential is better defined. This process allows us to focus on the highest expected return stocks and has resulted in a long-term track record of high returns with reduced volatility.
Qualitative: The success of an accounting-based strategy requires a certain amount of qualitative judgment overlay to interpret the data relative to a specific company. For instance, accounting adjustments are often required to maintain consistency. These qualitative factors require experience, which improves over time, but the quantitative features of the strategy will not change. Furthermore, no outside research or third-party sources of information are used.