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Forensic Research Gaining Traction

Forensic research, which analyzes companies for accounting irregularities, is gaining traction in the financial industry again, as the market begins to turn flat, experts say.

The analysis pays close attention to the footnotes on the financial statements, such as stock options, valuations, amortization assumptions, unrealized losses and gains and minority interests, to understand how financials are constructed.

The attractiveness of forensic research comes to the market in waves. In bear or flat markets, it is popular because it is easier to find short ideas; in a bull market it is hard to get good short ideas, said Michael Mayhew, chairman and co-CEO of Integrity Research, which just issued a new service evaluating investment management research called ResearchFocus. Targeted to buy-side directors of research, analysts, portfolio managers and broker liaison professionals, ResearchFocus will review and evaluate research firms in different sectors of the research industry every few months.

After the market collapse in 2000, the sector was red hot. When the market rebounded in 2003, the area cooled a little, but now that markets are less optimistic and accounting scandals are taking place, the practice is making a comeback.

Asset management firms are spending $60 million a year to purchase forensic accounting research, according to Integrity Research. "Given the global interest in this sector, we're projecting a 20% annual growth in spending on this type of research over the next five years," Mayhew said.

Additionally, in the past five years the number of forensic research firms has tripled. Prior to Enron, there were six providers and now there are 19, according to Integrity Research. Post-Enron and other corporate scandals, investors are paying closer attention to accounting practices and are looking for high earnings quality, said Tim Gaumer, director of fundamental research at StarMine, a San Francisco-based research shop, noting that over 100 of his clients are using this type of research.

StarMine offers earnings quality analysis, similar to forensic research, that aims to predict future earnings sustainability by measuring accruals, cash flow, operating efficiency and exclusions on the financial statements of 22,000 companies, rating them on a score of 1-100.

The demand for forensic research is due to an enhanced awareness and the advantages of its power, Gaumer said. It is an important focus for investors to pay attention to and it gives them a competitive advantage, he said.

Forensic research includes sell recommendations on stocks, which is generally not offered in investment research. Also, the sell-side does not produce a lot of forensic research, experts noted.

"Forensic research is particularly useful for hedge funds because they want and use short ideas," Mayhew noted.

Hedge funds admit that finding short ideas is the hardest part of their job, Gaumer said. No one is helping them much and "popular" short ideas are not useful to them, he said. Quantitative tools help them uncover short ideas in a lot less crowded market and help provide them with a source of future returns.

Long-only asset managers buy forensic research as they can use it to screen their portfolio and make sure they don't have risky stocks that could torpedo, Mayhew said.

The research has been valuable with the ongoing sub-prime mortgage woes occurring in the industry, experts commented. Managers are able to drill down to specific areas and company names, said Bill Crerend, president and CEO of Norwalk, Conn.-based EACM Advisors, a subsidiary of Mellon Financial.

In an August 2005 Gradient Analytics report, for example, the boutique flagged New Century Financial for heavy selling of shares by three of the firm's founders, warning that it was a sign that prospects for the company were clouding. This past November, the Center for Financial Research and Analysis, another forensic research firm, identified concerns about New Century's third-quarter 2006 earnings release.

Forensic research continues to evolve and become more innovative. Today, providers are focusing on executive compensation, legal risks and corporate governance more so than before. Some firms offer tools to buy-side analysts so they can execute their own analysis. Other firms offer data feeds into which quantitative asset managers can integrate their proprietary models.

Coverage is expanding internationally as well. This is taking place more as accounting practices become increasingly consistent and countries adopt International Financial Reporting Standards, Crerend said.

Currently, there are two U.S.-based firms that offer global coverage, according to Integrity Research. Either more research firms are going to expand coverage overseas, or the two firms will dominate that market, Mayhew commented.

Coverage is moving overseas, as more hedge funds are looking internationally for investments, and the landscape in the U.S. has become very competitive, said Ferenc Sanderson, a senior research analyst at Lipper of New York.

Hedge funds and mutual funds are not the only type of firms employing this type of research. It is an area very much exploited by private equity and leveraged buyouts as well, Sanderson commented. In addition, activist shareholders may have the desire to take vocal positions within a company, and forensic accounting can help them gain a better understanding of a company, Sanderson said.

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