Forensic analysis – a sustainable source of Alpha for global asset managers

Published on May 27, 2015 by Chanakya Dissanayake

Seeking sustainable methods of Alpha generation, most fund managers are adopting investment styles that involve concentrated portfolios made up of high conviction calls and long investment horizons. These bets are often preceded by proprietary research on sector themes and detailed valuation scenarios. However, this process is complicated by the need to safeguard these convictions against certain unique risks posed in global investing, such as potential accounting irregularities and corporate governance shortfalls, which could blindside even the hardest-working fund manager.

We, at Acuity Knowledge Partners, often hear a list of “if I had more time, I would have done this to add value” during our discussions with fund managers, most of whom agree that there is need for an additional layer of company-level due diligence before long-term bets are made. This emphasis on the need for closer scrutiny of reported financials and corporate governance practices is almost unanimous – particularly among those who are exploring emerging market stocks and those looking for shorting ideas. However, fund managers usually have so many things on their plate that this aspect of due diligence was long overlooked.

Demand for this service is, however, rising now, as reflected in the rapid growth we have seen in our forensic analysis services over the past few years. Our forensic experts, who have global chartered accounting qualifications and an in-depth understanding of International Financial Reporting Standards (IFRS), work as a virtual extension to clients’ onshore investment teams. Over the years, our teams have helped identify numerous financial reporting red flags that, if undetected, could have led to negative impact on clients’ investment performance. For some of our clients, we have also spotted serious corporate governance failures and instances where related-party transactions had placed minority shareholder interests at risk.

For instance, recently, we identified significant revenue recognition red flags in a software development company, which manifested through inconsistent cash conversion compared to its close peers’. Our findings helped the client divest its holdings well ahead of the stock price decline. On another occasion, we came across high gross margins at a large food commodity exporter, which was inconsistent with the industry average, and export volume figures out of line with the country’s macroeconomic data. Our findings helped the client exit the holdings well ahead of the eventual stock price decline.

While our forensic analysis does not always lead to spectacular findings, most of the issues we identify in the reported financials enable fund managers to have high-quality conversations with company managements and develop deeper understanding of the business and the quality of management. After these discussions, we often get a shortlist of issues to dig deeper and the follow-up discussions help fund managers determine the materiality and risk-reward balance to make the final call on the stock.

The time we spend on screening potential issues and doing first-cut analysis helps free up the onshore investment team’s time to conduct deeper analysis, generate contrarian ideas and spend quality time with company management.

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