Forensic accounting: You can't make bricks without clay

The short-term mentality that has seeped into the asset management industry means few investors have the time to get really granular in their analysis. Some may also assume that the research community covers every angle already, making further scrutiny unnecessary. In our experience this is not the case.

The sell-side, in particular, has an unhealthy obsession with calling quarterly numbers and is thus prone to missing details that are critical to the bigger picture. Softer aspects such as culture and the quality of leadership – how major decisions are made by the executive – are often treated as separate from the quantitative realm, despite being so strongly correlated.

As custodians of our clients' capital we want to wring as much insight as we can out of publicly available information, even if this means we can't pull the trigger very quickly. It goes without saying that this timing “sacrifice” matters little to long-term investors, and that it is significantly outweighed by the benefits of a thorough understanding of a company's broader prospects.

So what do we mean by forensic accounting, as applied to investment management In a nutshell, we want to know if historic financials reflect the economic reality of a business. And while it might suggest a sleuth-like search for evidence of fraudulent activities, the red flags we encounter are overwhelmingly on the right side of the law, but tell us something material about how (and critically, for whom) a company is run.

History teems with examples where company management has run roughshod over minority shareholders, and a between-the-lines examination of financial statements and company reports can reveal an awful lot about governance standards – the quality and motivations of the top brass – and thus the likely long-term journey for investors. It might be a hackneyed term, but we have to understand the alignment (or lack thereof) between management and key stakeholders. Importantly, even in the absence of any red flags, the analysis adds significant value, providing a very solid grasp of the nuts and bolts of a business – something that senior management often appreciates, making conversations with them more meaningful.

This type of groundwork is highly time-consuming (about 250 hours of research per report). Among other things, the research involves trawling through five years of annual reports, earnings call transcripts and key press releases; not to mention, corporate governance policies, articles of association and sustainability reports – the “Data! Data! Data!” that Sherlock Holmes famously proclaimed was the clay for his bricks.

This analysis should take place in the latter stages of the investment process, following on from steps such as initial company meetings/visits, financial modeling and assessments of a company's track record and performance against peers. In other words, it is only when a sufficient level of conviction has been built that an investment idea undergoes forensic dissection.

Why go through all this extra work when the annual reports are audited? Well, there's more than meets the eye with financial statements.

For starters, auditors work to materiality levels that are often different from those of investors and, importantly, only look at an isolated 12-month period. Such a snapshot tells you precious little about the consistency of the information or quality of earnings. Such forensic accounting, however, discerns trends and patterns (including the impact of any accounting changes) and what these reveal about management's stewardship of capital.

The instances when forensic work refutes an original investment thesis are (thankfully) rare, but when it does it is highly valuable. To give an idea, risks that we've unearthed include: excessive buildup of goodwill on balance sheets (suggesting a risk of overpayment in M&A); unsustainable shareholder distributions; suspiciously stable margins (despite M&A and fluctuating sales) indicating efforts to “smooth” earnings; inconsistent bonuses for executive directors; and cases where there has been questionable independence among board members. Such finding call for a conversation with company executives, with a view to clarifying findings that are potentially material.

As long-term investors with an absolute-return mindset, forensic accounting (as we define it) forms an integral part of due diligence, helping to build a holistic picture of companies and improve the quality of engagement. At a time of rapidly shrinking investment horizons, it is easy to forget that buying a stock for clients means making them part-owners in a business and that the process of conviction-building should be commensurately serious. Risk and reward might be inextricably linked, but they don't move in lock-step; this research is designed to identify opportunities where the gulf between them is as wide as possible.

Tom Walker is head of global long-term unconstrained at Martin Currie Investment Management, based in Edinburgh. The opinions contained in this document are those of the author. They may not necessarily represent the views of other Martin Currie managers, strategies or funds.