SEC Could “Short Circuit” One Type of Research


New York, NY – In the last few weeks, the U.S. Congress increased its pressure on the Securities and Exchange Commission to restrict the practice of short-selling, arguing that this trading strategy used by many hedge funds, artificially drove the stock prices of many companies below their fair market values over the past year.

In response to this pressure, last week the SEC unanimously agreed to put out for public comment a number of potential regulations reinstating the uptick rule. Of course, executives from the hedge fund industry quickly responded to defend the practice of short-selling. Unfortunately, one unintended casualty of any restriction on short-selling could be the firms that produce third-party forensic, quality of earnings, and short ideas research.
Firms That Could be Impacted

In the next few weeks, Integrity Research Associates will publish the next in its series of comprehensive ResearchFocus reports on this group of research providers that help investors find companies whose stocks are overvalued, or who want to evaluate their investment portfolios for ‘torpedo stocks’.

According to our proprietary database, Integrity Research Associates has identified twenty-one (21) forensic accounting, quality of earnings, or short-ideas research providers that primarily provide investment research. This small, but invaluable group of research providers currently generates between $70 million and $80 million in annual revenues from institutional investors – including mutual funds and hedge funds.

This does not represent the total universe of firms that conduct this type of analysis. Integrity has also discovered numerous other sources of data or commentary on the accounting policies and practices of public companies. This total also does not include accounting firms which specialize in forensic analysis, KPO firms which can build bespoke earnings quality models for investors, and academics with expertise on earnings quality and forensic accounting.

Based on our analysis, there are three main types of research providers that help investors discover companies that are overvalued, or “short ideas”. This includes forensic accounting, quality of earnings, and short ideas research providers. The following are definitions of these three analytical approaches.

Forensic Accounting is the study of financial statements, using accounting, auditing, and investigative skills, to assist in investment research. Trained to look beyond the numbers, forensic accountants study the details of financial statements (including options valuations, off-balance-sheet financings, capitalization of expenses, and goodwill amortization), in order to grasp the true financial position of a business. Qualitative factors, including reliability of management disclosures, discussions in the financial statements, etc. may also be examined.

Quality of Earnings analysis is a research methodology that seeks to determine if a company’s reported earnings are likely to persist, grow, or decline in the future. Much of this analysis is predicated on a close examination of a company’s accruals – the accounts on a balance sheet that are not associated with immediate cash transfers. These accounts are valued on the basis of management’s estimates about future cash flows. Inaccurate accrual estimates can be attributed to many factors, including poor foresight on behalf of management, unexpected events, or a deliberate attempt to manipulate the company’s financial statements. Taking into account these issues, quality of earnings specialists seek to determine whether a business’s reported earnings reflect the true stance of the business. The difference between forensic accounting and quality of earnings is subtle. Thus, many research providers combine elements of the two in their research process.

Short Recommendations providers combine earnings quality and forensic accounting analysis with other forms of fundamental company research in order to identify securities with significant downside potential. While both earnings quality and forensic analysis highlight firms which should be avoided because of high accruals or dubious accounting methods, short ideas providers go the extra distance to research other factors such as valuation and competitive dynamics. Short idea specialists seek to identify businesses with fundamental problems which have not yet been recognized by the market, giving an investor the advantage to profit through short selling.

Counter Cyclical Business

Since the inception of the third-party forensic / short ideas research industry in the late 1980s and early 1990s, the popularity of this type of research has gone through numerous peaks and valleys. As the stock market has fallen, interest in short-selling has grown and consequently, the demand for forensic/ short ideas research. The opposite effect has historically occurred during bull markets.

Investor interest in this sector became white hot after the equity markets collapsed in 2000. During the market declines in 2001 and 2002, forensic research and short recommendations became both highly visible and highly profitable as a number of independent research firms highlighted the problems with Enron, WorldCom, or Tyco in advance of their blowups. As the markets rebounded in 2003 and 2004, investor interest cooled.

In 2007, this type of research enjoyed a renaissance of investor appeal. While markets were less buoyant, a number of accounting scandals hit the headlines and research providers were able to demonstrate their skills in making early calls on accounting issues such as options backdating and subprime lenders. For example, CFRA highlighted problems at New Century three months before the stock collapsed and Gradient Analytics flagged the company a year before that for unusual insider selling.
Punishing the Innocent

In fact, it is quite ironic that third-party forensic accounting, quality of earnings, and short-ideas research providers might suffer from proposed SEC rule changes on short selling given the numerous times they as an industry have “gotten it right” and highlighted fraudulent company management behavior, accounting irregularities, or at least severely overvalued companies.

Unfortunately, the recent move by the SEC Chairwoman Mary Schapiro in reestablishing the uptick rule, or developing other circuit breaker mechanisms, is less about making the markets safer or more efficient for investors, but rather reacting to public sentiment. In fact, when the commission put forth its suggested rule changes for comment last week, it also acknowledged that it has no data showing that short selling played any significant role in creating the current market crisis and economic environment.

For more insight and analysis on the forensic accounting, quality of earnings, and short ideas research business, consider purchasing Integrity Research Associates’ upcoming ResearchFocus report on this topic. For more information about this report, or how you can subscribe to the entire ResearchFocus series, contact:

Matthew Bannister
Vice President, Sales
Integrity Research Associates LLC
53 West 36th St., 10th floor
New York, NY 10010
Phone: 646.786.6851
Cell: 617.968.0329


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