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.