LONDON (Reuters) - Fund managers are increasingly turning to investigative tactics, detailed accounting analysis and corporate sleuthing in a bid to uncover skeletons in company closets that can offer an investment edge in a low-yield world.
While billionaire investors such as Bill Ackman and David Einhorn have made such tactics famous by respectively betting against nutrition group Herbalife (HLF.N) - which denies Ackman's allegations it is a pyramid scheme - and Lehman Brothers in 2008, the broader industry is now adopting them.
Investors say the frustrating market environment - with interest rates at rock-bottom and stock markets holding near multi-year highs - and an impressive recent success rate from investigative hedge funds, which are on course to deliver their best returns in years, are pushing them to make deeper dives.
"The use of forensic accounting and investigative research techniques is noticeably increasing," said Bruce Harington, senior analyst at hedge-fund investor Stenham Asset Management, adding that investment funds were hiring former forensic accountants and investigative journalists.
These strategies offer a twist on traditional short-selling, which involves borrowing and selling a stock that is expected to fall before buying it back at a later date. If the wager was right, the price of the shares will be lower, generating profit.
What makes forensic short-selling different is that the wagers tend to be more aggressive - effectively betting that a company is worth next to nothing - and require more resources: Bill Ackman, for example, recently revealed he had spent $50 million on researching his $1 billion Herbalife bet.
But a Eurekahedge index tracking four global compliance-based hedge funds shows that the broader trend is paying off. It was up nearly 17 percent in the first six months of 2014, more than five times the average hedge fund and nearly three times the MSCI World index. The Eurekahedge index rose 13 percent in 2013 and 9 percent in 2012.
Forensic investors' tactics can involve anything from poring over company accounts to using private detectives to gather visual or physical evidence that might contradict public data.
Short-seller Glaucus Research began probing China Metal Recycling 0773.HK in 2013 after discovering the firm's revenue per employee was 11 times more than that of other recyclers.
Other red flags included financial statements that did not fit with government or industry data, followed by the abrupt departure of the group's chief financial officer and the sale of shares by the firm's chairman.
After Glaucus publicly unveiled its research, Hong Kong's securities regulator accused China Metal of exaggerating its accounts and is now seeking to liquidate the company.
With investment banks cutting back on research coverage, hedge funds believe that there are more skeletons out there.
"There's less and less research being done by banks and brokers, and hedge funds have seen this trend as an opportunity to jump in and boost their investigative work," said Philippe Ferreira, head of research for alternative investments at Lyxor Asset Management.
These bets are not risk-free: by announcing market-sensitive news on stocks they trade, investors who decide to go public with their research are vulnerable to legal action.
London-listed IT outsourcing services provider Quindell QPP.L, whose shares more than halved after Gotham City Research published a report in April questioning its revenue model and profit quality, said it had started legal action against Gotham.
Taiwan's market watchdog has also turned against short sellers, accusing Glaucus of "spreading rumors" about local recycling firm Asia Plastic 1337.TW.
A spokeswoman for Britain's Financial Conduct Authority said regulated companies can publish research as long as it is not false or misleading and they disclose any financial interest. The U.S. Securities and Exchange Commission declined to comment.
"If we accuse companies of malfeasance, we use publicly available information to argue for why the company is actually fraudulent or is overstating its earnings," said Sahm Adrangi, founder of forensic short-seller Kerrisdale Capital Management.
And in tough markets, the rewards have been trumping the risks.
Spanish Internet company Let's Gowex GOW.MC threatened Gotham with legal action for spreading "absolutely false" rumors at the beginning of July - but the bet paid off two weeks later when Let's Gowex filed for bankruptcy after admitting falsifying its accounts.
Additional reporting by Blaise Robinson in Paris, Svea Herbst in Boston, Andrew Winterbottom and Nishant Kumar in London; Editing by Lionel Laurent and Will Waterman