The need for forensic accounting

by Saurabh Mukherjea

24th February 2016

Simple quantitative forensic accounting can add five percent alpha to the Indian market return, according to Saurabh Mukherjea, head of institutional equities at Ambit Capital. The importance of accounting quality cannot be over-emphasised in an inefficient market like India, which has a peculiar feature of higher promoter holdings.

Mukherjea doesn’t believe in making statements without supporting them with evidence. Being an alumnus of the London School of Economics and a CFA charterholder, he is thorough with his research. He has published his findings in a client research note titled ‘Forensic accounting: Are you in a zone of darkness?’ Having ranked the accounting quality of the stocks in deciles, the research concluded that the top 5 deciles are not materially different from each other on investment performance, but the performance drops in the next 3 deciles to the ‘zone of pain’ and then slumps significantly in the last two deciles to the ‘zone of darkness’.


The ratios to look for

The report explained the methodology as using 11 ratios across four quality areas –


For example, a low CFA/EBITDA may be indicative of aggressive revenue recognition policies. Or a high proportion of miscellaneous expenses raises concerns regarding the genuineness of such expenses.


Auditors beholden to promoters

When asked whether these companies are doing anything illegal or just using loopholes, Mukherjea said it’s the latter. For example, giving overpriced contracts to related parties. So it’s siphoning off some of the profits of the company to related parties. The auditors are not to blame in that the leakage is genuine; they can’t block it.

One peculiarity of the Indian market that comes back to haunt it in many different ways is that the promoters own more than 50%. ‘The auditor is beholden to the shareholder who is basically the promoter. So even if the auditor is suspicious that the costs look high, he can’t do much because the main shareholder is saying it’s fine,’ Mukherjea explains.

Mukherjea believes that instead of questioning auditors, a better way to reform is for the institutional investors to say shun the company and whack the PE into the ground. ‘We have seen this happen in the past 5-6 years. So the process of transition has started. That’s why the bottom 50% in our ranking hasn’t given returns; it’s only the gullible who would invest in those stocks,’ he said.

‘The market is becoming more efficient, so to get alpha you have to go down the market cap spectrum. This is why you need the unconstrained fund, unconstrained from the index and from time horizons. In any country when the economy is growing rapidly, the index reflects history,’ says Mukherjea.


Great time for Indian alpha

In spite, or indeed because of, the inefficiency of the Indian market, it is a great place for significant alpha.

Mukherjea estimates that the long term return from the Indian market to be around 16% compounded annual growth. On top of that, one can get to low 20s, gross of fees, from reasonably sensible stock selection.

‘Half of the alpha between 16 and 22 comes from simply knocking of the dodgy companies,’ he says. He believes anyone can follow his forensic accounting approach and do reasonably sensible stock selection, which implies ‘knocking off that half of the BSE 500 that cooks its books.’ He thinks a quant approach could work, saying ‘Remember we are not doing any human intervention yet. We are doing this 9 months after year end. If you then apply some intellect to this, you can get to 25-26%.’

Good stock selectors can then analyse the rest on capital allocation or other qualitative factors. He summed up his excitement for India with ‘If you have the luxury of unconstrained money, you can make decent returns in this market.’

The report can be downloaded at