Photo credit: Tony Hoffarth

Forensic accountant John Del Vecchio likes to joke that he knows “where the bodies are buried” in the financial statements. In his line of work, you have to. John is a professional short seller and the author of What’s Behind the Numbers, an excellent primer on short selling I reviewed two years ago.

I call Del Vecchio the Horatio Caine of Wall Street. With single-minded purpose, he looks for the bad guys that are cooking the books and then brings their misdeeds to the light of day. Or more accurately, he looks for companies that are using aggressive accounting techniques to mask poor operating performance and then shorts them. Eventually, management runs out of ways to hide slowing performance, and when they do, the jig is up and the stock takes a tumble.

This is where it gets interesting. If Del Vecchio’s sleuthing can effectively catch earnings manipulators in the act, then it only stands to reason that it can also be used to identify good companies with high quality earnings and conservative accounting. And that brings me to the WeatherStorm Forensic Account Long-Short ETF (FLAG), which has been recently revamped and is now based on a new proprietary index developed by Del Vecchio.

“FLAG” is exactly what it sounds like. It’s an ETF that looks for accounting red flags, such as accelerated revenue recognition and manipulation of inventory and receivables numbers. But that’s only part of the story.

FLAG’s strategy combines six distinct forensic accounting and valuation factors for scoring and ranking stocks. These factors cover: cash flow quality, revenue recognition, earnings quality, shareholder yield, earnings surprise and valuation.

The FLAG ETF runs a 130/30 long/short portfolio, investing 130% of its capital in stocks that rate high for earnings quality based on Del Vecchio’s metrics and maintaining a 30% short position in stocks with low ratings. The net result is that you’re buying the highest-quality companies at reasonable prices… and you’re shorting the expensive junk.