I guess it tries to combine chains of txs and associate addresses with eachother. Like address A sending money to address B, and the change to address C. Now it may guess that address A and C are part of the same wallet (probably HD) or belong to the same person. Which is highly uncertain, as there is no proper way to distinguish change from other outputs.
I've tested walletexplorer.com with a few addresses of mine, but it was able to group none of them correctly. So I wouldn't have too much hope this actually works.
AFAIK, it puts all the input addresses of transactions into one wallet. Everybody knows there are exceptions but this is generally accepted way.
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How do you distinguish change addresses form normal outputs?
I found the refined version of Heuristic 2.
The simplest way is to identify the transactions that only have two output addresses.
And only one of the output appears first time in the blockchain (new address).
The new address will be identify as the change address.
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Its not correct. I have seen people asking to send Bitcoins to new addresses due to privacy concerns. I don't think "heuristic 2" will work. I might be wrong though!