By David Sterman
What do Warren Buffett and Sir John Templeton have in common? They both made billions by following one simple maxim: Find stocks or industries that are absolutely loathed. These are the only areas you will find the chance to score significant gains.
And in recent years, it was harder to find any industry as deeply hated as the for-profit education operators. Very high loan default rates led Congress to examine the industry back in 2010, and more than a few congressmen suggested that these schools weren't delivering a good education.
Throughout 2011 and 2012, investors steadily pulled their money out of these companies, sending share prices down 70% or even 80% from their previous peaks. At the time, it began to appear that these companies might not have much of a future.
What a difference a year makes. For investors who were willing to keep analyzing this broken industry, it slowly became apparent that business was starting to stabilize and current stock prices were beginning to flash powerful signs of deep value.
As I noted two months ago, this industry sprang back to life in May, with the average stock rising 22% in just one month.
The key driver? As I wrote at the time, "A lot of these firms noted on their recent conference calls that rising employment levels has been a big boon for them in the past, and though the industry's reputation has been tarnished, a degree from one of these for-profit institutions can still help students strengthen their standing with employers." I added that many of these stocks remained quite inexpensive in relation to their net cash balances.
Frankly, I had no idea that the stunning rebound in May would pave the way for further big gains in June and July, but it's now clear that this bull run in the for-profit education sector was just getting going. Here's how these stocks have fared since that article was published May 29.
A quick glance at this table, along with the performance in May, highlights the fact that Career Education (NASDAQ:CECO) posted strong gains in each period and has now doubled since bottoming out in late April. (As a side note, Richard Blum of Blum Capital Partners is kicking himself right now. According to a recent filing on GuruFocus.com, he has sold nearly 5 million shares while it was bottoming out and only beginning to rebound, though he still holds 7.6 million shares.)
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Is the for-profit education industry now getting too much love? To be sure, some of these gains are benefiting from short covering, as this was among the most heavily-shorted industries in memory this past winter. Short covering has a way of pushing stocks into being fairly valued or even overvalued. A look at 2014 price-to-earnings (P/E) ratios may help to see if that's the case.
Since aggregated projected earnings for 2014 are largely unchanged from two months ago, we can say that the recent rallies are due to multiple expansion and not accelerating bottom-line outlooks. And with an average forward P/E ratio of 15, nobody would call this industry cheap anymore. Especially when you consider that most of these firms are expected to generate a sales drop in 2013 and 2014 (with Grand Canyon Education (NASDAQ:LOPE) and American Public Education (NASDAQ:APEI) being notable exceptions.
The other pillar of value in this industry is impressive balance sheets. A few months ago, some of these stocks looked quite undervalued in the context of their net cash balances. Is that still the case? Definitely, as three companies have at least 40% of their market value represented in just cash, with most others sporting reasonably healthy cash balances.
But in this industry, value metrics aren't as important as these companies' ability to survive and thrive. It's increasingly apparent there are some quality operators in this industry, along with some real duds. For example, Career Education has sharply sinking revenues, ongoing operating losses, legal headaches from regulators and a falling cash balance. This stock has rallied sharply recently because the worst-case scenarios haven't panned out, but it's unclear when this company will become profitable.
It also may be tempting to focus on the stocks with the lowest P/E ratios in the industry. But both Apollo Group (NASDAQ:APOL) and Corinthian Colleges (NASDAQ:COCO) are suffering enrollment declines and are being heavily scrutinized by regulators. Those two are simply too risky to own right now.
In contrast, Grand Canyon Education appears to have struck a winning formula, with operating margins approaching the mid-20s. The school has struck a balance between cost management and educational value, which also explains why enrollment is growing at a 15% annual pace.
Students can attend classes on campus (in Arizona) or at home. More than 80% of students are enrolled online, but the option to mix and match holds great appeal to some students as their lifestyle and financial pictures change.
Grand Canyon "is focusing on improving quality, while leveraging its ground campus and benefiting from a differentiated marketing strategy," noted Merrill Lynch analysts, who rate the stock a "buy" with a $40 price target. The campus-based part of the strategy should get a boost when a second 15,000-student campus opens in the Phoenix area in 2015.
Risks to Consider: Though this industry has avoided fatal levels of congressional scrutiny thus far, these companies aren't out of the woods just yet. It's wisest to stick with higher-quality operators such as Grand Canyon Education, which appear to be in much better standing with regulators thanks to its superior education outcomes and lower student loan default rates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.