By Matt Doiron
Investors are fascinated by China. The sheer size of the population and its remarkable economic growth over the last several years- as well as the fact that the prospect of "only" 5-6% GDP growth amid a troubled global economy is considered a risk factor- mean that a lot of people are going to make a lot of money investing in the country. However, a number of famous investors have gotten burned by questionable Chinese companies which misled, and in some cases outright lied to, the financial markets. John Paulson's fund famously lost a fortune when Sino-Forest, a Chinese forestry company, was found to have exaggerated its assets and eventually was forced into bankruptcy. Another Chinese forestry company, Chinese Forestry Holdings, has likely cost the Carlyle Group and Partners Group (two major private equity firms) nearly $100 million after it too faced investigation, was suspended from trading, and recently was only able to provide records of receiving 1% of the revenue it had previously reported.
Last week, Muddy Waters, a research company which specializes in investigating public companies for potential fraud, accused New Oriental Education & Technology (EDU) of reporting a number of franchise locations as company-owned and submitting fraudulent financial statements. The stock is currently down about 50% from the beginning of the month after having been roughly flat for 2012.
Joho Capital, a hedge fund managed by Tiger Cub Robert Karr, had reported that New Oriental was the largest position in its 13F portfolio at the end of March, with 4.3 million shares owned. The value of these securities at that time had been about $120 million (see what else Joho Capital owned). According to 13F filings, Joho had been the second largest hedge fund holder of the stock. Lone Pine Capital, managed by billionaire Tiger Cub Steve Mandel, had owned nearly 10 million shares. Rather than double down on his position in New Oriental, Joho has decided to pull back slightly. An SEC filing reports that the fund now owns only 3.8 million shares, which could indicate that it would like to diversify its investments away from the business.
While any degree of misleading investors is worrisome, New Oriental is still an operating business and has smartly reacted to the price decline by initiating a share buyback program. Perhaps the drop in the share price has reduced the market cap appropriately- or perhaps short sellers have even overshot. Just because other Chinese companies have been shown to be large-scale frauds does not mean every one with any accounting irregularities should necessarily go to zero. New Oriental can be considered alongside for-profit education companies in the U.S., which have also struggled recently (partly as the federal government, which indirectly provides much of their revenue, weighs how much their services benefit students). However, many value investors have long been interested in for-profit education. At the May 2011 Ira Sohn Idea Contest, the winning presentation was on Bridgepoint Education (BPI). By the end of June the stock had risen 9%, but it gave back all of those gains over the next twelve months and has dropped 60% in July. Several Tiger Cubs also have large positions in the industry, and Lee Ainslie's Maverick Capital reported owning 4.8 million shares of market leader Apollo Group (APOL) in March (see other stock picks from Maverick Capital).
Wall Street analysts now give forward earnings estimates that imply P/E ratios of 9 for Apollo and New Oriental alike, even though New Oriental is in an all-else-equal more attractive market. DeVry (DV) and ITT Educational Services (ESI) also have forward P/Es in the high single digits and, like Apollo, have seen their earnings fall between 25 and 40% in their most recent quarter compared to the same period in the previous year. So far this year, Apollo Group and Devry are both down about 50%- matching New Oriental's decline- while ITT is down between 20 and 30%. We aren't investing in New Oriental right now, but if the price falls any further and no new worrisome news emerges we might consider buying it as having a lower valuation and better growth potential than its American-based peers.