By A. Ananthalakshmi and Megha Mandavia
BANGALORE, March 23 (Reuters) - For-profit colleges: they have something to repel nearly every kind of investor. And yet, investors are lining up to enroll their cash.
The companies that run the schools are dealing with setbacks that usually drive people away: the U.S. government disapproves of how they do business and has threatened to cut essential funding unless they change their ways. As a result, they have lost revenue and their stock prices have plunged. Still, a group of investors with a timeline longer than tomorrow say these companies will turn out all right -- and they are not the usual vulture investors who pile on when they see carrion ripe for snacking. "You might be seeing an evolution in the holder group with growth investors replaced with more value-oriented investors," said Piper Jaffray analyst Peter Appert. Most remain cautious of putting money into these stocks until they find out how new Education Department rules will affect the companies' earnings potential. Short sellers, meanwhile, are making the most of the uncertainty, keeping stock prices low in the near term.
This was the case last year when short selling was the dominant investment trend in the business. Many funds exited or reduced their exposure. The market value of about 15 education stocks fell $6.75 billion last year and growth at the companies began to decline towards the end of the year as they "reformed" to adapt to the new regulations. A few investors held on, betting on long-term growth or patiently waiting for their investments to reap some benefits. Companies such as Apollo Group and Corinthian Colleges are making an effort to choose quality over quantity, losing business in the process, even as demand for education in the United States is booming. The stock volatility is mainly because of speculation around the "gainful employment" rule -- the most controversial of the rules package introduced by the government last year. The rule threatens to cut off schools' access to federal aid, their primary source of income, if they fail to prove that their former students can pay their debts.
The for-profit schools have been criticized for low graduation rates and high student debt levels.
LONG TERM BETS Investor sentiment towards the end of the year and into 2011 improved after the rule was delayed and Republicans, who oppose it, gained more seats in Congress. Investors hope that high unemployment rates and student dissatisfaction with public community colleges will spur demand for higher education and specialized vocational training that they think for-profit schools can provide. The "Tiger Cubs" -- as the fund managers who used to work for Julian Robertson at hedge fund Tiger Management LLC call themselves -- are one of the most steadfast believers. Lee Ainslie's Maverick Capital, which has $9.44 billion of assets under management, is the second-largest shareholder in Apollo, whose stock fell 35 percent last year. Other Robertson proteges, Steve Mandel of Lone Pine Capital and Andreas Halvorsen of Viking Global Investors also accumulated stakes in for-profit schools. The funds that have gone long have invested in the colleges before, or are value-oriented investors willing to buy stocks when there is maximum controversy and the prices are down, said Rivannah Capital's Rahul Gorawara. Rivannah, which has a 2.06 percent stake in Bridgepoint Education , is one such fund. So is Yacktman Funds, which invested in Apollo. "We think Apollo has a strong business model that produces very strong free cash flow and margins over time," Yacktman fund manager Jason Subotky said.
Education stocks trade at 11.2 times their estimated forward earnings, compared with a three-year average of 17.9 times, according to analysts at Stifel Nicolaus. SHORTS RULE IN THE NEAR TERM Despite growing optimism among some investors, short interest remains high -- a proof of how big a role they will play in determining stock prices in the near term. "Generally what I have seen is the stocks are trading on who is shorting, who is covering -- not based on new or long investors coming in," Rivannah's Gorawara said.
According to Avy Stein, co-chairman of lobbying firm Coalition for Educational Success, short interest in the education stocks jumped 75 percent between Feb. 2009 and July 2010.
Short interest in some of the stocks still remain high -- about 29.3 percent of Corinthian's outstanding shares are shorted. Fund managers such as FrontPoint's Steve Eisman, Kynikos Associates' James Chanos and T2 Funds' Whitney Tilson are some well known short sellers of education stocks. "Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. I was wrong," Eisman said at an industry conference in May last year. Eisman, a hedge fund manager famous for shorting subprime home mortgages before the 2007 housing slowdown, also testified in a Senate hearing on for-profit colleges and said if the industry goes unscrutinized, the education department will face nearly $275 billion in defaults over the next 10 years. That large short position could end up helping the stocks, however, Piper Jaffray's Appert said. "If fundamentals improve and the regulatory environment becomes less threatening, then the high short interest can be a positive catalyst on stock performance because at some point, theoretically, the short sellers have to cover their positions," he said. (Reporting by A. Ananthalakshmi and Megha Mandavia; Editing by Robert MacMillan)