Why I Will Never Buy a For-Profit Education Stock

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The for-profit education stocks like Apollo Group (NASDAQ: APOL), ITT Educational Services (NYSE: ESI) and DeVry (NYSE: DV) have been lousy long-term investments.

Regulatory actions have weighed on the stocks of all three firms, and over the last five-years the stocks have lost 70%, 69% and 44% of their value, respectively.

Now trading at bargain valuations, these stocks appear cheap based on a number of financial metrics. Nevertheless, I continue to avoid the sector because, fundamentally, their business models are deeply flawed.

A 40-year old economic paper

My issue with for-profit education comes from an economic paper published 40 years ago by economist and Nobel Laureate Michael Spence.

Spence’s paper, Job Market Signaling, laid out a framework for understanding the nature of education. Specifically, Spence argues that education -- in and of itself -- is of little value. Rather, the purpose of education is signalling -- a means of communication.

Hiring a worker is risky, Spence notes, as an employer must commit to a new hire, either in the form of on-the-job training, or simply wasted wages and time. A given worker’s productivity is not readily observable until after they've begun working. In order to make a hiring decision, an employer must then rely on characteristics that are observable -- such as past work experience, and notably, education.

An economics degree from Harvard, for example, may not imbue a job candidate with the necessary skills to perform the daily functions of a corporate business analyst. However, it does demonstrate that the would-be hire has the mental capacity to learn and perform the required tasks.

The size of Harvard’s undergraduate population has not changed significantly since 1990, despite the fact that more students than ever before are applying. Advances in technology have made the “education” of a greater number of students possible, and it’s likely that if Harvard wanted to, it would not have to reject over 94% of its applicants (as it did last year). Theoretically, a school like Harvard should be able to put its resources online and serve hundreds of thousands of would-be learners.

And yet, to do so would destroy the value of the education -- if anyone could get a Harvard degree, the value of that degree would plummet in the marketplace; it would lose its ability to signal competence to employers.

This is the basis of the for-profit education business model

At their very essence, the for-profit education companies are operating in opposition to this notion -- that is to say, they believe finding a job in the workplace is a simple matter of learning skills.

Apollo Group’s subsidiary, The University of Phoenix, has an “open enrollment” policy -- almost anyone with a high school diploma (or equivalent) can become a student. 

The same is largely true for ITT Tech, as well as DeVry University.

A focus on equipping students with skills

As the enrollment rates of these publicly-traded educational institutions decline, management has focused on streamlining their operations to make it easier for their students to acquire skills.

On its last earnings call, Apollo Group’s CEO, in response to his school’s 25% decline in new enrollments, commented

Working adults, they want tangible skills now, there needs to be a variety of options to acquire the knowledge to compete more effectively in today’s labor force.

ITT Educational Service’s CEO made similar remarks:

We believe that our resident-based, career-oriented technology and health sciences-related programs of study that help graduates prepare for entry-level technician positions differentiates us from other post secondary institutions.

As for DeVry, it has seen steep declines in enrollment as well, but not all of DeVry’s schools are shrinking. Its nursing school, Chamberlain College of Nursing, continues to grow -- perhaps because of its stricter admission requirements.

To get admitted into the Chamberlain BSN program, a prospective student must have a high school GPA of at least 2.75 and an ACT score at least 21 -- this is notably more strict than the requirements for DeVry University (a high school diploma and a B grade in an algebra class).

Struggling to find gainful employment

The issue of “gainful employment” has been very crucial to these companies.

The majority of their funding comes from the federal government: in 2011, 67%, 81% and 86% of ITT Tech, DeVry University and The University of Phoenix’s revenue, respectively, came from federal student aid.

The gainful employment rule would’ve placed restrictions on the ability of these schools to receive that aid based on the incomes and debt burdens of their graduates. A federal court struck down the rule, but if it had been upheld, programs at all three universities would have failed the provision, as Motley Fool’s own Brian Stoffel notes.

In general, it’s likely that students of public or private nonprofit schools are better able to find employment -- their loan default rates are often half that of for-profit schools, despite the fact these schools take aggressive measures to manage their default rates.

Perhaps this is because -- unlike the for-profit schools -- not everyone can attend.

Investing in the for-profit schools

Based purely on a financial screen, all three stocks should have value investors salivating.

And yet I cannot get behind these companies.

Fundamentally, for-profit education companies are operating on a faulty business model. They believe in a form of skills-based education; that any person of reasonable intelligence can attain the skills necessary to find gainful employment.

Yet that notion runs completely counter to the economic theory on the subject. The actual subject matter taught in school is of little value; rather, as Spence argued 40 years ago, degrees act as a signal of competence to employers.

For that reason, over the long-term, it’s likely that most of these schools’ students will struggle to find gainful employment -- and their investors will struggle to find decent returns.

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