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The battered education sector may look tempting, but this is one group that deserves to be cheap and may well get cheaper.

As value investors, we love controversy. Bad news and the uncertainty it brings can wreak havoc on share prices and result in bargains. Our investment in BP (symbol BP) over the summer was a perfect example. As terrible as the oil spill in the Gulf of Mexico was, we believed that the ultimate damage to BP would prove to be less than that implied by the stock’s 50% decline from April to June. From our average purchase price of less than $30, BP has recovered to $41 (all prices are as of the October 14 close), and it remains one of our largest positions. We think the stock will exceed $50 by early next year.

Bad news barrage

No industry is more rocked by controversy today than the companies that provide for-profit education. The industry, which features such big players as Apollo Group (APOL) and Strayer Education (STRA), has faced a barrage of bad news. The stocks took a horrific beating on October 14 after Apollo, the industry’s biggest player, said that new enrollments in the current quarter could be 40% lower than in the same quarter a year earlier. Apollo shares tumbled 23%, and most other school stocks dropped by double-digit percentages.

Before the Apollo bombshell, the Government Accountability Office released a report describing how all 15 of the "mystery shoppers" it sent to the recruitment offices of several for-profit colleges encountered deceptive marketing practices. School employees often exaggerated the potential salaries of graduates and encouraged applicants to falsify financial-aid forms to qualify for federal aid.

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Senate hearings have focused on high default rates on student loans and low student graduation rates at for-profit colleges. Sen. Tom Harkin, the Iowa Democrat who chairs the subcommittee sponsoring the hearings, concluded that the system "invites abuse."

Stricter regulations proposed earlier this year by the Department of Education pose the biggest potential challenge to the industry. The new rules aim to ensure that students don’t take on more debt than their earnings potential would reasonably allow them to handle.

The rules have yet to be finalized. But if they were to be enacted in their current incarnation, schools with students who are deemed to have too much debt or who are falling too far behind on repaying loans would face enrollment restrictions and onerous disclosure requirements. And that’s the best case. At worst, schools could lose access to federal student aid for new students. The latter would be a death blow, as federal loan and grant dollars account for the vast majority -- in some cases, nearly 90% -- of total revenues at many for-profit institutions.

Following the October 14 rout, many of the for-profit education stocks appear to be remarkably cheap. For example, ITT Educational Services (ESI), at $56, sells for less than six times the previous 12 months’ earnings per share. Corinthian Colleges (COCO), at $5, can be had for less than three times earnings.

So is the market overreacting and presenting mouthwatering bargains? Our answer is an emphatic no. In fact, we remain short a basket of companies in the industry (that is, we’re betting on their share prices to fall).

The key to cashing in on a controversy is to determine whether the problems are both temporary and fixable. In this case, we believe that any final regulations will ultimately require the industry to be more selective in enrolling students and to provide their customers with more-attractive benefits in relation to costs. Such an outcome is likely to cut sharply into the industry’s long-term profit growth and reduce the enviable 25%-plus operating-profit margins that many industry players enjoy. In our view, the challenges these companies face from new regulations and bad publicity are proving to be more acute than even skeptics like us expected. If we’re right, school stocks, though beaten-up, have further to fall.

Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson are short Apollo Group, Brightpoint, Career Education Corp., Corinthian Colleges, Education Management Co., ITT Educational Services and Strayer education.

John Heins
Contributing Editor, Kiplinger's Personal Finance