New Oriental Education (EDU) is quickly becoming another victim of the slowing global economy. Last week, the company reported earnings for its second quarter ending November 30. While the historical earnings and sales figures were relatively attractive, investors were spooked by the forward guidance which indicated a slowing of growth from 50% plus revenue growth the last two quarters to a level in the low to mid 20’s.  Management tried to put a bit of lipstick on the guidance by stating that the growth was on top of a very strong third quarter last year but investors quickly sold the stock off as the multiple was pricing in long-term growth levels much higher than the new guidance.

EDU is a good example of the life cycle that many strong growth companies go through.  In the beginning, investors bid up the stock due to the expected growth rate of the new business.  These optimistic assumptions were confirmed each quarter as management continued to execute on the business plan and the small company captured more market share each period.  It can be easy to grow a small company at a rate that doubles every 18 months, but as you begin to deal with larger numbers, the growth rate is much more difficult to maintain.  At the same time, investors often overshoot their assumptions and become overconfident in the company’s ability to continue the geometric growth rate.

Only a select few companies can achieve the track record of stocks like Google, and so at some point investors usually become disappointed when their aggressive expectations are not met.  Investors who rationalized paying 40 or 50 times earnings now have very little logical reason to buy more stock when growth rates are contracting.  In fact, funds and momentum investors who have bought into the hype will be quick to jump ship pushing a stock price sharply lower.  This action does not always take place quickly on an earnings release.  For many very healthy companies, the migration lower in expectations is manifested in a stock price that sits rangebound for several months as the fundamentals need some time to catch up with the expectations.  However, some stocks experience sharp drops as the inflated expectations are shattered by the hard hammer of reality.

I think that EDU fits into the latter camp and in a time of contracting multiples and declining economic activity, this appears to be a dangerous name to hold.  While the stock is currently already depressed and nearly 40% off it’s high, it is still not at a price that would be likely to draw value investors who would support the price.  It seems to me that the best way to play this name would be to wait for any kind of stability or strength and then slowly build a short position being careful to honor stop levels and exercise risk control.  This turbulent market offers opportunity from both the long and the short side, but it is brutal and merciless to those who do not have a well defined risk control process.

Alternatively, it could be worthwhile to play some other names in the sector that have not been hammered quite as hard yet.  For instance, one could begin to build a short position in Capella Education (CPLA) or Strayer (STRA) assuming that they will experience similar weakness due to the same forces that are causing EDU to guide more conservatively.  These names all have individual sets of circumstances and operate in different geographical areas, but as contagion is seen in global markets and correlation increases, it becomes easier to take advantage of trends using multiple investment vehicles.

EDU Notes:

FD: Author has short position in CPLA