How will the Fed taper affect small cap value? (Part 2 of 7)
Who is taking the investment risk?
The below graph reflects the performance of Apollo Education (APOL) formerly known as The University of Phoenix, since 1999. This for-profit educational institution declined after being a star performer until it was taken over by Leon Black’s Apollo Global Management in 2011. After performing horribly on economic and regulatory intervention concerns, the stock has recovered strongly, and since 2013 is up 55%, while the iShares 1000 Value Index is up 30%. This article considers the prospects for small cap value shares like APOL in the context of the recent Fed announcement and post-March rally in small cap value shares.
For a similar analysis of how the Fed announcement has affected large cap stocks, read Will the Fed take a bite out of Apple? And for mid caps, read The Fed tapers–will mid cap value hold up better then mid cap growth in Q2?
University of Phoenix—political football rallies with small cap value
Apollo Global Management’s Leon Black’s acquisition of the University of Phoenix in 2011 appeared to be a great investment in a value stock with great growth potential. Since 2012, Apollo Education (APOL) had fallen from $55 per share to $16 per share, and has recovered to over $33 per share. Not only has enrollment in the University of Phoenix declined since 2011, but the very issue of using Federal student loan monies for tuition purposes has become a political game. Truth in advertising surrounding the value of an online education is an important political issue which became politicized during the financial crisis, when the Federal budget deficit reached record proportions. However, now that the Federal budget deficit is improving in conjunction with the labor markets, perhaps the hard data on the University degree has become an issue lobbyists have been able to smooth over. On the other hand, for-profit institutions like APOL could continue to see regulatory pressures to disclose the economic value of their degrees, and the availability of Federal student loan revenues that fund APOL tuition costs could become an issue in the future.
Why for-profit colleges are sub-prime debt investments for the U.S. government
On one hand, Apollo maintains that it provides opportunity for the underserved and undereducated sector of our society. That’s true—but at what price to the tax payer? Politicians are concerned that the economic value of the University degree may be overrated, and that the Federal Stafford government guaranteed loans ($20,500 per year up to $160,000) that support APOL may not be positive return investments for the U.S. tax payer. When the Fed’s average borrowing costs are under 2.0%, as they are now, student loan debt is cheap, and probably a good investment. However, for the average American who might end up with $100,000 Stafford debt on a University of Phoenix degree in art history, this would be a huge problem if rates rise, as interest charged on these loans is typically around 3% over the 90-day rate. When the Fed funds are over 5%, the loan payment comes to over $700/month.
However, under the new Obama rules, student loan payments would cap out at 10% of personal income, or AGI. The government would be on the hook for the rest. Given the cost of financing this payment versus the average 10% of AGI of University of Phoenix grads, the Federal Government could be on the hook for a lot more than it bargained for when it thought that education was always a great investment—just like Fannie Mae thought that the sub-prime mortgages were AAA investments. Perhaps the loan originators are not as focused on the repayment capability of the borrowers as they should be, once again. Therein lies the arbitrage.
Morningstar small cap value holds Apollo Education as #15 in its index, at 0.71% of holdings. Apollo Education has a market cap of $3.63 billion, 2015 forward price earnings ratio of 17.24, a 19.21% return on equity, and total debt of $6.26 billion on $719 million in earnings before interest, taxes and depreciation (or EBITDA). This reflects some leverage, although nothing like Caesar’s Entertainment (CZR) which has an EBITDA of $1.64Bn on over $21 Billion in debt (Capital IQ).
While the U.S. consumption may remain soft, as reflected in the University of Phoenix enrollment level of 173,000 in the last fiscal year, versus the 2010 peak of 371,000, it is important to note that small cap stocks—both value and growth—can be influenced by many factors other than simple economic growth numbers. Regulators and activist investors can impact stock prices much more quickly than simply a little soft economic data. Plus, activist investors which may seek to add to a company’s debt level may also have a tendency to add risk/return to a stock. However, if management adds to a company’s debt level, they can lower the credit quality of the company’s existing bonds. This dynamic can pit risk embracing equity holders that want growth against the interests of risk averse bond holders, who seek stability of earnings. This is simply the ages old tug-of-war between equity and fixed income investors. However, Apollo Global Management’s Leon Black is pretty good at this game against the bond holders.
To see how the Fed’s taper could impact the small cap value rally in the long run, read the next part of this series.
Constructive macro view
Despite problems in Ukraine and China, and despite the modest consumption data in the U.S., the U.S. labor market appears to be recovering—with the exception of the long-term unemployment. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still showing a modest recovery, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find a way into a new wave of profitable investment opportunities, and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption, and investment in the works, the recent out performance of value stocks over growth stocks could become the prevailing trend, favoring iShares Russell 1000 Value Index (IWD) over iShares Russell 1000 Growth Index (IWF).
Cautious macro view
Given the China and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY) and Dow Jones SPDRs (DIA), and iShares S&P 500 (IVV). Accordingly, long-term investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD) including companies like Wallmart (WMT).
Browse this series on Market Realist:
- Part 1 - Why did small cap value suddenly go red hot in the US market?
- Part 3 - Why is Third Point’s Dan Loeb after small cap growth?
- Part 4 - Will the Fed’s tapering eventually crush small cap value?
- Investment & Company Information
- University of Phoenix
- Apollo Global Management