Would You Short This Stock?

When it comes to shorting, investors should be careful. That's because while your downside is capped and your upside unlimited when you go long a stock, when you go short, your upside is capped and your downside is unlimited. So you don't want to short a stock that has the potential to keep going up and up and up.

That's how I think about shorting, anyway, so when it comes to finding shorts, I like to find a company in a low-growth niche that also has flawed operations or unethical management. Then, even if I turn out to be wrong in my analysis of the operations or management, I'm protected by the fact that the company likely won't see outrageous growth.

Thus, I was surprised to see Chinese private education company New Oriental (NYSE:EDU) show up on short-selling website Citron Research the other day.

The background
First, let me say that Citron's work is generally of very high quality. It's thorough, it's well-written, and it's generally right.

But the work on New Oriental (a stock we've recommended at Motley Fool Global Gains) doesn't match its usual high standards. Further, the potential rewards of shorting New Oriental are far outweighed by the risks.

But before we get to that, let's go through what Citron had to say about New Oriental and why I think its conclusion misses some key points.

Let's go to the videotape
Citron claimed in its report that New Oriental had a "fantasy-land valuation" and was destined for "extreme price erosion." As evidence for this, Citron cited the recent price-to-sales multiple that Pearson (NYSE:PSO) paid to acquire Wall Street English from The Carlyle Group (apparently gleaned from this brief Wall Street Journal article).

The "short" version is that Pearson bought Wall Street English and its $70 million revenue stream for $145 million (a P/S ratio of 2.1). That's an enormous discount to the whopping 7.9 P/S ratio that New Oriental is fetching on the New York Stock Exchange.

Seems like an airtight case ...
Now, peer multiple comparisons are useful in any valuation analysis, but the important thing to remember is that they're relative.

After all, it's natural for a company to be overvalued relative to its competition if it turns out to be a superior company with superior growth prospects. Similarly, you won't make money buying companies that are undervalued relative to their peers if they happen to be inferior companies.

In other words, pointing out that New Oriental is overvalued relative to Wall Street English is meaningless without an analysis of the two businesses that confirms that they are, in fact, of equal quality. And that's where I think Citron got it wrong.

The better business
First, Citron fails to point out that New Oriental is already a bigger business than Wall Street English, with more than $250 million in trailing revenue. That's worth a slight premium right there.

Second, Citron claims that Wall Street English is the faster-growing of the two by comparing Wall Street English's compound annual growth from 2006 to 2008 (40%) with guidance for New Oriental's top-line growth for 2009 (28% to 35%).

This is a daft comparison. Not only does it measure two different time periods, but it's comparing growth at a time when China was booming (2006 to 2008) with expected growth at a time when China's GDP growth will be historically low (2009).

In fact, we're given no information about Wall Street English's expected 2009 growth rate, and if we compare Wall Street English's 2006 to 2008 CAGR with New Oriental's, we find that New Oriental is the faster-growing company -- it grew the top line more than 45% annually from 2006 to 2008. I suspect New Oriental will continue to outpace Wall Street English in 2009, which is worth another slight premium.

Third, Citron fundamentally misunderstands just how different New Oriental's business is from Wall Street English's. Wall Street English is a Western brand that caters exclusively to the elite adult market (a segment that makes up a small percentage of New Oriental's overall business).

New Oriental is one of China's most recognized domestic brands, its CEO is a celebrity role model for Chinese students who seek to learn English and study abroad, and it offers English courses to kids, students, mass-market adults, and high-income adults, as well as test prep courses for overseas exams and the gaokao (China's highly competitive national college entrance exam).

Here's the breakdown of New Oriental's enrollments in each of these segments for fiscal 2008:

And while profit margins vary from segment to segment, Wall Street English competes with a small percentage of New Oriental's total enrollments. In other words, New Oriental is a much broader enterprise with far broader growth prospects ... a trait worth another slight premium.

Finally, Citron tries to argue that the folks who sold Wall Street English -- The Carlyle Group -- are "not exactly naive investors who would sell a property for a mistakenly low price." Thus, paying two times sales for a Chinese education company might already be overpaying!

This analysis ignores the fact that The Carlyle Group is reportedly down 40% this year. If Carlyle needs to raise cash -- which isn't an outrageous assumption in this market -- that would make it a more motivated seller than it has been. There's even some evidence that might be true, because New Oriental Chief Financial Officer Louis Hsieh claimed on the company's recent conference call to be unable to comment on the Wall Street English deal conference call because New Oriental had signed a confidentiality agreement. I suspect this means that New Oriental has seen Wall Street English's numbers and that The Carlyle Group may have shopped the deal to it.

All of this is to say
I think the case for shorting New Oriental is flimsy at best. And though investors are right to avoid buying overvalued stocks, that doesn't mean you should go about shorting them -- even in the teeth of a bear market.

For proof of that, here's a sampling of names that were selling for more than seven times sales at the beginning of 2002 that would have turned out to be painful shorts both that year and for the long term:

It's no coincidence that two of these stocks (HDFC and Infosys) benefited from the tailwinds of operating in a fast-growing emerging market.

Your next step
Just to be clear: I'm not arguing that New Oriental is a deep value stock. Rather, I'm arguing that New Oriental is a well-run company in a fast-growing niche that may well grow into its valuation and beyond.

That's not the type of name you want to be short -- and we actually have a pretty good track record of helping you avoid Chinese shorts that didn't work out so well.

At Global Gains, we believe China will be the global economic success story of the next 25 years. And while we're happy to continue holding our market-beating shares of New Oriental, we're even more excited about some of the small-cap bargains we're finding in Chinese stocks today.

To get a look at all of our research and recommendations, just click here to join Global Gains free for a limited time. There's no obligation to subscribe.

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Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of HDFC Bank. New Oriental and HDFC Bank are Global Gains recommendations. InterDigital is a Stock Advisor pick. Pearson is an Income Investor choice. The Fool's disclosure policy is short, but in a good way.