How to spot a brittle business

One sector has done a better job of destroying shareholder value than any other over the past few years. Welcome to vocational education and training (VET), a world where governments hand over billions of dollars to questionable businesses delivering sub-standard education to students who are ill-equipped financially – and sometimes physically and mentally – to complete overpriced courses they were sold but didn't want.

This was a business model that generated high rates of profit growth without triggering any underlying concerns. 'How good is Australian Careers Network (ACN)?,' asked one broker at a company presentation, 'it's growing like crazy!'.

You've probably heard the names, although not in the Intelligent Investor, which steered clear of stocks like Vocation and the aforementioned ACN. The rise and fall of these stocks offers some vital lessons for investors intent on avoiding the 'next big thing', as well as the benefits of understanding in the most elemental way how a business makes money. Waste the learning opportunity at your peril.

For eons, TAFE was the cornerstone of vocational education, offering high-quality courses at affordable prices. By introducing competition – 'contestability' as it was called – a wider range of courses would become more accessible to a higher number of students, or so the theory went.

A real disaster

It didn't quite work out like that. Private operators cherry picked the most profitable courses, leaving TAFE to deliver the expensive, low-margin programs. More significantly, government funding caps were removed, allowing students to take out low-cost loans for approved diploma courses up to a value of $95,000. Governments paid the fee for the entire course upon student registration but colleges only incurred costs as lessons were delivered (in many cases sub-contracted). If a student dropped out, as many did, the college kept its fees and the student kept the debt.

If someone had designed a system to deliver exactly the wrong result for students, investors and taxpayers, it would look like this. To steal a line from Paul Hogan: 'Pink Batts isn't a disaster, this is a disaster'.

The ABC's Paddy Manning described how these incentives played out in a recent Background Briefing program, citing the example of Lukas, a young man on his way to Centrelink stopped by a representative from Aspire College. Offered a free computer, he signed up to a business management course but subsequently struggled with the work. Aspire then sold him another diploma course and, presumably, collected another fee. Lukas now wears an $18,000 debt and Aspire College has collapsed.

In 2012, government expenditure in the sector ran to $325m. By the end of 2014 it had hit almost $1.8bn. Enterprising opportunists had quickly found their way to a rich plunder and were keen to cash in. Vocation, one of the biggest providers, listed in December 2013 at $1.89 a share, reached a high of $3.31 in September 2014 and entered administration at 12 cents a share in November last year. It now faces three class action lawsuits. In total, founders, staff and directors sold about two-thirds of their shares into the float.

Australian Careers Network's story wasn't so different. It listed at an issue price of $1.70 in December 2014 and by October last year had risen above $3.40. After burning through $10.4m in the December quarter and with just $13.5m remaining in the kitty, it entered voluntary administration a few weeks ago.

'Rampant and unethical'

Both companies had expanded quickly, taking on debt to do so. But what really bought them undone was Federal and State governments realising the extent of their own stupidity. Investigations were launched, including a scathing senate hearing that described government oversight as a 'failure' and the misbehaviour of some private providers as 'rampant and unethical'. Eventually, the money pump was shut down.

Easy to predict, right? Well, sort of. We certainly didn't recommend any of these stocks. What troubles me are some eerie echoes between vocational education and a sector we did get roped into more than six years ago – one that cost members dearly.

After making a number of successful recommendations in managed investment scheme (MIS) stocks like Forrest Enterprises and Great Southern Plantations, we came unstuck with Timbercorp, a name that even now is hard to write. There were analytical errors but our big mistake was not to see the sector for what it really was.

Ostensibly, companies like Timbercorp were agribusiness investment managers. They would buy land, plant trees or crops like almonds and olives, and then manage them on behalf of investors. The trouble was, investors weren't getting anywhere near the returns they were promised.

As we said in a review of Great Southern in 25 Sep 2008, a woodlot investor that kicked in $3,000 in 1998 could expect 'net harvest proceeds of around $2,600. That's a loss for locking money up for a decade, whether considered before or after tax. The results for all six timber projects involved in this offer are abysmal, and the cattle projects are even worse.'

If the product was so bad, why did investors keep coming? Financial planners were offered a fat 10% commission and investors got a nice up front tax deduction in the year of their investment for another. It was government policy to encourage agricultural and forestry investments and these products fitted the bill, at least for a while. Okay, so now you can see where this is heading.

Pottery lessons

At the 2006 Berkshire Hathaway annual meeting, Charlie Munger became transcendentally philosophical: 'You don't make clay out of turds', he said.

The MIS sector and vocational training companies sold turds. The dream of a good education, rather than the reality of a poor one, is a dud product, as is a nice tax deduction travelling under the guise of an MIS that returns less than your initial capital.

Of course, if you incentivise the selling of a dud product you can get away with it for a while. Eventually, though, the dope stirs, looks into his empty pockets and looks around for a thief. That's when the investment case goes up in smoke.

Having warned members to avoid the MIS sector's investment products, we believed we could recommend Timbercorp because it was making enough money from the charade to justify a substantially higher share price.

We were wrong. If the product is a charade, one that wouldn't exist without favourable legislation and a nice sales commission, how can it be a good business? That's the lesson. You can't make clay from a turd.

Disclosure: The author John Addis made money on Great Southern before losing it on Timbercorp. He has learnt his lesson.