In a not so distant past, the United States boasted the highest ratio of college degree holders relative to the overall population.

Unfortunately this is no longer so. The United States ranks No. 11 right now, far behind counties such as Russia, Korea, and even Spain.

As a country’s economy develops and shifts from manufacturing to services, the level of education becomes a critical factor in productivity and success. Accordingly, the value of a college education has been steadily increasing over the years and the average salary gap between college-educated and non-college-educated workers clearly reflects that. Higher educated workers earn more, and increasingly more so, over time.

This tendency has translated to a steady increase in demand for providers of higher education. Of course, most people earn their degrees in universities, most of which are either public or nonprofit organizations. Unfortunately, these two entities alone cannot possibly meet the enormous existing demand (only about 28 percent of U.S. citizens have a college degree) and the gap is currently being filled (partially) by another player: for-profit education institutions.

For-profit education institutions are exactly what they sound: profit-seeking corporations whose product is education and whose clients are students. Typically, but not exclusively, these institutions tend to cater to the needs of adult students, who prefer evening, online, or weekend classes and do not necessarily need on-campus accommodations, dining, and extracurricular activities.

‘Back to School’ is in Demand

These companies have benefited handsomely lately from increased demand, not least because of the economic downturn and its stubborn unemployment rate: when there is no work out there, it is a good time to go back to school.

The entire for-profit education sector has been under the spotlight for the past year or so. In order to understand why, we need to first understand how a typical degree is financed. While a minority of students—those affluent enough—can pay their tuition out of pocket, a majority take out student loans. These loans typically have a high default rate and banks would not be as forthcoming without an existing federal guarantee that effectively reimburses the bank in the event of default. In practice, the system uses taxpayers’ money to subsidize the tuition of students who default.

So far so good. However, given the recent financial difficulties of the U.S. government, politicians are attempting to reduce spending and their watchful eyes have fallen on the education sector as well. In all fairness, it must be said that at least in some cases, the system has been abused. Encouraged by strong demand and lucrative gains, some for-profit universities have embarked on an aggressive marketing campaign trying to recruit as many perspective students as possible, regardless of their academic qualifications or their chance of finding employment post-graduation. Some have even resorted to compensating admission officers with bonuses tied to the number of students they admit. This phenomenon has led to the sad result of having many students burdened with debt and unable to obtain a job. The response of the government has been to threaten a large-scale reform limiting access to the federal loan guarantees for those schools that meet certain parameters, such as the percentage of students who default after graduating, or the percentage of students who haven’t started repaying their loans after a number of years.

Not surprisingly, the threat of reform has had a tremendously negative impact on the stock prices of companies in this sector, which suddenly saw their survival in jeopardy (in most institutions the percentage of students benefiting from such loans is above 70 percent).

Choose Carefully

After years of investing in the stock market, I have learned to pay close attention to the rising of situations where there may be a “baby thrown out with the bathwater.” In other words, a state of affairs where all stocks in a given subgroup are sold indiscriminately by the market because of some perceived threat to the industry, regardless of the quality of individual issues. This situation usually presents juicy profit opportunities for those patient and brave enough.

According to this line of thought, I reason that it was highly unlikely that the Department of Education (DoE) would put the entire for-profit sector out of business, as the huge need to increase the education level of the average American still stands. Rather, new legislation would likely aim to weed out the less efficient as well as the dishonest players. Following the reform, with some competitors out of the way, the surviving companies would find a free field of action in a rapidly growing industry.

Among the many players in the for-profit segment, I’d like to single out one of the most impressive institutions: Strayer Education.

I particularly like the company for a number of reasons. First, it enjoys the widest profit margins and return on capital in the entire industry. Second, it has a strong brand image deriving from its being in the business for over 100 years. Third, it focuses on Bachelor of Arts and master’s degrees, unlike some of its competitors, which concentrate on two-year professional degrees (students enrolled in four year programs tend to have higher graduation rates and higher subsequent salaries). Fourth, unlike some of its peers, which already have nationwide presence, Strayer operates in only about 20 U.S. states, leaving plenty of room for future expansion. Fifth, the company can boast a strong balance sheet with plenty of cash reserves.

And lastly, I like the quality of the management team. I have come across few companies with better leaders. The CEO is Robert Silberman. I was very impressed with the clarity with which he described Strayer’s business model, corporate strategy, and the threat of reform from the DoE. Additionally, rather than wasting cash on dubious projects, management has been returning as much as 80 percent of cash to shareholders, further proving the high profitability of the company which has been growing at double digit rates with only 20 percent of reinvested cash. In short, we have a rational, honest, transparent leadership team that seems committed to the long-term profitability of the company.

The threat of DoE reform caused Strayer’s valuation to drop to a multiyear low with a P/E ratio of only 12.5 and EV/EBITDA (earnings before interest, taxes, depreciation, and amoritzation) of roughly 6.5. Both measures suggest undervaluation for a company expected to grow at double-digit rates.

The reform eventually did go through, but it did so in a highly watered-down version. Rightly, the stock prices of these for-profit colleges jumped across the board on the news. Fortunately, for new investors, the recent market decline means that most of these stocks have already given back a good part of their post-legislation gains. Perspective buyers now have the opportunity to buy in a growing industry at a good price point without the risk of DoE regulation.

DISCLOSURE: the author is long Strayer Education

Gabriel Grego is the managing partner at Zanshin Capital, a global asset management firm. Established in 2007, the firm focuses on achieving exceptional returns for its clients. Zanshin’s investment strategy is in strict compliance with the principles of value investing as practiced by Warren Buffett: seeking to acquire shares in extraordinary businesses at reasonable prices. For further information, visit http://www.zanshin-capital.com/ or e-mail info@zanshin-capital.com.