Traders: short this poorly-scoring online tutoring firm

The rally in US equities, with the benchmark S&P 500 index now up 40% from its low in mid-March, has left many stocks trading only slightly below their level at the start of this year. However, some technology shares have surged by even more as investors think that the crisis could lead to many activities traditionally carried out face-to-face being conducted online instead.

One of these is GSX Techedu Inc (NYSE: GSX), a Chinese company that specialises in after-school online tutoring. A year ago the shares were trading at barely $10. However, by January they had risen to more than $23. They are currently at $66: a 750% rise in a single year. But the firm’s meteoric rise, which follows the implosion of Chinese companies such as Luckin Coffee, has attracted attention from short-sellers, who have argued that things are not quite what they seem.

Do the numbers add up?

In particular, they claim that GSX is exaggerating the number of people attending its classes, with noted short-selling hedge fund Muddy Waters Research estimating that at least 70% of users are fake “online bots” (internet robots). Muddy Waters also claims that the group is understating its costs. As a result, it alleges that far from making a profit, GSX is actually an “empty box” that is making a loss.

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Naturally, Larry Chen, the founder and chairman of GSX Techedu, disputes the allegations, claiming that the hedge fund doesn’t understand its business model. Still, even if you assume that the allegations are false and take GSX’s numbers at face value, the stock seems to be priced absurdly optimistically at 409 times trailing earnings. Even if earnings and revenues explode in the way that the company predicts – hardly a certainty, as once restrictions are removed people can access schools and tutors – it will still be trading on a 2021 price/earnings ratio of 80.

Another problem that should give investors pause for thought is potential competition. GSX isn’t the only company trying to make money from online tutoring. The sector has low barriers to entry (it is easy for potential rivals to get established), so GSX will be vulnerable either to losing business or to having its profit margins squeezed. So even if online tuition expands at the rate that Chen expects, GSX won’t necessarily be the one to profit from the trend.

I think that GSX is a prime candidate for shorting. However, with the stock price doubling over the last six weeks there is always the risk that it could surge higher before it starts to fall, especially if the short-sellers end up being “squeezed” (a manoeuvre where people buy shares in a company in an attempt to drive the price up and force short-sellers to cover their positions). So I’d wait until it falls below $50 before shorting it at £40 per $1. In that case, I’d also cover the position if it rises above $75, implying a downside of £1,000.

How my tips have fared

This last fortnight hasn’t been kind to my long tips, with all five declining. International Consolidated Airlines Group (ICAG) slipped from 264p to 225p; energy giant Royal Dutch Shell declined from 1,376p to 1,314p.

Television group ITV fell from 80p to 70p. The pubs were allowed to reopen in England last weekend, but pub chain JD Wetherspoon failed to profit; the stock slipped from 1,161p to 1,002p.

Even equipment company United Rentals, currently my most profitable recommendation, went down slightly, from $158 to $151. Overall, the profit on my long tips fell from £2,128 to £700.

The performance of my short tips was more mixed. On the one hand two out of the three went in my favour, with health insurance broker eHealth declining from $107 to $104 while electric truck manufacturer Nikola depreciated from $70 to $49.

However, online dating firm Match Group surged from $95 to a peak of $107. While it later fell back to $95, if you had taken my advice you would have automatically covered your position at $102, for a loss of $990.

This demonstrates that while stop-losses can prevent you sustaining large losses, they can also mean that you get stopped out of volatile positions. Counting Match Group, the overall losses on my short tips are $710.

I now have five long tips (ICAG, Royal Dutch Shell, ITV, JD Wetherspoon and United Rentals) and three short tips (eHealth, Nikola and GSX).

With my ultimate goal being to balance my long and short tips, I plan to add some more short tips in the next few weeks. However, since my oldest position was taken out in March, I’m not going to close any of my existing tips or suggest that you adjust any of the stop-losses further.