Investing Lessons From a 4-Bagger

Since Motley Fool Stock Advisor opened its pages in 2002, David and Tom Gardner's stock picks have bested the S&P 500 by a wide margin.  We're celebrating the newsletter's 10-year anniversary by releasing -- for free -- the original recommendation articles for several of the newsletter's biggest winners. Today we look at Liquidity Services, which has gained 345% since it was picked in the July 2009 issue.

Let's take a look at David Gardner and Karl Thiel's original recommendation in its entirety to understand what they saw in the thinly traded small-cap stock. Re-join me at the end of the article for the investing wrap-up.

Below you'll find the write-up exactly as it appeared in the July 2009 issue of Stock Advisor.

David’s Top Stock: Liquidity Services

Take note: Liquidity is a thinly traded small-cap stock, and its price is likely to be volatile. When placing a trade for this stock, use a limit order.

I'm usually drawn to high-growth stocks with a technological edge, while my brother Tom often takes a page from Peter Lynch's book and favors overlooked companies in industries that other people find drab, boring, or even unpleasant. This month, I've found a company that has the traits we both love -- and that should appeal to investors looking for exceptional returns.

Liquidity Services (Nasdaq: LQDT  ) is an online auction vendor dealing in salvage, surplus, and wholesale, primarily from government sources. It's the eBay (Nasdaq: EBAY  ) of the armed forces, the Overstock (Nasdaq: OSTK  ) of the public sector. But it's not just another online auctioneer in a crowded field.

On Top of Its Scrap Heap
Liquidity has little direct competition for much of its business. Just check its GovLiquidation.com and GovDeals.com sites, and I promise you'll never buy a used bulldozer anywhere else. About 48% of Liquidity's revenue comes from two exclusive Department of Defense contracts to sell surplus and scrap -- cash cows nobody else can milk. But there's more to the competitive edge, which includes services that other online auctioneers won't or can't offer for these specialized items, tasks such as warehousing, title transfers, dispute resolution, and even marching through salvage yards to take photos of the lots.

There's plenty of opportunity to expand this government footprint, where Liquidity has little competition besides traditional auctions. It may have locked up DoD, but there are thousands of federal, state, and local governments around the world that dispose of surplus goods inefficiently.

Liquidity shares the high-tech, dirty-industry appeal of Copart (Nasdaq: CPRT  ) . That recommendation from Tom has a strong lock on its auto salvage niche through a combination of a network effect and specialty services. With less than a decade of experience, Liquidity is a much younger and smaller company, but it's on a similar growth trajectory.

An Untarnished Opportunity
The stock has doubled since March, yet Liquidity still trades for less than its IPO price from early 2006. A big culprit for the drop is the worldwide recession, which has bitten into revenue and may continue to do so in the months ahead. While revenue increased at a compound annual rate of 30% over the past three years, sales have shrunk 5.6% in the first half of the company's fiscal 2009, which started Oct. 1.

Liquidity's main money engine is profit sharing. For scrap, it gets 23% of the profits from each sale, but after a seven-year bull market, commodity prices came crashing back to earth last October. Lower sales prices and thinner profit margin on scrap are a direct hit on the bottom line.

But here's why I'm not worried -- and why Karl and I don't think you need to wait to invest in Liquidity. First, while commodity prices have affected the scrap business pretty drastically, that made up only 31% of revenue last year and is even less now. Second, the stock price already reflects much of the economic trouble. If Liquidity's free cash flow simply returns to its level from last September, just before the market meltdown began in earnest, and the company never grows another penny -- zero, forever -- the stock would still have an intrinsic value roughly equivalent to today's $10 price. Of course, we expect a lot of growth, particularly once an economic recovery really takes hold.

That's not just wishful thinking. Even through the downturn, Liquidity has managed to increase its gross merchandise value each quarter, along with its transaction volume, which increased 32% year over year in the second quarter. The number of registered buyers continues to climb, too, and now tops 1.1 million, more than double the count when Liquidity went public three years ago.

Liquidity's marketplaces are cementing a powerful network effect as they grow in reach and become an entrenched part of how businesses and governments cut logistics costs and reclaim money from surplus goods. This suggests to me that the company's profit and cash flow will bounce back quickly as the economy improves, commodity prices rise, and the profit margin on sales picks up.

If you expect these things to get better -- as we do -- you can invest ahead of the rebound at a price that reflects the past year's bad news. This is a strong company with an exceptional balance sheet showing no debt and almost $2 per share in cash and investments. I give the management team high marks for generating an 18.4% return on invested capital over the past 12 months. Management is also invested in the company's success: Co-founders William Angrick (chairman and CEO) and Jaime Mateus--Tique (president and COO) own 42% of the shares.

Risks and When We'd Sell
This is a thinly traded small cap, with only about $700,000 worth of volume on an average day. That means it's likely to be volatile, so consider using a limit order when you buy.

Liquidity depends on government contracts for a large part of its revenue. It renewed the DoD contract on surplus goods to 2011 -- on substantially better terms that will start showing up in the results in the third quarter -- while its contract on scrap extends through 2012. But when these contracts expire, Liquidity may have to go through a new competitive bidding process. As businesses that buy government surplus and scrap become more accustomed to Liquidity's channels, government sellers will find it increasingly hard to change vendors -- there's that network effect -- but losing these deals would be devastating to the growth thesis we're counting on.

The Foolish Bottom Line
Liquidity Services has quickly become a leader in auctions for surplus, scrap, and wholesale items -- including a monopoly on many government goods. With huge expansion opportunities, Liquidity promises a long period of strong growth, yet it's priced as if today's hard times will be its whole future. That's treasure worth digging for.

-- David Gardner, July 2009

Investing lessons
Besides David and Karl finding a great business benefiting from a strong network effect, two things stand out to me from this recommendation:

1. They were able to avoid anchoring on past prices while assessing the company's present value.
After falling sharply with the rest of the market during the economic crisis, Liquidity Services had doubled in just a few months. It would have been easy to bemoan lost gains at that point and move on to the next stock, but they were confident Liquidity had plenty of room to run.

2. They were able to avoid recency bias and knew the economy would eventually get better.
Liquidity Services was suffering from lower sales and thinning profit margins, and the market was pricing it as though it would never grow again. Always simple in hindsight, it's not easy to look past the wailing and gnashing of teeth to better times ahead, but David and Karl knew that when the inevitable recovery began, their recommendation would rebound nicely.

Fool analyst Rex Moore tweets but is not a twerp. He runs a real-money portfolio based on his screens. He owns shares of eBay. Motley Fool newsletter services have recommended buying shares of Liquidity Services, Copart, and eBay. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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