It's a dirty word, the bane of many an existence. But it's been a very good place to be for investors over the past two years. Motley Fool Hidden Gems recommendation Portfolio Recovery Associates (NASDAQ:PRAA) is up 60%, Tiny Gem International Assets Holding (NASDAQ:IAAC) is up 170%, and Watch List denizen Asset Acceptance Capital (NASDAQ:AACC) is up 52% since its 2004 IPO.

But this recent success is now one of the biggest risks facing the industry -- as two insiders pointed out to me after my last debt-related article two months ago. Let me explain.

Industry downside
Charged-off debt has been in an inflated pricing environment for the past 18 months. That's because entrepreneurs have caught on that there's coin to be made in the receivables-management business.

The problem is that as new (and likely inexperienced) money enters the industry, it serves to bid up the price of debt portfolios. Long-standing firms are then forced to compete for price, expand their reach, or take a pass on purchasing. Public companies that report to shareholders on a quarterly basis may be loath to pursue the last of these options. Yet taking a price on overpriced debt in the current operating environment is exactly what management shouldn't be doing for the health of the long-term horizon, even if it means a few quarters of pain for shareholders.

Don't believe me? Consider the current plight of reinsurance companies facing massive payouts in the wake of Hurricane Katrina. If they're not well-capitalized and conservatively managed -- such as Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) and (presumably) Motley Fool Hidden Gems recommendation Montpelier Re (NYSE:MRH) -- they could be on the ropes.

In calmer times, capital pours into the industry and lesser firms write policies that underprice risk and leave them unable to meet payout requirements when the inevitable disaster strikes. Disciplined companies (i.e., those that decided not to compete for business at unsatisfactory levels), however, are able to meet their requirements and do very well in the hardened post-disaster market -- there isn't as much competition, after all.

The same goes for debt
It's no hurricane, but recession is the looming threat for debt buyers. Low savings, high gas prices, possible unemployment, and rising interest rates on debt could cause many folks to default -- leaving undisciplined debt buyers and their investors in the lurch. My one industry friend was unequivocal about this possibility, stating that the biggest risk in this industry -- by far -- was overpaying for debt.

Yet I remain bullish on the debt industry -- if that's not too offensive, given the subject matter. Take a look at how Americans continue to use debt to finance their lifestyles:

Metric Amount Source
July 2005 consumer debt obligations $2.2 trillion U.S. Federal Reserve
2010 consumer debt obligations (projected) $2.8 trillion The Nilson Report
1990 receivables charge-off rate $8.2 billion The Nilson Report
2002 receivables charge-off rate $51.1 billion The Nilson Report
2010 receivables charge-off rate (forecasted) $86.7 billion The Nilson Report

This is an expanding market, but it's also a widening market. And although an economic downturn would shift some clients from the willing-to-pay to the cannot-pay camp, there is a silver lining: The industry is largely recession-resilient. During a downturn, there is likely to be more debt charged off -- increasing supply and lowering prices.

So, then, we should all be gleefully investing in debt buyers, right? Well, no. We should be investing in the most disciplined debt buyers. Why? Because just as disciplined insurance companies have capital to deploy in a hardened post-disaster market, so, too, will disciplined debt buyers be able to buy more debt when prices stabilize. On the other hand, those that overpay for portfolios today will suffer decreased collections and be unable to finance new debt purchases -- the industry's lifeblood -- out of their own cash flow in the future. Which brings me back to Portfolio Recovery and Asset Acceptance ...

The debt buyer's checklist
For long-term success in this industry, a company needs:

  1. Experience. Portfolio Recovery and Asset Acceptance both have solid management teams and industry histories that long predate their IPOs.
  2. Diversity. Both companies maintain evolving proprietary pricing models over different asset types and ages.
  3. Discipline. Both companies put debt-purchasing decisions through multiple committees and assessments to avoid overpaying. These checks and balances enforce discipline.
  4. Endurance. Neither company is in the debt resale business. (Competitors often sell non-performing accounts to bump short-term performance.)
  5. Relationships. Both companies enjoy repeat business from debt sellers and low turnover and improved performance from employees. Both also stress working together with their clients to solve mutual problems.
  6. Market growth. Asset Acceptance is educating non-credit-card debt issuers on the benefits of selling distressed receivables. Portfolio Recovery has diversified through its acquisitions of IGS Nevada (auto loan collateral) and AlaTax (tax collection).
  7. Strategies to contain costs. Both companies focus on metrics such as "collections per hour paid" to build in resilience to economic downturns.
  8. Capitalization. Both Portfolio Recovery and Asset Acceptance have growing cash balances and minimal debt/capital lease -- minimizing future financial risks.

The Foolish bottom line
Both companies still look pretty good to me, in spite of the reservations raised by one of my newfound industry-insider friends. The reason: They're best-of-breed firms. And because of that, it doesn't surprise me that both have graced the pages of Hidden Gems. Fool co-founder Tom Gardner and his team of analysts have made it their mission to uncover some of the market's best small-cap opportunities for subscribers. To date, the team has posted returns of 25.5%, compared with S&P 500 returns of 8.3% over the same time period. To view their more than 40 recommendations, read hundreds of pages of buy reports, and interact with thousands of investors who are actively following these companies, click here to kick the tires on a 30-day free trial. There is no obligation to subscribe.

At the end of it all, I remain quite happy with my stake in Portfolio Recovery and am whetting my appetite for Asset Acceptance. Excuse me while I start my valuation.

Fool contributor Jim Gillies owns shares of Portfolio Recovery but no other company mentioned in this article, although he's been casting bedroom eyes in the direction of Asset Acceptance for about six months. The Motley Fool has a disclosure policy.