Turning Debt Into a Double

Every stock I own was bought with the intention of holding it for a very long time. Yet I know there are some riskier companies in my portfolio that I may wind up selling a lot sooner than I expect. These are the volatile small caps; they are businesses that could lose a lot of value, or -- every investor's Holy Grail -- transform into one of the market's 10 best stocks.

But there's one small cap in my portfolio that I fully expect to be there until I retire: Portfolio Recovery Associates (NASDAQ:PRAA). It has performed well for me and has nearly achieved two-bagger status as of my official recommendation two years ago in Motley Fool Hidden Gems.

Why does this company not make my stomach flip-flop like some of my other small caps? There are four reasons. But first, let me tell you a little about the business.

Great American hero
PRA performs a much-needed service for the U.S. economy by collecting on debt that other companies have given up on. But don't get the wrong idea; it doesn't send out big guys named "Vinny" to convince deadbeats to pay up. Instead, it relies on incredibly efficient collection teams that operate from state-of-the-art call centers in Virginia and Kansas.

The company purchases blocks, called portfolios, of defaulted consumer debt from credit card companies, banks, and retailers. It then attempts to collect on that debt, typically over five to seven years.

The economics are good. PRA purchases the debt for about $0.03 on the dollar, and typically collects around $0.09 per dollar. That includes debt at all stages of the life cycle, from recently defaulted "fresh" paper to receivables that have been owned by many different collectors.

Revenues and earnings are growing at better than 25% annually and the company has a solid balance sheet.

Four signs
Now, back to the four reasons this small cap is more stable than most:

1. An extremely disciplined business plan. Debt collecting is a strange business. Companies will bid to purchase the blocks of debt, and there's a strong chance some will overpay in order to get the business. Of course, firms that overpay will see their margins and profitability decrease and may soon wind up out of business.

PRA's proprietary modeling techniques help it nail down fair prices for the blocks of debt, and management refuses to overpay. If it doesn't get as much business as a result, that's fine. It will gladly stand by and watch the competition suffer.

2. An efficient business model. This company is able to get the most out of its talented employees. Its "cash collections per hour paid" figure has risen steadily from $77.20 in 2001 to $133.39 in 2005. I don't know of any competitor that can match this, though other companies are stingy with such data.

3. A strong balance sheet. In an industry with a checkered past that has seen some companies completely flame out, PRA stands strong. It's more than able to withstand any pricing wars, outlasting and outshining weaker competition.

4. Excellent management. To be honest, this is the big one that drives all the above points. CEO Steven Fredrickson and CFO Kevin Stevenson left Household Recovery Services together in 1996 to start PRA. They have been immersed in the collection business for most of their professional careers, and provide the best one-two punch in this industry. They are honest, open, and more than willing to talk to anyone about the business. They've been expensing stock options long before it was required, and they use the most conservative approaches in their financials.

Aside from these four points, I believe this is a good time to be looking at the debt recovery industry. New IPO MasterCard (NYSE:MA) may have grabbed a lot of attention, and rising interest rates have generated greater awareness in credit card issuers such American Express (NYSE:AXP) and Capital One Financial (NYSE:COF), but as consumer debt levels continue to soar, it makes greater sense to me to look farther down the line at the companies that will be collecting on record amounts of bad debt.

From debt to double
Portfolio Recovery is a small, disciplined company with an efficient business model, strong financials, and excellent management. Each month, our team -- led by Fool co-founder Tom Gardner -- screens through the thousands of small-cap companies for Hidden Gems members looking for these and other successful traits. There's no need to reinvent the wheel; we simply look at what has worked well in the past to help us find great companies today.

Hidden Gems is now some three years old, and our total average return during that time is around 33%, compared with 10% for like amounts invested in the S&P 500. If you'd like to check out all of our recommendations, plus more than 20 valuable investing lessons, we're offering a special 30-day free trial. Click here to give it a whirl.

Rex Moore helps Tom and team pan for Hidden Gems. He owns shares of Portfolio Recovery Associates. The Fool is investors helping investors.