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Investors could be forgiven for overlooking listed law-related stocks. After soaring share price gains last year, Slater & Gordon and Shine Corporate have been hammered. And litigation funder, IMF Bentham, has, to a lesser extent, fallen.

Those with long memories are wary of professional service firm that grow rapidly through acquisitions. Inevitably, some take on too much debt, issue too much equity, pay too much for acquisitions or cannot integrate them. Their share price crumbles.

Slater & Gordon soared from $4.50 at the start of 2014 to a 52-week peak of $8.07 in April this year. The market initially loved its acquisition of Quindell’s Professional Services Division (PSD) for $1.25 billion in March 2015 – a deal that would make it the UK’s largest personal-injury law firm. 

Then a selling frenzy followed when Britain’s Financial Conduct Authority announced in June an investigation into Quindell plc’s financial accounts, and when Slater & Gordon said it had contacted the Australian Securities and Investments Commission (ASIC) about an accounting error that related to differences between UK and Australian accounting standards and had no effect on its profitability and cash flow. Slater & Gordon fell as low as $2.55.

Shine Corporate was affected by sentiment towards Slater & Gordon and regulatory changes in Queensland personal-injury law. The Brisbane-based firm dropped from $3.36 in March, just as Slater & Gordon’s problems emerged, to $2.25. 

For the record, both stocks look oversold and undervalued, but could take time to recover.

The well-run IMF Bentham has fallen from a 52-week high of $2.48 to $1.45. A rare run of four case losses, by IMF’s standards, has driven the share price lower and created an opportunity for long-term investors to buy one of the more promising small-cap stocks.

IMF Bentham

Source: The Bull

IMF funds shareholder and consumer class actions and typically takes 30 to 50 per cent of amounts won in cases. Its core expertise is picking the right cases to fund – it loses its investment if cases are lost and may have to pay for the defendant’s legal costs.

IMF’s revenue and earnings can be lumpy, but it has a history of paying good fully franked dividends and has lost only 6 per cent of cases backed over 14 years. It has collected more than $1.6 billion for its clients since listing on ASX in 2001 and averaged a gross return on funds invested of 158 per cent. It’s a great business model, provided the right cases are picked.

Think of it like a funds management business in legal cases. IMF allocates capital to the highest potential cases and manages a portfolio of them here and overseas, to spread risk. Its portfolio of 39 cases had an estimated claim value of $2 billion at June 30, 2015. That assumes all cases are won and is the total claim, not IMF’s share of it. 

IMF has some traits of exceptional companies: consistently high return on equity, low debt and good cash flow. The balance sheet had $130 million of cash at June 30, more than enough to fund IMF’s international expansion. It opened in the United States in 2011 and now has three offices, 11 staff and has funded 26 cases. IMF expanded to the UK and Europe in 2014 – markets with fledgling litigation-funding industries.

Litigation funding is a growth market, albeit one that is becoming more competitive. All signs points to continued growth in litigation funding for product and investment cases. The rise of shareholder activism suggests more retail and institutional shareholders (in the background) will take on listed companies here and overseas that breach their continuous disclosure obligations, and destroy shareholder wealth. In the US, more pension funds are participating in shareholder class actions.

IMF’s sustainable competitive advantage is its expertise in picking and managing cases, and networks with law firms. Critics of litigation funding underestimate how much skill is needed to choose the right cases, and the importance of scale in managing a portfolio of cases and taking on larger class actions.

Add it all up and IMF has a defendable position in a long-term growth industry, thanks to higher barriers to entry than the market may realise. Of course, it depends on funding successful cases, finding news ones to back, turning case wins into larger revenues and profits, and delivering a consistently high and rising return on equity that ultimately leads to a higher share price.

With the share price near five-year lows and three-quarters of IMF-backed cases due for completion in FY16 or FY17, the stock has long-term appeal. As a $244-million micro-cap company, it suits experienced investors who can tolerate higher risk.

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Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at October 28, 2015