Penny stocks can experience larger share price movements than more established companies. This means investors take on considerable volatility risk, but potential rewards can be attractive.
One small-cap share I’m eyeing up for my portfolio is Litigation Capital Management (LSE:LIT). The Sydney-headquartered business provides financial and risk management services associated with the legal industry. It has a particular focus on litigation and arbitration.
The share price has skyrocketed recently following the realisation of a highly successful direct arbitration investment. With a range of legal cases awaiting judgment, I think the AIM-listed stock has potential to climb higher. Here’s why.
A big win
Litigation Capital Management generates revenue by funding costly legal actions. If the claims it invests in are successful, the company stands to benefit. It also typically charges success fees.
Such investments can be highly profitable. Recently, the firm realised a spectacular 635% return on a longstanding confidential dispute in the London Court of International Arbitration. The company secured a gross profit of nearly £31m from an initial investment of £4.8m.
Further potential
There’s more to this business than one successful dispute. The group’s indicated a series of recent resolutions will likely lead to its “strongest performance to date by a significant margin” when its full-year results are reported in September.
What’s more, the business is exposed to dozens of projects that are due to mature over the coming months and years.
The direct investment portfolio is well-diversified. It spans class actions, arbitration, commercial disputes, competition claims, insolvency, intellectual property, and more. As of 28 February, 56% of the portfolio was concentrated in EMEA and 44% in the Asia-Pacific region. This diversification helps the company to perform well across different stages of the macroeconomic cycle.
Confident in their projections, the board’s announced a dividend of 2.25p per ordinary share in September. So not only could investors potentially benefit from future share price growth, but there’s a handy amount of passive income on offer too.
Risks
Litigation and arbitration are inherently unpredictable. Although the firm has a well-qualified team of experts who conduct due diligence on the legal and financial risks, the company will inevitably invest in unsuccessful claims. Bad investments can hurt revenues and, in turn, the share price.
In addition, the company operates in a highly regulated sector. A recent UK Supreme Court judgment will have considerable consequences for the litigation finance arrangements that are enforceable in the UK.
The decision’s expected to have a “very limited or no impact” on Litigation Capital Finance, according to the company. That’s because the group structures its funding contracts using a rising multiple of invested capital over time, rather than solely calculating the return as a percentage of the court’s award.
However, there’s a risk future legal changes might pose challenges for the business model. After all, the growth in litigation financing is a relatively recent phenomenon and the company is subject to a dynamic, evolving regulatory climate.
A stock I’d buy
This penny stock offers exposure to an exciting sector. Recent successes and a solid investment portfolio point to a bright future.
Although it faces potential challenges, the risk/reward profile looks attractive to me. If I had spare cash, I’d buy today.
