A great deal of inefficiency exists at the small end of the market. And where there is inefficiency, there is opportunity. The trick is in knowing how to identify the genuine opportunities, while avoiding the risks. If you are able to do that, there is a great deal of alpha on the table for shrewd investors. So after we asked four small cap managers on their outlook for small caps, and how to avoid the blow-ups, we then asked each of them for a stock they think can perform well in the current market, and why they like it.

A deeply undervalued, well-run, high-quality business

Michael Goldberg, Collins St Value Fund

A small company that our fund likes is Litigation Capital Management Limited (ASX:LCA). LCA is a funder of litigation cases. The business finds its niche in being able to recognise funding opportunities in a space not serviced by the larger litigation funder IMF Bentham. The business passes each of the tests we’ve mentioned above.

1. LCA has a proven business. Having run privately for 19 years the company recently listed with no debt and a robust flow of new business.

2. Management of LCA each have a substantial interest in LCA shares. The management stand to profit considerably more from performing well and creating shareholder value than they do from directors’ fees.

3. Having recently floated, LCA is one of the few IPO’s in recent times that listed at below market multiples. On re-confirmed prospectus guidelines, the company is currently on a PE of just 6.3 times, with a ROE of 22%. When a growth company with a return on equity over 20% is trading on below market multiples, we think it’s worth consideration.

4. LCA’s business model ensures that they seek many smaller cases rather than taking on the risk of large cases. While diversification of business ensures that they are not heavily reliant on a single case, it also ensures that their cash flows are consistent and easier to anticipate. We much prefer this business model to that of the bigger funders who generate lumpy earnings.

Given Litigation Capital’s strong balance sheet, competent and committed management, attractive valuation, and relatively low-risk business model, we at the Collins St Value Fund is happy to be invested in what we think is a deeply undervalued, well run, high-quality business.

A low multiple with growing earnings

Roger Collison, DMX AM

Pioneer Credit (ASX:PNC) is a high conviction DMX Capital Partners portfolio holding worth highlighting.

With a 10% market share Pioneer is the smallest of the ASX listed debt purchasers, after Credit Corp (ASX:CCP) and Collection House (ASX:CLH). The company purchases debt ledgers, often for less than 20c in the dollar, from other financial institutions. The company’s objective is to recover these debts at a significantly higher rate than they purchased them for, thus generating a profit in the process.

Our conviction in PNC is high because the stock meets our two main investment criteria:

High quality: We view the company as high quality with a solid and aligned management team, a well-defined growth strategy, a strong balance sheet and shareholder friendly dividend policies.

Significantly under-valued: PNC has provided guidance for its FY17 profit of at least $10.5m which puts the stock on a PE of just 9.5x FY17 earnings – a large discount to its two listed peers, CCP and CLH. We believe the combination of having a low profile in the investment community, trading on a low earnings multiple, and having a growing earnings profile offers substantial valuation upside.

We look forward to continued earnings growth and share price appreciation in the years ahead.

A Stock with a PE of 6% and a yield of 11%

Ron Shamgar, TBF

Mcpherson’s Limited (MCP) is a brand owner within the health, beauty and wellness sector of the market. Investors currently perceive MCP as a distributor of other brands, but in fact 90% of its $25M of forecast EBIT this year comes from its own brands.

One of the key highlights from the 1HFY17 result is the significant earnings leverage in MCP's under-utilized state of the art distribution warehouse. The warehouse is currently only 48% utilized and management has highlighted that for every additional 5% of utilization through its own brands or agency partnerships, MCP generates an incremental $2M of EBIT. To put this in context, that's a potential $20M of incremental EBIT over the next few years, over and above on our $30M forecast EBIT for FY18.

We believe investors have overlooked the recent successful turnaround, and the acceleration of growth within the core business as the significant earnings leverage starts to kick in. We forecast MCP will earn 14.5c EPS and pay 9.5c of fully franked dividends in FY17. In FY18 we estimate EPS at 17.5c and franked dividends of 11c.

Our forecast places MCP on a forward PE multiple of 8x and a gross yield of 11%. We expect the market to slowly but steadily re rate the stock over the next 12-18 months as management executes accordingly.

Cheap valuation with global growth optionality for free

Nigel Littlewood, Harness AM

Shriro (ASX:SHM) is a simple business that is easy to understand with management that has a long-term, shareholder friendly track record. It trades on a single digit earnings multiple and pays an attractive div yield of nearly 8% fully franked.

While at first it appears pretty low growth, it has a global growth strategy that is looking positive, which we are not paying for at all at the current price

Read more from this series:

(1) Red flags to watch out for

(2) The road ahead for smallcaps