Sustainable Small-Caps: Once a Challenge, Now an Opportunity

Small-cap companies have long been overlooked by sustainable investors. In an SRI 2.0 era, sustainable small-caps can represent an attractive opportunity.

Small Caps have long been overlooked by sustainable investors

Small-cap companies have long been overlooked by sustainable investors. Historically, the first strategies to apply sustainable and responsible investing approaches where predominantly invested in large-cap companies, which had sufficient human and organisational resources to provide extensive ESG reports and communicate about their corporate social responsibility initiatives. Sustainable investment portfolios often relied on sector-neutral “Best-In-Class” screenings, based on ESG research sourced from external providers, whose ESG ratings were often strongly correlated with the length of company’s sustainability reporting. These sustainable investment approaches were ill-fitted to any small-cap investment universe, where, in stark contrast with large-caps-oriented strategies, companies typically lacked resources to provide sufficient sustainability reporting, and where the coverage by dedicated extra-financial was limited in scope and in quality. Hence, the conjunction of insufficient availability of ESG data and unsuitable investment processes caused small-caps strategies to be somehow left aside. Meanwhile, sustainable and responsible investing developed quickly in other asset classes.

Ratings coverage between Providers. Ratings coverage based on Indices.

Source: Berenberg ESG ratings : the small and mid-caps conundrum May 2020

Thankfully, the picture is now changing rapidly. The steady growth in demand for ESG-oriented investments in recent years has already been reflected in the higher valuation multiples for many large-caps companies. In this context, asset managers are increasingly led to search for diversification in new market niches that are still offering attractive valuation or significant growth potential. The small-cap investment universe offers just that, with many interesting and under-researched companies with sustainability features, where the sustainable growth potential may not have been fully valued yet by the market. For a sustainable asset manager, it is key to detect and invest early in such companies, through adequate ESG research and agile stock-picking, which integrates ESG aspects.

Emphasis on companies’ Sustainable positioning

Smart and agile ESG-oriented stock-picking requires an adapted sustainable investment approach. Even though extra-financial rating agencies are gradually improving their coverage of the small-cap investment universe, the general lack of ESG data, and the remaining tilt in favour of companies providing extensive ESG disclosure on “good practices”, mean that the ratings from ESG rating agencies should not always be taken for granted. Instead, it is advisable to build dedicated ESG scoring models, using ESG quantitative data as much as possible. Investors should also put the emphasis on ‘what the company actually does’, its business model (i.e. its lines of products and services) and to what extent they bring solutions to sustainability issues. As an example, a company producing key components for energy-efficient heat-pumps, green heating and ventilation systems may be well-positioned to benefit from the growing efforts to cut greenhouse gases emissions from buildings across the EU, and therefore would be positively positioned on Sustainable Development Goal 13 “Climate Action”. Typically, such companies may not provide extensive ESG reporting. Nevertheless, we believe that a smart sustainable investor should engage with its executive team in order to obtain the missing ESG information, as well as to ensure that the company is managed in a responsible manner and that it does not carry any significant ESG-risks. If these conditions are respected, such companies should be eligible for investment in a sustainable portfolio. This may not be possible with a traditional “Best in class” approach that relies on external ESG ratings.

Adapted investment process = SRI 2.0

Thus, for an investment process to seize interesting sustainable investment opportunities in a small-cap investment universe, and from an early stage, the sustainable investment approach has to be built around dedicated ESG research. The latter is often developed internally, and has to assess how sustainable the business model of the company is. In other words, a smart way of investing in sustainable small-caps necessarily analyses the “impact exposure” of the companies. This emphasis on impact exposure is a defining feature of “Sustainable and Responsible Investing (SRI) 2.0”, the more modern, agile and “impact-oriented” manner of performing sustainable investing, which is currently emerging in Europe.

The United Nations Sustainable Development Goals (SDGs) are a useful instrument here. The thirteen SDGs are not only objectives that humanity must achieve, they also constitute long-term sustainability trends, which are increasingly shaping the world of today and will be defining the world of tomorrow. By identifying the companies that are best positioned to contribute positively to these SDGs, sustainable investors can select the companies which are best suited for this future world. In doing so, they can bring together their two core objectives: generating financial performance while supporting sustainable businesses and responsible practices.

European regulation as an accelerator

This trend toward SRI 2.0 and the growing emphasis on measuring the impact of SRI portfolios is also supported by the regulation at the European Union (EU) level. On the side of investee companies, the EU Commission is working on upgrading the non-financial reporting directive (NFRD) (Directive 2014/95/EU) in order to improve the disclosure of non-financial and diversity information by companies. While on the investors’ side, the EU Taxonomy and the regulation on sustainability‐related disclosures in the financial services sector will require investment managers to provide improved transparency on the impact exposure of their investment portfolios. As sustainable investment strategies will be increasingly compared based on their impact exposure metrics, there is little doubt that these pieces of regulation will accelerate the transition towards a more impact-oriented investment process, that it to say towards SRI2.0.

A possible premium for early pioneers

Furthermore, the EU Commission makes no secret of its intention to channel capital towards companies providing solutions to key environmental and social issues. It is one of the stated objectives of its EU Action Plan on sustainable finance, and of its EU Green Deal in general. This strong regulatory support and the future additional measures against climate change and other sustainability issues, should gradually lower the cost of capital for sustainable businesses and support their valuations. This will generate interesting premiums for early sustainable investment pioneers. In anticipation of this, sustainable small-cap strategies are a particularly attractive option.

Thus, in a context of quick and steady growth in demand for sustainable investments, supported by a strong regulatory push, and while ESG-oriented companies are more and more often displaying high valuation multiples, sustainable small-cap companies constitute a particularly promising asset class.