The positive outlook for small-cap earnings growth into 2022 is supportive of small-cap performance. But it is the ability of small-cap companies to adapt, innovate and identify environmental opportunities that is causing investors to sit up and take notice.
Global small caps, with their ability to adapt their operations quicker than their medium and large-cap peers, are driving many of the trends that are attractive to environmental, social and governance (ESG)-minded investors.
For instance, because of their smaller size and agility, small caps are often well positioned to benefit from environmental and social trends. They are typically more nimble than larger companies and are able to adjust to changing market conditions more efficiently.
Furthermore, small caps tend to operate in a limited number of business lines. Having a streamlined organisational structure allows these companies to shift business focus more easily to target emerging trends or themes in the market.
Launching new products or expanding into new geographies may have much greater impact on a small firm’s fundamentals – including earnings growth trajectories – compared to large companies.
And with many leading green-tech innovations coming from small-cap players, they can play a vital supply chain role for larger companies wanting to tackle climate change, including those in the renewable energy and electric vehicle industries.
Small caps may also have an advantage over larger companies when it comes to regulation, as they can more quickly adapt to changing regulations and leverage incentive programs.
Global small caps and climate
When it comes to the environment, there are a few options for climate-focused investors. One is seeking companies that can innovate to reduce their carbon emissions, another is identifying leaders in cleaner energy solutions. Investment managers have many options in the global small-cap universe, as it consists of many renewable energy providers, including solar, wind and geothermal energy companies.
Canada-based Boralex is one such example. Boralex is a provider of renewable energy solutions, and is accelerating the transition to cleaner energy. Over the past five years, the company has more than doubled its portfolio of wind and solar projects and is helping customers achieve their renewable electricity targets. The firm also recently announced a purchase agreement to supply renewable power to IBM’s French operations, equivalent to 55 per cent of IBM’s energy needs.
The proliferation of electric vehicles globally is another green area where small-cap companies are making inroads. Many factors have contributed to the surge in demand for electric vehicles (EVs), including automobiles and trucks. Heightened interest in climate change and the depletion of finite natural resources have fuelled demand, with lower-priced and more efficient batteries reducing the cost of buying and operating EVs.
With the share of EV sales also expected to surpass internal combustion engine vehicles between 2035 and 2040, focus is being put on the supply chain supporting EV design, production and distribution.
One example is French semiconductor manufacturer Soitec, which produces chips used widely throughout the automotive industry, and focusses on delivering mobility, connectivity and, most importantly, energy efficiency. With more than 6 billion of its chips already employed in EV and conventional vehicles, Soitec is a small-cap stock with an important link to the EV supply chain.
Avoiding ‘green bubbles’
While green investment opportunities abound in small caps, however, there remains a level of risk. Greenwashing and “green bubbles” are issues that occur within every market, and investors need to be aware of the potential impacts.
Greenwashing (when a company promotes environmentally friendly products or operations without substantiation) and “green bubbles” (where ESG-related investments drive valuations to unsupportable levels) are two key risk areas for small-cap investors.
Detailed fundamental analysis is key to counteracting the possibility of greenwashing. Investment managers recognise the importance of bottom-up financial analysis to independently verify a company’s green claims and potential. This is especially important in small-cap companies with less analyst coverage, and also with fewer resources dedicated to ESG disclosure requirements.
A green bubble is much like tech and real estate bubbles; it may initially start from legitimate, fundamentally supported investment opportunities, but the rush to participate pushes valuations well beyond levels business fundamentals can support.
As with greenwashing, it is key to use fundamental analysis to identify attractive opportunities with sustainable growth potential, but at reasonable valuations relative to the underlying business case.
Trevor Gurwich, senior portfolio manager, American Century Investments
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