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ESG and small caps – how strong is the relationship?

ESG and small caps – how strong is the relationship?

5 minute read

The enduring alpha opportunity investing in small caps has been widely identified. However, with investors’ increasing focus on ESG risks and opportunities, concerns surrounding the lower ESG performance of smaller companies versus their larger peers have emerged.

Although the small caps universe provides exposure to innovative companies that are producing technologies driving strong social and environmental outcomes, unlike larger companies, smaller companies typically do not have the resources to produce thorough ESG-related disclosures. 

Indeed, small caps may be leading the charge in solving global sustainability issues, however, their positive social or environmental impact may go unheralded. This is why we believe small and mid-cap companies to be fertile ground in finding innovative companies who are shaping a better future. 

It was the 19th century French novelist Victor Hugo who said that “nothing is more powerful than an idea whose time has come”. For a growing number of investors, whether institutional, wholesale, or retail, that idea is ESG. From that day in 2004 when the former UN Secretary-General Kofi Annan wrote to more than 50 CEOs of major financial institutions asking them to find ways to integrate ESG into capital markets, it is an idea that has resonated throughout most of the investment world.

The raw numbers tell the story. By 2025, Bloomberg estimates global ESG assets will exceed $53 trillion, representing more than a third of the $140.5 trillion in projected total assets under management — a remarkable growth story for an investment concept that will have just celebrated its 20th anniversary in that year. 

There are a myriad of reasons why. But one fundamental cause stands out — investor demand.  From small investors to the top end of town, they want their capital to be a positive force in creating a more sustainable and better future while also generating compelling investment returns.

Investor demand is being underpinned by a coalition of factors that are creating the perfect storm for ESG investment. Technology and ESG coverage is helping improve corporate transparency, with new data sources providing a better understanding of how companies are performing from an ESG perspective. 

With this, there is a greater investment research focus on ESG. No longer a poor cousin to the balance sheet and profit-and-loss statements, ESG is being seen as just as integral to a company’s long-term corporate viability. But unlike larger companies, smaller companies often lack the ESG coverage, particularly from third-party data providers. So, when investors are looking to small caps to access companies shaping a better future, engagement on ESG-related matters becomes a core component in driving change. 

For many companies, too, it did not require investor demand or government policies to push them down the ESG path. They understand pro-active environmental policies, good corporate governance, and sound social policies are critical if they are to deliver long-term sustainable growth. 

ESG as an analysis tool to understand a company’s non-financial risks and opportunities is mainstream. The early argument, especially from institutions, that their sole fiduciary duty was to maximise shareholder values, has gone the way of the dodo bird as studies after studies have shown that sound ESG policies are not inimical to healthy earnings. In fact, in theory, ESG strength should be accretive to a company’s financial success. 

But what form will ESG take? In its early incarnation, it was very much about avoiding the “sin stocks” — fossil-fuel producers or companies involved in alcohol, tobacco, and firearms. Tick those boxes, and it was game, set and match for investors to parade their ESG credentials. The first iteration was easiest within the larger company space. 

Today, it is far more sophisticated — and demanding. How are corporations — and not just energy producers — responding to climate change; staff health and safety policies; water management; and labour relations, including companies that are part of their supply chains. And more importantly, investors are wanting access to companies whose intentionality is to provide a product or a solution to a sustainability challenge. These are companies finding innovative ways to treat cancer, improving lung imaging, providing renewable energy, creating better educational outcomes, solving environmental issues, just to name a few. 

Many of these companies are smaller or mid-cap stocks and as such often go under the research radar compared with large-cap stocks. They can even slip under the net of ESG data providers. But this lack of research does not have to be a barrier for investors.

By definition, a company that is addressing a waste management issue has sustainability credentials. This does not necessarily make it an investment opportunity, but it has, at the very least, a fundamental building block in place – a commitment to sustainability. 

But it still requires research into business fundamentals such as debt and working capital, research, culture, and staff (senior staff turnover is often a tell-tale sign), as well as CEO and board tenure, including succession planning. And for smaller companies, the question of their corporate evolution as they grow. Can they deal with their capital structure, more stakeholders, and the greater demands and responsibilities that come with growth?

For investors, companies that get the innovation right can prove a wonderful investment opportunity. While larger companies often have innovation within their business practices, smaller companies can have it at the heart of their business. There are also fund managers offering investors pure-play access to companies whose business goal is to address a sustainability challenge.

This is why small and mid-cap companies are an area of the market that should not be looked over while investing sustainably — they provide investors with a pure-play, under-researched alpha opportunity. 

George Whiting, head of distribution for sustainable funds, Perennial Better Future Trust