The ESG Challenges of Small Caps

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Stockholm (NordSIP) – As the demand for sustainable investments continues to grow amid increasingly tight spreads, asset managers have to find new market niches that satisfy asset owners’ requirements for financially competitive and sustainable returns. NordSIP was interested to hear from Anna Lundén, Managing Director, Equity Portfolio Manager at Wellington Management about her firm’s Pan European Small Cap Equities Strategy and its ESG credentials. Before joining Wellington in 2017, Lundén spent almost four years at Montanaro Asset Management, first as a portfolio manager and then as Head of Investments focusing on small- and mid-cap funds.

Increasing ESG Awareness Among European Small Caps

According to Lundén, ESG awareness is on the rise among European small-caps. “This general shift in sentiment is driven by changing consumer behaviour, regulation and a shift in asset owners’ views and needs,” she starts. “While this is apparent across companies of all sizes, many smaller and mid-sized companies appear less well resourced to deal with the increased demand for data – not only from investors but also from public data providers/databases across the industry.”

Idiosyncratic Small-Cap ESG Risks

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The ESG analysis lays bare some of the unique hurdles facing investors outside of the large-cap space. “Small- and mid-sized companies have less public information and, given the lack of disclosure versus large-cap companies, reliance on ESG data from third-party providers may lead to an incomplete picture that would penalise these smaller companies,” Lundén explains.

“Founders or management have a significant ownership stake in many European smaller and mid-sized companies,” she continues. “We believe this is supportive as stakeholders arguably have a bigger vested interest in delivering strong and sustainable returns and keeping the company on a growth path. Higher insider ownership can be a double-edged sword, however, and we must scrutinise governance of every company to understand the ownership structure and control as well as the board composition (governance factors). In addition, we often invest in knowledge-intensive businesses, so human capital management is a key asset (social factor) and a specific area of targeted research for us.”

These risks are different from those faced by large-cap companies, according to Lundén. “Large-cap companies do not typically have the same high level of stakeholder ownership,” she says. “These companies also have much greater resources and are better able to afford programmes to develop ESG capabilities and data disclosure. Companies with better communication and disclosure resources tend to score better on ESG ratings by third-party data providers.”

“We typically observe more specific differences at a sectoral level than across geographies,” Lundén adds. “The European Small Cap universe is large, diverse and under-researched. While countries are subject to EU regulation, implementation practices often vary, because of their different regulatory frameworks and cultures.

Small Caps but Long Term

“In our view, ESG considerations are crucial inputs to long-term investing, especially in small caps. We believe non-compliance can threaten the viability of a business, while positive action can support its growth. Therefore, we want to align ourselves with companies that are ESG-conscious. In doing so, we look at companies’ core product or service (the’ what’) as well as their operations, behaviour and policies (the’ how’),” Lundén says regarding the Pan European Small-Cap Strategy’s approach.

“With some companies, their core product or service is directly linked to solving an environmental or social problem,” Lundén continues. “For example, we invested in a UK company that manufactures and sells lighting products for the industrial market, specialising in LEDs. The company is an innovation leader and dominant in a niche market. It is a leader in sustainability, and its LED product is a positive and direct solution towards a more energy-efficient environment. Lower energy use reduces the demand from power plants and decreases greenhouse gas emissions.”

Understanding ESG issues enables more informed investment decisions. At Wellington, the ESG process covers a company’s actions to reduce carbon emissions (E), its policy on water usage (E) and how it works to understand and mitigate its supply chain risks (S). Human capital, e.g. employee retention (S), as well as board composition (G), are also taken into account, according to Lundén.

“A good example is a global manufacturer and distributor of sewing thread and supplies with ambitious sustainability goals. The company has industry-leading practices for labour management, production capacity and resource utilisation. This is key at a time when regulatory authorities are closing down industry capacity that doesn’t meet waste management and labour practice guidelines.”

A Research-Intensive Process

While, according to Lundén, information by third-party data providers and databases is backwards-looking and often generates an imperfect picture that reflects size, disclosure and industry bias, these issues are not impossible to overcome. “We need to do more work ourselves. In fact, we believe this market inefficiency is an opportunity for us to add value. It means regular engagement with company management and boards to get to know the company’s approach, business model, market. We need to probe to understand if management has grasped potential gaps and how these may be filled to create value. It means bespoke site visits to observe the production process, speak to employees, observe interactions and the company’s culture.”

“We then focus on turning this mosaic of information into actionable and profitable insights. Having an experienced portfolio management team with specialist small-cap expertise is key. Investing in small caps is research-intensive, and given Wellington’s wealth of resources, we can leverage multiple research perspectives, for example from our ESG Research Analysts, Fixed Income Credit Research Team and Global Industry Analysts. We seek to deliver a focused portfolio of high conviction ideas, which essentially is a small-cap expression of the breadth and depth of our world-class proprietary research.”

Engaging With the Investment Mosaic

“We believe that partnership and engagement with our portfolio companies enhance our value-add for our clients,” Lundén adds. “For each company, we seek to support and influence positive outcomes through informed and active ownership. Our size and access to management teams and boards give us an engagement edge. Globally, we conduct 10,000 company meetings a year.”

“We take a hands-on approach, meeting in person with boards and management teams, writing letters or hosting calls multiple times each year. A successful engagement starts by defining the opportunity. We tend to set milestones and outline our long-term objectives. Companies are increasingly receptive to requests for transparency or additional reporting on business strategies or practices. In our view, successful engagement outcomes result in better alignment between all stakeholders.”

“For example, we researched an attractive investment case for an Italian manufacturer of hydraulic and water jetting systems, but the data relating to the company’s ESG practices was poor. Through several engagements with the company, we learned that this was due to low transparency – a classic issue we come across in smaller companies. Having expressed our desire for greater disclosure and after learning from the company that we were the first institutional investors to have made such a request, we were delighted when the company published its first sustainability report six months later. We initiated a position and the company subsequently sought to engage with our ESG Research Team directly for further insight.”

Image courtesy of Wellington Management

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