The economic climate of the past few years, first bolstered by post-credit bubble quantitative easing, later depressed by pandemic lockdowns and escalating geopolitical tensions, has made it challenging for US small-caps to outperform the wider market. For over a decade, large-cap giants have dominated the headlines, overshadowing the smaller players. However, there is some evidence that the tide is turning.
As part of NordSIP’s series of insightful interviews with sustainable investment experts, we meet Tim Skiendzielewski, Associate Portfolio Manager at Rockefeller Asset Management. Skiendzielewski, who has spent 15 years in the financial industry and joined Rockefeller Asset Management small caps team in 2023, argues that the time is right for investors to focus on US small caps, particularly those that are improving their ESG profiles.
“It’s been no secret that small cap earnings growth has lagged that of larger cap companies for several quarters now. But as we look into the back half of 2024 and beyond, we think small cap earning growth will catch up with that of large caps and be sustained at a higher level,” Skiendzielewski argues.
The Opportunity Nexus for Small Caps
Skiendzielewski points to three key factors that suggest small caps are poised for a comeback. Firstly, small caps are currently trading at historically low valuations relative to large caps. He explains, “If you look at small caps, we believe they’re currently historically cheap relative to large caps based on forward P/E ratios. They’re essentially trading near all-time discounts.” This valuation gap, according to Skiendzielewski, provides a compelling entry point for investors.
However, he warns that “valuation alone isn’t enough to get excited about an asset class.” There must be a strong fundamental backdrop to support these valuations. According to Skiendzielewski, the second factor in small caps’ upcoming comeback is the fact that these stocks earnings growth is on the cusp of a significant shift. “We believe earnings growth for smaller companies is on the cusp of inflecting positively, benefiting from both cyclical and secular drivers,” he says pointing to supportive developments such as de-globalisation, reshoring, and legislative initiatives like the Inflation Reduction Act (IRA).
The third factor is the macroeconomic environment. Skiendzielewski notes that small caps tend to perform well in periods of high but declining inflation, coupled with the prospect of rate cuts. “If you look back historically around how small caps have performed in these types of macro environments, they do offer fairly compelling returns,” Skiendzielewski explains. These three factors—valuation, earnings growth, and macroeconomic conditions—combined generally create a favourable environment for small caps.
Rockefeller Seeks Undervalued ESG Improvers
Notwithstanding the role that this environment plays in improving the earnings potential of small caps, Skiendzielewski argues that Rockefeller Asset Management’s bottom-up fundamental analysis investment process focusing on ESG improvers is an excellent approach to find opportunities. “We’re looking for approximately 35 to 45 companies that have quality – a blend or core strategy that focuses first and foremost on finding high-quality companies,” he says.
“This strategy is focused on ESG improvers,” Skiendzielewski explains. This is one of the key differentiators of Rockefeller Asset Management’s approach. “Our long-held belief, backed by academic studies and quantitative analysis, is that there may be alpha potential in investing in companies that are in the process of rapidly improving their ESG profiles, as opposed to those companies that are already leaders in the ESG space,” he explains.
The rationale behind this method is that the market often undervalues companies that are improving their ESG practices. “We believe the market systematically undervalues the ESG improvers while overvaluing the leaders, and the data supports our view that a portfolio that tilts towards improvers offers alpha potential for our clients,” Skiendzielewski notes.
To identify these potential candidates for investment, Rockefeller Asset Management employs a proprietary tool known as the Rockefeller ESG Improver Score (REIS). This system ranks companies based on their improvement in key material ESG issues relative to industry peers. Skiendzielewski looks for factors such as “air quality, climate physical risk, transition risk, customer privacy and data security, diversity and inclusion, and labour rights management.”
The REIS tool is customised to account for the specific challenges and opportunities of different industries, ensuring that the analysis is relevant to each sector. “We use a materiality matrix that ranks the most important issues for each sector of the market,” Skiendzielewski notes, adding that “we have to be cognisant [… that the issues we focus on are specific to the company and the industry we are looking at. We don’t take a one size fits all approach. The questions that are applicable to a smaller software company are not going to be the same that are pertinent to a smaller industrials or energy company.”
Engagement: A Key to ESG Improvement
Rockefeller’s small caps strategies enhance ESG analysis by engaging with potential investee companies. According to Skiendzielewski, the strategies “seek to create value for companies and our clients. […We pursue] catalysing change with our companies via engagement.”
This engagement is a proactive and ongoing process. Rockefeller employs a dedicated engagement analyst, who works closely with the companies in the portfolio to help them improve their ESG practices. “The job is to liaise with our holdings, develop relationships with the management teams, and act almost as a quasi-consultant to help these companies along their journey on ESG considerations,” Skiendzielewski explains.
To illustrate the engagement approach, Skiendzielewski recounts how a medical device investee company based in Utah initially had limited resources dedicated to ESG questions. “When we started engaging with the company, we saw that their ESG framework needed a lot of work,” he says, adding that as a result, over the years Rockefeller held “countless meetings with the management team focused solely on these ESG issues and we’ve discussed subjects ranging from supply chain management to human capital management to environmental disclosures.” These engagements yielded improvements, and the company has published its first ESG report and adopted established reporting frameworks such as those of the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-related Financial Disclosures (TCFD).
“Managing engagements is an ongoing organic process that lives throughout the life of the investment,” Skiendzielewski says, emphasising the long-term nature of engagement commitments. The ultimate goal is to help these companies move from ESG laggards to recognised improvers, thereby unlocking value for Rockefeller’s clients.
Sector Focus: Industrial Strength and Technological Innovation
While Rockefeller’s small-cap strategy covers multiple industries, the industrial sector has long received special attention. “We’ve long had an overweight to the sector, given it’s just an area of the market where we’ve always been able to find these underfollowed, misunderstood businesses with opportunities for margin and return on invested capital improvement,” he says.
Recent trends, such as the aforementioned de-globalisation and reshoring, along with significant legislative initiatives in the US, are also expected to benefit small-cap companies in the industrial sector. “A lot of legislation [such as the inflation reduction Act and the CHIPS Act] has been passed in the US to bring back manufacturing. Our view has been that these benefits will accrue to the benefit of smaller US companies and allow for longer tailed earnings growth.”
Skiendzielewski highlights a recent investment in an engineering and construction company as an example of these trends. The company is involved in “big infrastructure projects in the USA, [including] roads, tunnels and bridges. (…) A large segment of the company does big data centre projects and big chip plants for semiconductor companies. That is a theme that we are quite positive towards in light of the trends that I mentioned before. As we engaged with the management team, we understood that given the company’s product offering it really stood to benefit […] from some of the trends that we were seeing […]. When we looked at the ESG side of the equation, we saw that they were an ESG improver.”
In addition to the industrial sector, Rockefeller is also exploring opportunities in technology, focusing on how small-cap companies can leverage artificial intelligence (AI) to find improved efficiencies. Skiendzielewski cites the example of a company that uses AI for revenue cycle management in the airline industry. “The software essentially runs an AI algorithm to help that airline better price tickets, change the price of tickets depending on capacity, on how full the flight is, and on how close to the actual travel date is,” he explains.
Skiendzielewski acknowledges that while the airline industry may not have the best ESG reputation, the software company’s role in improving operational efficiency aligns with Rockefeller’s broader ESG goals. “Our approach to ESG investing is, for the most part, not exclusionary,” he says, noting that the goal with this investment is not “to change the travel habits of the world. What we do look for are companies that can have a positive impact on the industries they serve, which we think this company can by enabling better load management and potentially cutting down on the number flights an airline has to run.”
The views and opinions shown herein represents the views and opinions of Rockefeller Asset Management and is subject to change at any time. The views and opinions expressed may differ from or conflict with those of other divisions of Rockefeller Capital Management. The information has been obtained from, or are based on, sources believed by Rockefeller Capital Management to be reliable, but Rockefeller Capital Management makes no representation as to their accuracy or completeness. Actual events or results may differ materially from those reflected or contemplated herein.
Investing involves risk, including risk of loss. Past performance is no guarantee of future results. The asset classes discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Investments in foreign securities are subject to foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets.
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