The Uncharted Greenspace in Small-Cap ESG

Small capitalization (small-cap) companies, and many teams that analyze them, are behind the curve when it comes to the implementation of environmental, social and governance (ESG)-friendly practices and analysis, making it largely uncharted territory. A company’s ESG practices, in our view, are intrinsically linked to long-term performance and business sustainability. As more small companies utilize ESG business practices and investors become more adept at evaluating them, these benefits may become a standard component of company returns. However, like the emerging markets investment landscape in the 1980s, the first investors to plant their flag as ESG pioneers may gain early access to the creation of additional shareholder value as the ESG landscape develops.

Navigating the Unknown

We view ESG analysis as a set of tools that allows investment managers to improve their portfolio risk management practices and become better stewards of investor capital. An investment is a vote of confidence in a company, and misplaced confidence can lead to a loss of capital and poor management of client funds. Examples of suboptimal corporate practices regularly end up in the news, and these shortcomings can damage corporate reputations, people or the environment. Punctuated by infamous events like oil spills and account fraud scandals that illuminate the need, integrating ESG analysis into investing has been gaining traction in the large-cap space for many years. Avoiding companies with gaps in their operations or policies that would allow for negative events such as these to occur can lead to a smoother ride for investors. Identifying companies that foster ESG-friendly practices can reinforce a culture of responsibility and innovation. Unfortunately, many small-cap companies are behind the curve with implementation of these elements which, over the longer term, may boost a company’s stock price and reduce downside risk.

We think the slow integration of ESG standards in the small-cap space is due to a wide range of factors, including small companies having fewer resources than their large-cap counterparts to devote to ESG practices and reporting. Development and implementation of ESG business practices takes time and resources, which are two things many small companies do not have to spare. We believe underdeveloped reporting of ESG metrics plays a significant role in poor MSCI ESG ratings, with 51% of the US small-cap benchmark Russell 2000 Value Index rated BB/below or unassigned, while only 22% of the US large-cap benchmark Russell 1000 Value Index scores this poorly.1 This discrepancy reflects a lack of coverage and in our view, an opportunity to have a significant impact.