Putting small caps in the ESG spotlight

After BRIC and FAANG, ESG is currently the preferred alphabet soup flavor for investors. The unrecognized ESG characteristics of small caps are an important factor in positive share price performance – Rory Stokes and Ollie Beckett, portfolio managers in the European equities team at Janus Henderson Investors, are convinced of this: “As companies become more professional in presenting their ESG benefits, we expect market participants to look more closely at the ESG opportunities of smaller companies. There are many small caps that have the potential to shine. We suspect that finding ‘hidden ESG potential’ is likely to be a structural theme within smaller companies for some time to come.”

Environmental, social and governance (ESG) factors are becoming increasingly important to stock performance. Companies that seek to make the world a better place typically benefit from strong demand for their products and services. As ESG factors have become more important, so has the need for ESG data and analysis.

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Impact of ESG frameworks on markets

In recent years, the valuation of ESG factors has become increasingly regulated, most recently in the form of the EU taxonomy and disclosure requirements for sustainable finance by rating agencies such as Sustainalytics and MSCI. “We have seen a significant reassessment of what the market is willing to pay for companies that can demonstrate a strong ESG record,” said investment experts. But only companies that traditionally have strong ESG records have benefited from this trend, while recognition of ESG potential among European small caps has been tepid. The reasons are many: smaller companies tend to focus more on operations than self-promotion. Public relations budgets tend to be limited. They also receive less scrutiny from analysts and investors than their larger peers, resulting in a wide range of underappreciated and mispriced stocks. “However, we believe small caps offer purer exposure to growth trends. Moreover, there is often a lot of ‘hidden ESG potential’ in small companies that needs to be discovered,” the investment experts are convinced.

Turning toxic waste into value – a German ESG champion

Befesa, the German listed hazardous waste recycling company, is the epitome of the circular economy. It recycles toxic byproducts from the steel and aluminum industries that would otherwise have ended up in landfills into valuable products such as zinc and aluminum alloys. For a time, the company was considered more of a mining company because a key revenue driver is the price of zinc. But the company is far from that.

“Befesa fits the image of a sustainability champion. The company has highlighted the benefits it offers through its business model, so the positive impact of converting toxic waste into value is clear,” explain investment experts. While the market now perceives the company as an industrial rather than a mining company, it is still not recognized for its ESG performance, according to the investment experts.

Production of insulation materials to reduce carbon dioxide

Another example of a “hidden champion,” according to the investment experts, is Recticel SA. a publicly traded company based in Belgium. Its main business is manufacturing foams and synthetic compounds for the insulation industry. And insulation is critical to reducing carbon dioxide production. For example, in its full-year 2020 investor presentation, Recticel stated that its products reduce carbon dioxide production by a factor of 46 for every ton of carbon dioxide. Recticel’s second business segment is engineered foams. These foams are used to increase acoustic safety, comfort in hospital beds and filtration of toxic substances.

“The company offers a number of social and environmental benefits while pursuing policy goals such as further reducing workplace accidents. They also aim to increase the proportion of women in their management team,” explained the investment experts. Recticel also has a 74 percent stake in the TURVAC joint venture, which manufactures the highly insulated packaging used to transport Corona vaccines. This has received little attention from market participants.

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(Featured image by nikofendi via Pixabay)

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