The ESG difference in small cap investments

There is a danger that the sustainable investment world focuses too much attention on large companies. There is a rationale to do so, as they may be responsible for larger footprints and greater impacts, but this misses the significant portion of global GDP in the hands of small to medium companies, and the capacity for these companies to respond to environmental and social issues.

While we don’t invest in true SMEs, we do invest in small public companies. These companies are equally ignored by the sustainable investment world. Indeed, ESG coverage of small cap European companies remains low, particularly for securities that do not feature in major indices. For instance, MSCI coverage of the QCF (Lux) – Argonaut portfolio is only 21%. For our Eastern European focused fund QCF (Lux)- New Europe, coverage is 16%.

Even when there is a rating, it is often largely reflecting a lack of disclosure relative to larger companies. Reliable and available data is a major issue in ESG analysis, and more so for smaller companies who have smaller budgets for reporting and communication. This puts them at a disadvantage in ESG rating algorithms, resulting in a well-documented large-cap bias in ESG ratings. We meet many companies who have sustainability rooted in their company ethos and strategy, but who have poor scores due to not yet providing the kind of data investors and rating agencies need to sufficiently analyse their profile and make effective comparisons with their competitors.

We expect much of this to change in the coming years, thanks in part to regulation. About 11 600 companies in Europe have been reporting extra-financial data and information since the Non-Financial Reporting Directive was launched in 2014, however, once the Corporate Social Reporting Directive is enacted in 2023, 49 000 EU companies will be required to report. This new directive specifies in more detail the information that companies must disclose and presents new and more complete reporting requirements. Among others, companies are to provide information on their strategy, business model, targets and engagement of board and management. In addition, the ESG report will need to be audited for the first time, making the data much more reliable than in the past. The first draft of these standards is under review, with the first reports expected to be published in 2024.

While this is a very valuable step for ESG investors, we continue in the meantime to engage with companies to improve their reporting as we have done for many years already. We encourage companies to report to the CDP (formerly Climate Disclosure Project), giving significant disclosure on their climate strategy and management. In 2021, we engaged with 12 companies across our European small cap funds, 3 of which disclosed during the year. This information is very valuable in our analysis of companies.

We also see an opportunity to improve communication on ESG issues with management teams. As an example, we realised that companies whose AGMs we were voting at, with the support of our proxy voting provider, were completely unaware of the recommendations that proxy voting providers were giving to investors. While there is good reasoning for this in terms of the agencies maintaining independence, a failure to understand if and why there is an opposing view on your AGM ballots is a lost opportunity. This is especially true when, despite all the talk about active stewardship, very few votes are voted against by the majority of shareholders. Without the rationale of those that did dissent being shared with the management team, these minority votes against are unlikely to garner future change. Ahead of AGMs we intend to increasingly advise the management teams what the proxy voting agencies recommendations are, how we intend to vote and why. The Argonaut fund voted against management on 16.7% of ballots in 2021.

What we see in general from small European companies is an appetite to learn from investors and improve their actions and communications on ESG issues, and we will continue to increase our activity on this front. When action is decided, the ship can be steered much more rapidly for smaller companies.