The Complexities of ESG & International Small Cap

While ESG metrics and standards make progress in the U.S., international comparisons, especially within small cap, remain elusive.

It goes without saying that Environmental, Social, and Governance (ESG) investing has garnered plenty of attention recently, particularly as investment mandates prioritize ESG more than ever. In the international small-cap arena, ESG investing has been going through what can only be described as a long evolution. Much analysis has gone towards quantifying a company’s return on factors associated with prudent ESG management, such as inclusion and sustainability. It is clear to many that companies utilizing an ESG framework may not only benefit society, but they can also improve the quality of their own businesses. Longstanding debates on sustainability and gender rights in addition to recent developments in the movement for social and racial equity all but guarantee that the focus on ESG investing will be enduring.

As the relevance of ESG increases, information on ESG practices at the company level are wildly varied and, in some instances, non-existent, especially outside of the U.S. Hence, there is a need for fundamental active managers who focus on owning companies that are excelling at ESG practices and diligently conduct their own work to uncover what companies are truly up to. Below, we discuss three areas where fundamental research is critical to ensure ESG information is being considered when investing in the international small cap space.

Coverage is Limited

While there are rating agencies that exist for ESG metrics, the coverage of small international companies remains low, particularly for non-index securities. Active investment managers may screen the entire universe of international small cap companies and not just the index holdings, exacerbating this challenge. One prominent ESG ratings provider, for example, covers less than half of the eligible international small cap portfolio companies, leaving the bulk of the work to analysts to uncover and rate specific ESG practices, thereby adding to the inefficiencies of analyzing companies in this asset class.

“Many leading ESG ratings providers focus on large and mid-cap companies with less than 40% coverage of our portfolio holdings under $2.5 billion in market cap.”

Digging Deep into the Fundamentals

Firms may follow industry-wide standardized metrics or their own proprietary ESG scorecards when it comes to how they evaluate their ESG holdings. However, for fundamental, active managers, the task is not a simple one for many reasons. For instance, when screening for quality in financial metrics, we can set hurdles for areas such as growth, return on invested capital (ROIC), cash generation, and balance sheet strength. When looking for quality in ESG metrics however, the hurdles are often less clear. An example would be scoring how well a company treats its employees. The exercise is certainly more subjective than analyzing free cash flow realization. As a result, fundamental investors who care about ESG are required to work harder and smarter in gathering relevant information, whether through meetings with management, site visits, or employee surveys. In the international space, hurdles only grow with geographical, language, cultural, and other potential barriers to assess. Investors must ensure that the manager they work with is going deep enough to verify claims made by the companies in which they invest and evaluate the potential impact, both positive and negative, of a company’s ESG policies on their fundamentals going forward.

Lost in Translation?

As international investors, we must also be cognizant of the different cultural norms when it comes to ESG practices. ESG is not unique to the U.S.; Europe has been a leader in this area for some time, but specific issues of importance abroad vary dramatically on a country and regional basis. As an example, during our most recent research trip to Korea, I asked a CEO to review his company’s ESG practices. After the interpreter presented my request, he was silent. I followed up by asking more specifically about the diversity of his management team and the company’s board. This time, the investor relations representative of the company answered by saying that although there are no ESG policies in place, the management team was working to develop ESG governance practices, which were similar to ones we use to evaluate companies. That response was typical for many companies as recent as two years ago. Several quarters after my meeting, we were pleased to receive an email from the investor relations representative with a copy of the firm’s first attempt at establishing an ESG mission statement, which include actionable goals. Their response was certainly encouraging, despite the company having a long way to go before we would rate their ESG practices as acceptable, and gave us a place to begin when evaluating their long-term potential in this area.

While certain countries like China and Russia are just beginning to realize the importance of an ESG framework, there are other regions like the Nordic countries that rate highly in ESG practices, according to our research. There are also encouraging moves in places like Japan where despite cultural norms preventing ESG excellence, the Japanese government is stressing ESG adoption.

 

Efficacy of ESG Practices Worldwide

 

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Source: SBH Research.

Caveat Emptor

Given the intricacies of ESG in the international small cap space, investors should ensure that the managers they work with are following a verification process to ensure that the ESG evaluation they are performing genuinely meets the investor’s goals and requirements. As international small cap investors, we are accustomed to the lack of transparency, uniformity, and availability of data – having to perform deep, bottom-up research when it comes to the ESG front is nothing new to us. We believe that a company’s attention to ESG factors contributes to their long-term performance and sustainability and consider their ESG approach heavily when making investment decisions. We find that our most valuable work is done one-on-one through management discussions and our own fundamental research. This is meaningful work for us as we also find ourselves helping to shape the future of ESG by sharing its importance with the companies in which we analyze and invest.

 

To learn about Fundamental International Small Cap investing at SBH, please visit our strategy page or reach us at contactus@sbhic.com.

 

Author

image of portfolio manager

John C. Fenley, CFA
Principal, Director of Fundamental International Strategies

 

The opinions expressed are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion in this material as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed in this material are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s opinions are statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this material. For illustrative purposes only.