Aberdeen Standard Investments - The importance of ESG in small-cap investing

ESG in today’s World

The importance of integrating an environmental, social and governance (ESG) approach in investment frameworks has recently come to the fore. Traditionally, investors assessed each of these factors in isolation. Only companies operating in specific industries, such as the energy sector, were deemed relevant for environmental or social evaluation. For the majority of companies, while certain governance norms were accepted, investors considered environmental and social concerns immaterial.

Since then, however, issues like climate change, social inequality and corporate malpractices have forced consumers, corporates and regulators to take action and demand higher standards of E, S and G. Today, many apply the principles of ESG investing across the investment universe. For us, they are an integral part of a comprehensive investment process.

"We believe that better ESG practices lead to superior financial outcomes for companies, and ultimately, investors."

The reason for this is simple. We believe that better ESG practices lead to superior financial outcomes for companies, and ultimately, investors.

ESG in action

Yeti’s success as an outdoor living brand is aligned to its ESG principles. The company was born out of the need to find high-quality, hard-wearing and efficient coolers that were able to withstand the rigours of outdoor adventure. In developing products that last a lifetime, Yeti has done away with single-use plastics. Product reliability and durability have meant customers are willing to pay a premium for Yeti’s products – and keep coming back to buy more. The company became a founding member of the Outdoor Industry Association’s Climate Action Corp. It has continued to innovate and expand its product offering and reduce its packaging footprint. The company is also working closely with its suppliers to improve its supply chain and promote fair labour practices. For us, this culture of ‘best practice’ ensures seamless operations, while resonating with Yeti’s customers.

ESG work in progress

However, the extent to which investors assimilate ESG into their decision-making processes varies according to region. Europe takes the lead in driving forward the ESG agenda. The UK is pushing ahead its ESG policies, while Japan has made significant strides to improve corporate governance. China is addressing its carbon levels. We await ESG reforms in the US.

Alongside geographic differences, we also find biases at the market-cap level. In our experience, smaller companies tend to fare less well in ESG ratings than their large-cap peers. This is in part due to the increasingly onerous disclosure requirements. Many smaller companies don’t have the additional resources necessary to prioritise disclosure, particularly if the company is based in a non-English-speaking country.

Further, a greater proportion of small-cap firms are founder-run which, on paper, can result in weaker governance scores. The reality, though, is often different. Indeed, adequate checks and balances at the board level, a visionary founder at the helm and ‘skin in the game’ can be transformational for companies. What is the take-home message? Broad-brush ESG box-ticking exercises can misrepresent underlying operations. This is why, in our view, a bottom-up, active investment approach is essential to uncover potential small-cap ESG gems.

Powering the future

Take Voltronic, the Taiwanese manufacturer of UPS (uninterruptible power supply) units and solar inverters. At present, external ESG agencies have yet to rate the company. Despite this, we think there’s a lot to like. Alex Hsieh, the current chairman and largest single shareholder, founded the business in 2008 after selling his previous business to Eaton, the global power-management giant. For many, Mr Hsieh’s knowledge, experience and ambition for the company places Voltronic at the top of its game as an OEM (original equipment manufacturer) supplier to Tier 1 electrical companies.

An eight-strong board, half of whom are independent and two of whom are female, support Mr Hsieh. As well as selling UPS units, approximately one-third of Voltronic’s revenues come from solar inverters. These allow solar energy to be converted for use, stored in battery form or sold to the grid. This enables Voltronic to provide affordable energy solutions in countries where the grid is unreliable. The company itself has implemented various environmental initiatives at its plants in China, Vietnam and Taiwan, including explicit carbon emissions targets.

We believe these factors, together with stable labour management practices and supply-chain oversight, allow the company to deliver its goal of sustainable growth. This reliability, along with scale and innovation, make Voltronic a critical partner for global electrical majors and governments. The results are clear to see. Since listing in 2013, the shares have delivered an 18-fold return with healthy dividend income on top.1 Like many of the companies we look at, we are encouraged by the ESG steps that management has taken to date and we see scope for further improvement.

Final thoughts…

Contrary to perceptions, many smaller companies are at the forefront of ESG. However, disclosure can often be weak. Analyst coverage is also usually poor. As investors, part of our role is to engage with management and support positive change. In the end, we all stand to benefit from better ESG.

1 Source: Bloomberg 10/8/2021

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

Important Information

Risk Warning: The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

The information herein should not be considered an offer, investment recommendation, or solicitation to deal in any financial instruments or engage in any investment service or activity. The information is provided on a general basis for information purposes only, and is not to be relied on as advice, as it does not take into account the investment objectives, financial situation or particular needs of any specific investor. It does not constitute investment research and whilst every care has been take in its preparation the accuracy, adequacy or completeness of the information contained herein is not warranted and liability is expressly disclaimed for errors or omissions.The information herein is protected by copyright, however it may be quoted, provided the source is acknowledged. It may not be reproduced, copied or made available to others for commercial purposes without our permission. ASI reserves the right to make changes and corrections to the information, including any opinions or forecasts expressed herein at any time, without notice.

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