European smaller companies portfolio managers Ollie Beckett and Rory Stokes discuss the impact that the rise in ESG has had on the market and why it is important to look beyond ESG ratings.
- The rise in ESG data and analytics has led to the market reassessing the valuation of individual stocks.
- Smaller companies are generally less well-researched meaning that their ESG credentials may often be overlooked. This can leave “hidden” ESG waiting to be discovered by market participants.
- The team believe that unrecognized ESG capabilities of smaller companies is a large potential source of future value.
We had the BRICs, we had the FAANGs and now the current flavor of alphabet soup is ESG. Environmental, Social and Governance (ESG) factors have increasingly become very important drivers of stock performance as companies that are perceived to be making the world better typically find plentiful demand for their products and services. As ESG has grown in importance, so has the need for ESG data and analytics.
How Have ESG Frameworks Impacted Markets?
In recent years the analytical framework to evaluate ESG credentials, coupled with a new legal framework in the guise of the European Union (EU) Taxonomy and the Sustainable Finance Disclosure Requirements has been complemented by rating agencies such as Sustainalytics and MSCI to assess the impacts of individual stocks. As a result, we have seen a dramatic reassessment of what the market is prepared to pay for businesses that are seen to have strong ESG credentials. This has been especially pronounced in the large company segment of the stock market, not least because such companies are often viewed as having a structural growth tailwind.
Among European smaller companies, the recognition of strong ESG credentials has been far less consistent. Only businesses that are traditionally associated with strong ESG credentials have benefited from this trend. There are many reasons for this. Smaller companies are usually more focused on the operation than the presentation of what they do. Public relations budgets are rarely large. They are also less scrutinized by analysts and investors than their larger peers, opening up a broad array of neglected and mispriced stocks as a result. However, we believe that smaller companies offer a purer exposure to the growth trends they take advantage of and there is a strong seam of “hidden ESG” in small caps that is waiting to be discovered by the market.
Turning Toxic Waste into Value
Befesa, the German-listed hazardous waste recycling company, seems to be the epitome of the circular economy. It takes toxic by-products from the steel and aluminum industries that would have otherwise gone to landfill and recycles them into valuable products such as zinc and aluminum alloys. For some time, the business was perceived to be more akin to a mining company because a key driver of sales is the zinc price. Notwithstanding the fact that if it were a mining company it would be one of the lowest cost zinc producers in the world, the company is far from that.
In reality, Befasa fits the bill as a sustainability champion. The company has sharpened up the way in which it presents the benefits it offers to the world through its business model. As a result, we recognize the positive impact of turning toxic waste into value. Although the market has started to view the company more as an industrial rather than a miner, it is still some way from being considered for its ESG credentials.
Producing Insulation to Reduce Carbon Dioxide
Across the border from Germany is Belgian-listed Recticel. According to data provider Bloomberg, “Recticel SA manufactures a wide range of foams and synthetic compounds.” Its industry classification is Rubber & Plastic. What does this mean in practice? Well, the primary business is the manufacture of foams and synthetic compounds for the insulation industry. Insulation is a crucial industry for reducing carbon dioxide production. In fact, Recticel stated in its 2020 full-year investor presentation that the group’s products reduce carbon dioxide production by a factor of 46 for every ton of carbon dioxide produced.
Recticel’s second business line is technical foams. These foams are used to deliver benefits such as acoustic safety, comfort in hospital beds and filtration of toxic substances. The company delivers a strong set of social benefits as well as environmental ones, while pursuing policy objectives such as further reducing health and safety incidents and boosting the presence of women in its senior management team. Beyond this, Recticel’s 74% ownership in the TURVAC joint venture that makes the super insulated packaging for the transport of COVID-19 vaccines seems to be little acknowledged.
We believe that the unrecognized ESG credentials of smaller companies may be a potential source of future value. As companies become more polished in presenting their ESG benefits, we anticipate that market participants will begin to delve more deeply into the ESG opportunity set of smaller companies. There are plenty of companies that will have the opportunity to shine and we suspect the revelation of “hidden ESG” is likely to be a structural theme within smaller companies for some time to come.
BRICs: An acronym associating the five major emerging economies of Brazil, Russia, India and China
FAANGs: An acronym used to describe the five major US technology companies: Facebook, Amazon, Apple and Alphabet (formerly known as Google)