Investor interest in responsible investing continues to grow as stakeholders pay increasing attention to environmental, social and governance (ESG) issues. We believe investors often overlook bottom-up investment opportunities within the small-cap space and the positive impacts certain small companies are having on the environment.
Limited sell-side coverage and small-cap firms’ generally lower levels of ESG disclosure create challenges and opportunities for active investors. In our view, taking a rigorous approach to research and engagement with management teams is key to identifying upside opportunities and mitigating downside ESG-related risks.
By nature of their more manageable size, small caps may be well-positioned to benefit from environmental and social trends. They can typically be more nimble than larger companies and adjust to changing market conditions more efficiently. Small caps also tend to operate in one or a limited number of business lines.
A streamlined organizational structure may allow small-cap companies to shift business focus more easily to target emerging trends or themes in the market. Launching new products or expanding into new geographies may often have much greater impact on small firms’ fundamentals—including earnings growth trajectories—compared to large companies. However, due to their size, small caps can also carry more risk than larger companies. Exposure to these kinds of trends may result in greater volatility than large caps.
Often leading green tech innovators, small companies can play vital supply chain roles for larger companies tackling climate change, including those in the electric vehicle and renewable energy industries.
Corbion is one such firm in the small-cap universe. Its innovation in biotechnology is translating to more sustainable products used in degradable food packaging, touch screen computers and durable automotive components. Corbion’s bioplastic partnership with France-based Total also highlights the differing impact product innovation may have on small versus large companies. While bioplastics may meaningfully affect Corbion’s earnings growth prospects, it will not move the dial for its much larger partner, Total.
Green energy, energy-efficient construction and the electrification of vehicles are three current growth areas in the “E” pillar of ESG investing. We believe small-cap companies offer attractive opportunities in this arena.
Reliance on fossil fuels and its effect on climate change have been widely discussed since the outset of ESG investing. Regulatory changes and pan-governmental treaties, such as the Paris Agreement, have amplified the discussion. Companies have greater incentives to reduce greenhouse gas emissions and lessen the impact of climate change. Small caps may have an advantage over larger companies, as they can more quickly adapt to changing regulations and leverage incentive programs.
One investment option is seeking companies that can innovate to reduce their carbon emissions. Another is identifying leaders in cleaner energy solutions. The global small-cap universe contains many examples of alternative and renewable energy providers, including solar, wind and geothermal energy companies.
Canada-based Boralex, a provider of renewable energy solutions, is accelerating the transition to cleaner energy. Over the last five years, the company has more than doubled its portfolio of wind and solar projects and is helping customers achieve their renewable electricity targets. The firm recently announced a purchase agreement under which it will supply renewable power to IBM’s French operations, equivalent to 55% of IBM’s energy needs at these sites and data centers.
The supply chains supporting renewable sources also rely on many small-cap companies. Examples include makers of photovoltaic panels for solar energy, testing and measurement systems for wind turbines, and components for electric vehicles.
Figure 1| Renewable Energy Capacity Is Accelerating
Solar and Wind Capacity Forecast
Data from 9/30/2018 – 9/30/2020. The data for 2020 forward is estimated. Source: Bloomberg.
Infrastructure improvement, such as more efficient turbines to create electricity, can reduce costs and enable further investment in cleaning up production and distribution systems. Small-cap companies are helping drive innovation and facilitating growth.
Approximately one-third of global energy use is attributable to buildings, according to the Organization for Economic Co-operation and Development (OECD). Finding more energy-efficient methods of commercial and residential construction is therefore a key concern for ESG investors. Small-cap companies are among the leaders in using more energy-efficient design, sustainable materials, and lower-energy equipment and devices.
Better design includes more efficient ventilation, insulation and drainage. Poor air circulation and/or drafts often represent the largest contributors to a building’s energy usage. The development of air sealing and double-wall construction for insulation (think of your double-wall-insulated Yeti®) has improved the energy performance of many new commercial and residential buildings.
Small-cap companies have also taken the lead in the installation of energy-saving devices, a third component of efficient construction. They have developed much of the technology behind energy-efficient equipment. Such technology includes control, testing and regulation systems for heating, cooling and air conditioning (HVAC) systems, low-energy and recycled water heaters and water pumps, and solar cells for electricity, heating/cooling and hot water.
Switzerland-based Lindab is a small-cap example that helps achieve energy savings and compliance with increasing governmental green initiatives and regulations related to building codes and HVAC efficiency standards.
Case Study | Hannon Armstrong
Hannon Armstrong is a U.S.-based financial services firm that provides capital for investments in climate solutions, energy efficiency, renewable energy and sustainable infrastructure. It lends to and invests in energy service companies and utilities as well as manufacturers and developers of energy-efficient equipment and systems.
Key markets for the firm include “behind-the-meter” energy-efficient building solutions, grid-connected wind, solar and storage solutions, and sustainable infrastructure for stormwater remediation, ecological restoration and resiliency. The company is the first U.S. public company dedicated to investment in the climate solutions area.
Investments have resulted in:
Sources for all data: American Century Investments, Hannon Armstrong company publications.
Many factors have contributed to the surge in demand for electric vehicles (EVs), which include automobiles, trucks and e-bikes. Heightened interest in climate change and depletion of finite natural resources have fueled user demand. Lower-priced and more efficient batteries have helped reduce the cost of buying and operating EVs, while improved charging infrastructure has increased their driving range.
Stricter regulations on emissions and government incentive programs have changed the economic dynamics for vehicle manufacturers globally. With the share of EV sales expected to surpass internal combustion engine (ICE) vehicles between 2035 and 2040, investors are putting their focus on the supply chain supporting EV design, production and distribution.
Figure 2| EV Sales Are on Track to Surpass ICE Vehicles
Source: BloombergNEF. Data from 1/1/2015 – 12/31/2019 and estimated from 2020 onward.
Innovative small companies supporting the EV supply chain are helping drive the green revolution. Such firms have designed and manufactured many of the components, sensors, cameras and lenses used in EVs—as well as much of their charging infrastructure. The need for more secure assisted and autonomous driving programs is spurring innovation in the components of EV navigation, control and security systems.
Case Study | Soitec
Soitec is a France-based maker of semiconductors and chips used in electronic equipment, Internet of Things (IoT) devices and automobiles. The firm produces its silicon on insulator (SOI) wafers using proprietary Smart Cut™ technology with a focus on delivering improved reliability, mobility, connectivity and energy efficiency for their customers, including the automotive industry.
The company has a portfolio of more than 3,300 patents and a strong emphasis on innovation, with 11% of revenues dedicated to research and development. A wide range of electric vehicle applications use Soitec chips, including battery management systems and autonomous and assisted driving systems.
With more than six billion of its chips already employed in (electric and conventional) vehicles and 50 billion chips in IoT objects, Soitec is an important link in the EV supply chain.
Soitec is also at the forefront of EV battery component innovation. The firm is seeking to develop Smart Cut-based silicon carbide (SiC) products that have the potential to increase battery efficiency and EV car range up to 60 miles.
Sources for all data: American Century Investments, Soitec company publications.
As with their potential for easier conversion to cleaner-energy practices and smoother transition to new regulatory environments, small-cap firms may have an advantage over larger companies when it comes to implementing more environmentally sound business operations. One such way is through circular economy techniques, including recycling used tires into new athletic shoes or converting wastewater for irrigation and fertilization. Another way is through creating business systems that reduce environmental impacts in the first place, such as lowering water intensity, usage and waste.
Case Study | Kornit Digital
Kornit Digital is the leader in direct-to-garment (DTG) and direct-to-fabric (DTF) printing and machines for the garment, apparel and textile industries. Its printing for apparel, accessories, textiles, and upholstery is more environmentally friendly than traditional methods.
The firm’s printing systems are 100% waterless, and its inks are non-hazardous, non-toxic and 100% biodegradable. This is noteworthy in the fashion industry, which uses 1.5 trillion liters of water annually and accounts for approximately 10% of global carbon emissions. The company also invests in high-efficiency equipment and solar power generating systems, and they design their products for recyclability.
Sources for all data: American Century Investments, Kornit Digital company publications.
Greenwashing occurs when a company touts environmentally friendly products or operations without substantiation or when it features one green aspect of its business while continuing to engage in other environmentally damaging activities. Potential “green bubbles” may occur when investors chasing ESG-related investments drive valuations to unsupportable levels.
Detailed fundamental analysis is key to counteracting the possibility of greenwashing. Investment managers recognize the importance of bottom-up financial analysis to independently verify a company’s green claims and potential. This is especially important in small-cap companies with less analyst coverage.
Investment managers can also analyze the entire enterprise to lessen the chance of greenwashing in one division of the operation. It is important to note that smaller companies tend to have smaller staffs devoted to investor relations and ESG disclosure. While limited disclosure may create challenges for investors, fewer resources may also lower the risk of greenwashing.
Has the rush to find sustainable investments created a so-called green bubble? We continue to believe bottom-up analysis is the best way to evaluate companies on their individual merits. However, we recognize the possibility that the love of everything green could heighten valuations and contribute to the risk of unsustainable growth.
A green bubble is much like real estate or tech bubbles. It may initially start from legitimate, fundamentally supported investment opportunities, but the rush to participate in the trend may push stock valuations well beyond levels business fundamentals can support, thereby creating a “bubble.” As with greenwashing, it is key to use fundamental analysis to identify attractive opportunities with sustainable growth potential, but at reasonable valuations relative to the underlying business case.
Case Study | TOMRA
TOMRA is a Norway-based recycling company that develops and operates reverse vending machines. With approximately 80,000 units in more than 60 markets, the firm is the leader in collection and recycling of plastic, glass and aluminum drink containers.
Each year, TOMRA’s deposit recovery programs collect more than 40 billion beverage containers thereby reducing CO2 emissions by approximately four million tons. The company also provides a range of solutions for materials recycling and sorting. This prominence in recycling has made TOMRA enormously popular with environmentally conscious investors and helped drive the company’s stock price to lofty levels. The company’s credentials in the circular economy are unassailable, and the effects of its operations on waste reduction and energy savings are well-documented and quantifiable.
But its popularity with ESG investors and lack of viable alternative investments in the same space have driven valuations to potentially unsustainable levels. TOMRA’s operations remain successful. However, it is our view that investors have created a green bubble and pushed its valuations beyond levels investment fundamentals can support. Trading at greater than 50 times forward consensus earnings, the company is valued like a high-growth tech stock but is expected to grow its top line by less than 10%.
Sources for all data: American Century Investments, TOMRA company publications.
Global small caps are driving trends that represent opportunities for ESG-minded investors. Because of their size, small caps may be able to adapt their operations more quickly as they identify and promote environmental opportunities. Such trends often strengthen into larger themes that spread across industries and sectors in the broader market.
We believe active management and bottom-up financial analysis are important to help identify opportunities with improving and sustainable business fundamentals. An active approach may also lessen the risk of investing in popular “ESG darlings” with bubble-like valuations. A rigorous integrated ESG approach, including engagement, can also help verify that a company’s green initiatives align with its actual activities and lead to more informed investment decision-making.
A strategy or emphasis on environmental, social and governance factors ("ESG") may limit the investment opportunities available to a portfolio. Therefore, the portfolio may underperform or perform differently than other portfolios that do not have an ESG investment focus. A portfolio's ESG investment focus may also result in the portfolio investing in securities or industry sectors that perform differently or maintain a different risk profile than the market generally or compared to underlying holdings that are not screened for ESG standards.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
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