1.How do smaller cap companies fare in adapting ESG-requirements compared to large cap companies?
“Looks can be deceiving”, says Catherine Stanley: “Some smaller companies can appear to look worse on ESG, because their disclosure of ESG-related aspects can be poor and smaller companies have less resources in general for sophisticated disclosure. This does not necessarily mean that they have not thought about ESG. Often you need to ask them to find out where they are. You cannot apply the same bar to large and small caps.”
Irina Hunter agrees: “If we ask for too much detail and reporting from our small companies regarding their ESG credentials, we may not get a good answer. Discussing the company culture and principles on which the business is run is often better when meeting with management teams at small companies; how they allocate capital, how they treat both minority shareholders and their employees as well as other stakeholders. This is not market cap specific. Then it becomes clearer which businesses we want to invest in for the long term.”
2.Also, Smaller Caps are covered less by ESG research houses such as MSCI and Sustainalytics. If disclosure is patchy, can you as portfolio manager, access enough ESG data on companies?
A no brainer for Irina Hunter: “You need to talk to your portfolio companies regularly and ask the right questions. Not all small cap companies produce glossy sustainability reports. But we never hold this against them. Again, for us it is more important that the business we invest in is run responsibly and if they are treating water, electricity and other resources responsibly. Transparency is a sign of a well-run business and this doesn’t depend on market cap.”
“This is also where the BMO Responsible Investment team comes in’’, says Stanley. “For us, talking and keeping in close contact with the companies we invest in is the most important way of obtaining information. But we also receive input from our Responsible Investment team, whose 19 members form an integral and essential part of the wider BMO GAM organization and have extensive experience in conducting research and voting and engagement.’’
“The level of disclosure does vary in different markets”, says Irina Hunter. “Companies in China and South Korea fare much worse than businesses in India, Eastern Europe or Mexico on average. Also, it matters where a company is listed. Exchanges such as the ones in Hong Kong, Europe and the US have extensive disclosure requirements.’’
3.Then how do you integrate ESG in your investment decisions?
“Since we are not an explicitly Responsible strategy, we focus on those elements of ESG that may materially affect the financial performance of an investment’’, says Catherine Stanley. “We believe that a strong and improving ESG profile will support the valuation of a stock. And we think there is an overlap between ESG risk and investment risk. Poor management of the workforce for example will ultimately lead to higher churn, higher absence and higher costs. If ESG risks are indicated, we will take this into account in our assessment before we invest and decide whether they could be significant to the financial performance of the business in the future.”
Irina: “The Emerging Markets Small Cap strategy we manage is not a responsible strategy from an industry wide ESG-definition either, although our investment philosophy of long term investing in well run, high quality businesses is in-line with what the industry now considers Responsible. Our mindset is firmly set on the fact that our portfolio companies should be run responsibly with a long term view. If a company in our universe does not meet our quality criteria as far as corporate governance, prudent allocation of capital, fair treatment of minorities and their own productive resources, we just do not invest.’’
4.What are the effects on the small-cap category of adapting ESG-aspects?
Catherine: “Considering ESG-aspects helps companies think long term about risk and sustainability of their business model. This does involve some time and costs, but businesses that manage to do this properly, have an opportunity to stand out. An example is the American tank barge operator Kirkby, whose leadership position enables it to invest ahead of its competitors in environmentally safer and more efficient boats, allowing it, again to maintain that leadership position.”
This also applies in the EM-area. Irina: “Yes, there are several examples of small cap businesses, whose corporate governance standards and culture would rival that of their Large Cap peers. Take Amrest, for example, our operator of KFC and Pizza Hut in Eastern Europe. Their corporate culture is based on operational excellence and a sense of ownership at every level – every store manager knows how much they make in revenue and what their costs are. Their governance reflects a long-term approach to growing the business and their approach to talent is driven by encouraging initiative and promoting from within. These are the kind of small cap businesses that we focus on.”
5.Do you have a post-investment process to follow-up on ESG-issues and can you have an impact on smaller companies as an active owner?
Catherine: “We have a system of closely keeping track of our meetings with companies and of all issues that were discussed during the meeting. ESG-analysis is part of our ongoing assessment of a business, but this is different from engagement, since we usually do not set specific ESG-targets post-investment. However, raising ESG-issues regularly in meetings is a good way of getting ESG on the board agenda.
With the BMO Responsible Investment team, who runs an extensive engagement program that also involves small and midcap companies, we mostly work on governance issues. Last year one of their focus areas was ESG-disclosure at mid and small cap companies. Once invested in a company we use the quarterly ESG analytics reports that the RI team provides, monitoring companies for ESG related issues.”
For the Emerging Market-strategies, Responsible Investment expertise is also available through a dedicated RI-team member. Irina: “In addition to staying very close to our companies and regularly discussing governance issues, we engage with our companies on a variety of topics such as resilience of their supply chain and sustainability of various resources such as water. The latter was a topical discussion with our South African companies a few years ago during the drought. We also engage to improve disclosure in our companies.”