Hidden corners of sustainability-related innovation

We believe that good ESG practices are a critical driver of companies’ long-term success but identifying these can be hard given the lack of reliable, forward-looking data. This is especially true in the under-researched European small-cap universe. More broadly, we see sustainability as a major driver of innovation and growth. European smaller companies are at the forefront of that innovation as they seek to satisfy a growing customer demand for sustainable solutions. We think this combination of high inefficiency and high opportunity offers active investors significant scope to add value through fundamental ESG research, constructive engagement and, crucially, a long-term approach.

Capturing ESG inefficiencies in the European small-cap universe

While we believe ESG factors significantly contribute to a company’s competitive advantage and growth, ESG data and ratings are still in an early phase of their development. We believe this creates inefficiencies for active managers to exploit. We think this potential is particularly compelling in a relatively under-researched area such as the European small-cap universe.

Numerous vendors currently develop ESG data and ratings for companies. Although these vendors perform a valuable service, each has its own methodology and materiality emphasis, which results in substantial scoring differences even in highly researched markets such as the S&P 500. Figure 1 illustrates this by comparing the ESG scores from two prominent data vendors. If the vendors’ ratings for each company were identical, the dots would form a straight 45-degree plot line from bottom left to top right. However, the dots are significantly scattered, meaning these vendors have very different ESG assessments of the same companies.

In addition, because third-party ratings are based on disclosures of past activity, they ignore recent or planned improvements. In our view, this challenges their ability to provide a reliable view of a company’s ESG trajectory. Notably, in recent years, the market has driven up the share prices of companies perceived as leaders on ESG, while others with a more promising long-term trajectory may get overlooked.

Deep fundamental research of the companies and the ecosystem in which they operate, along with forward-looking ESG assessments of opportunities and risks, can help capture those ESG inefficiencies. We also think it increases the ability for investors to spot sustainable innovation potential ahead of the market.

ESG engagement: a source of insight and value creation

Proactively engaging with companies on ESG matters and building a constructive long-term partnership may also yield significant insight and, over time, create value. A constructive dialogue can help capture ESG inefficiencies, address ESG misconceptions and support companies on their sustainability journeys. This can be particularly impactful for companies that are still trying to identify and prioritise their material ESG factors. Other companies may already have sound practices, but engagement can help them accelerate their sustainability journey and increase their innovation potential.

We do not believe investors should seek perfection; often longer-term outperformance is found in the improvement stories. The key requirement is that the companies are constructive on sustainability and are aligned with our focus on ESG best practices.

In Figure 2, we illustrate the key topics we cover in our company meetings and board engagements to try to identify areas of development and improve on these issues.

European small-cap equities: sustainable innovation in practice

The European small-cap universe encompasses numerous sustainability-conscious companies doing innovative work that potentially enables them to outperform their competition. Below, we outline two company case studies, where we believe in-depth research and engagement has helped uncover significant potential.

The first is a UK manufacturer of hard landscaping products. This company has not historically been viewed as an ESG leader by the market as it is a high carbon-emitting sector and relatively high emitter for our universe. In reality, it has a very thoughtful and innovative approach to ESG and sustainability.

• This unexpected ESG leader has a long-standing agenda on all aspects of ESG, and an increasing percentage of its research and development budget has been channelled towards sustainable and environmentally conscious projects.
• The company manufactures innovative anti-flooding products, provides product-level carbon-data, which is unique in the industry, and has even developed a carbon-neutral process for manufacturing concrete bricks.
• Its offering helps customers to manage their environmental impact, reduce their carbon emissions and make informed product decisions. In addition, it reports full CO2 emission data on large-scale construction projects.

The second example is a Scandinavian producer of biochemicals. Again, the market and existing ESG metrics have failed to capture the significant strides this company has made in relation to ESG and sustainability.

• For more than a decade, this company has evolved from a relatively cyclical business with a narrow end-market exposure to one that has a diverse and expanding range of new applications, all requiring natural raw materials.
• Using every component of its raw material — wood — and the expertise of its R&D and technical sales team, the company enables customers to replace oil-based products and ingredients with sustainable alternatives.

Thanks to its innovations, wood-derived ingredients are now prevalent in everything from concrete admixtures and plant protection to animal feed, electric car batteries and even toothpaste.