Exploring Profit Drivers in the Secondary Market's Undervalued Spheres
Small-cap companies often face challenges in Environmental, Social, and Governance (ESG) ratings, resources, and corporate governance compared to their larger counterparts, creating unique opportunities and risks for investors.
### ESG Ratings and Resources
The size bias in ESG scores tends to favour larger companies due to their greater resources and better disclosure capabilities. Small-cap firms, on the other hand, often have limited ESG data coverage and fewer resources to implement extensive sustainability programs. However, specialized ESG strategies like Bailard’s ESG Capture® method can tailor ESG assessments to small- and micro-cap companies, allowing for better identification and management of ESG-related risks.
### Corporate Governance
Large corporations typically have more established and sophisticated governance structures due to regulatory scrutiny, visibility, and investor demands. They often have dedicated compliance, risk management, and ESG teams. In contrast, small caps may have less mature governance frameworks and fewer resources to devote to transparency and stakeholder engagement, increasing risks related to governance and operational oversight.
### Implications for Investors
Investors in small caps face greater ESG-related information asymmetry and risk due to limited disclosure and variable governance standards. However, these challenges also present opportunities for active managers to identify undervalued companies with improving ESG profiles using specialized ESG scoring methodologies tailored for this market segment. ESG investing in small caps can contribute to broader positive societal impact by driving sustainability improvements in less visible sectors of the economy.
From a performance perspective, long-term ESG investment strategies have demonstrated competitive or slightly better returns compared to traditional funds, though small caps may have more short-term volatility. Companies with high social ratings in employee management, for example, have outperformed lower-rated companies and the broader market, with returns of up to 25.8% over three years.
### Summary
| Aspect | Small-Cap Companies | Large Corporations | Investor Implications | |----------------------|----------------------------------------------------|-------------------------------------------------|-------------------------------------------------------| | ESG Ratings | Generally lower or less comprehensive; size bias exists | Higher ESG ratings aided by better resources and disclosure | Need for specialized ESG assessment tools for small caps | | Resources for ESG | Limited budgets, fewer dedicated ESG teams | Extensive resources for sustainability | Active management can uncover ESG leaders in small caps | | Corporate Governance | Less mature governance structures | More robust, sophisticated governance frameworks | Higher governance risk in small caps to monitor | | Investment Impact | Potential for long-term ESG-driven growth | Established ESG practices influence large-scale impact | Diversification and risk mitigation through ESG focus |
In essence, small-cap companies often lag behind large corporations in ESG ratings, resources, and governance, but with the right ESG analysis and active management, investors can uncover opportunities and contribute to meaningful sustainability improvements in this segment. It's crucial to pay close attention to the ownership and control structure, the composition of the board, and succession planning to better understand the risks resulting from governance.
The investment strategy focusing on small-cap companies should consider the unique challenges they face in Environmental, Social, and Governance (ESG) ratings, resources, and corporate governance compared to their larger counterparts. Finance professionals and investors who invest in small caps should be aware of the higher ESG-related information asymmetry and risk due to limited disclosure and variable governance standards, and utilize specialized ESG assessment tools and active management to uncover opportunities and manage ESG-related risks in this sector.
