Screening for sustainable small caps

As the climate debate continues to elevate and financial risks begin to mount, we expect ESG factors to become increasingly important in the investment decision-making process. Therefore, we have run a screen to identify ASX-listed companies which have technology or products that have a positive impact on the environment and are potentially nearing an inflection point in the financial trajectory of the business.

Environment-related risks are rising and this has brought climate change to the forefront of social consciousness, particularly over the past 18 months. This has underpinned community activism and increasingly people/consumers are demanding that governments, corporates and asset managers make ESG considerations with every decision. Change is beginning to take place, and recent announcements have come from industry leaders such as Microsoft, Amazon, and Blackrock. 

However, emissions projections are tracking materially behind medium- and long-term targets, indicating the velocity of change must lift markedly. Further, it is becoming apparent innovative technologies and companies must play a large role in this change and that ESG is likely to become an increasingly important factor in investment decisions.

ESG assets under management (AuM) have grown strongly over the past decade (~20% CAGR 2010-2019), as has the number of investment options available to investors.

This trend is projected to persist in the medium term, underpinned by

(1) greater consumer demand,

(2) weight of money, and

(3) growing evidence ESG investment does not always have to come at the expense of returns.

Does ESG really hurt performance?

A common ESG investments misconception was that it would negatively impact returns. However, meta-analyses of academic literature have found the pervasive outcome is either a statistically insignificant difference in corporate financial performance, or improved performance, with only ~10% finding negative performance. 

In an Australian context, the Deloitte CleanTech Index has outperformed the ASX 200 since 2015, and there is international evidence of low-emission companies tending to outperform high-emission companies, along with a difference in multiples paid.

Further, as changes are made towards a sustainable economy, there is significant transition risk, particularly for companies with high emissions or non-sustainable products which, in our view, will also add to the demand for ESG investments.

ESG friendly companies to get cheaper capital

The combination of the weight of money and the changing risk outlook could have real potential positive cost of capital and valuation implications for ESG-friendly companies, and we believe those companies which can capture both the ESG tailwind and improve financial performance will outperform.

If this takes place and cost of capital lowers for positive-ESG companies, multiple expansion should eventuate. We expect this trend will be seen across ESG broadly, albeit we expect multiple expansion will be focussed on companies which capture the trend and deliver from a financial perspective.

Ultimately, we view SRI/ESG becoming more engrained in the investment decision-making process/framework, providing a tailwind for ESG-friendly companies.

What is apparent to us is that as climate risks rise, financial risks are also rising. In our view, this coupling, along with (1) a shift in public sentiment and awareness, and (2) comparable or potentially improved corporate performance, will underpin ESG as a larger part of the investment decision-making framework/process.

Screening for sustainable small-caps

Therefore, we have run a screen to identify a series of companies that have technology or products that are making or are looking to make a positive impact on the environment.

In order to identify the emerging companies in this theme, we ran a screen based on the following characteristics:

1. ASX listed
2. Sustainability-themed investment; i.e., product/company makes a positive impact on the environment
3. Market-cap of $20-200m
4. Cash flow breakeven or expected to be within the next 12 months
5. Revenue LTM (or pro forma revenue based on company announcements) of at least $10m

We explore the sustainability theme in detail in the following report and highlight five micro-cap ASX-listed companies that passed our screen.  

You can access the full report here.