Small caps have taken bit of a beating recently. But is the market right to treat all small caps the same? Given, they share some similar characteristics, it is not irrational to assume that they are vulnerable to the same pressures, but investors underestimate sustainable small caps at their peril.
During 2022, it has almost felt as though investors have abandoned fundamental analysis – key company metrics such as cash flow and return on assets – in favour of short-termism. Climate change targets have been pushed aside while investors back the likes of Shell and BP, the latter of which recently announced projects to develop several oil and gas projects in the North Sea and West of Shetland areas (BP, 2022).
Uncertainty in the markets has been fuelled by continuing fears around inflation and an oncoming recession. To add to this, pandemic-related supply chain disruption, which should be fading as we come to the half way point of the year, is showing no sign of abating. The recent spikes in steel and nickel prices were enough to jangle the steadiest of nerves. Finally, the war in Ukraine has added another layer of dread and uncertainty to absolutely everything.
In short: we are at peak bad news. Against this backdrop, sustainable portfolios have started to look quite contrarian.
However, there are certain common features of sustainable small caps, which may make them more resilient than their counterparts in other sectors.
The first is their relative invulnerability to certain types of inflation. Inflation is a phenomenon that affects businesses across the board – none is immune to increases in wage cost. Drill down a little, though, and some important nuances emerge. Sustainable companies are much less affected by rising raw material input costs, for instance, than other small caps.
Take a recycler of used drinks cans, or a company recycling woodchips to manufacture fabric for clothing. By definition, they are comparatively less affected by a rise in oil prices than their small cap cousins in other sectors. Ditto the recent high prices of steel and nickel. By in large, the entire mission of sustainable companies is to integrate sustainability into every aspect of their business. Less input to achieve a different output, goes the formula; ergo, raw materials matter less.
The second distinction is that many sustainable small caps have low penetration. Electric vehicles are a case in point. Most people today are familiar with the EV story but although electric car sales were up 40% from 2019, after a decade of rapid growth, there were only 10 million electric cars on the road in 2020, representing around 1% of the global car stock. (International Energy Agency, 2021).
Ground source heat pumps are another example. Although The EU market is expanding quickly, with an average of 12% annual average growth since 2015, they still only meet 7% of global building heating demand (International Energy Agency, 2021). Despite this, it is difficult to call to mind the name of the leading brand of heat pump.
Thirdly, investors should consider the importance of sustainable small caps’ ability to innovate. When the Peleton share price collapsed last year, the following day, Nike, Netflix and Apple were all circling, wanting to buy the company. They recognised the great opportunity that real innovation represented, even when penetration was low.
Perhaps investors are simply too exhausted fighting fires to focus on the long term. Sustainable small caps are not untouched by all the headwinds that markets face, of course. They are undoubtedly bruised but they are not dead and there are good reasons to believe in their relative ability to weather the storms. Those unable to see through the uncertainty towards a future where markets stabilise and the world refocuses on the huge climate risks to our planet, may live to regret it.
Mona Shah is Head of Sustainable Investments at Stonehage Fleming.
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