Small-cap firms with high sustainability rankings tend to outperform lower scoring peers
  • While investors worried about ESG risks for companies with small market capitalizations are finding a dearth of information, a Bank of America Global Research report may provide stakeholders with alternative data sources.
  • Small-cap firms are not publishing sustainability metrics with the same frequency as companies with more resources and larger market capitalizations.
  • ESG measures are a valuable tool for evaluating the financial performance of smaller companies, since small-cap firms with a high sustainability ranking tend to outperform lower scoring peers, analysts say.

Investors seeking to assess the environmental sustainability and governance risks for companies with small market capitalizations are finding a dearth of information, but a report by the Bank of America may provide stakeholders with a workaround to the problem.

Investors are increasingly asking about the ESG scores of companies with small market capitalizations and are stymied by a lack of data, says Jill Carey Hall, a CFA, equity and quant strategist, who helped produce a BofA Global Research report in August to help market players assess the sustainability record of small-cap enterprises.

The Russell 1000 index tracks some of the U.S. companies with the largest market capitalization. Only 34% of companies with the smallest market capitalization on the index released a sustainability report in 2018, compared with a majority of the larger companies, according to the Governance & Accountability Institute.

“One of the challenges in evaluating small caps from an ESG lens is the lack of disclosure,” Hall told Karma. “Many smaller companies just don’t have many internal resources dedicated to this, or they may not be publishing sustainability reports like a big large corporate might do. So we’ve found certain alternative data sets can be helpful.”

Hall says bank analysts work around the problem by looking at different available metrics, such as data from the Swiss-based RepRisk, an ESG evaluation company, that publishes a yearly report called the “Most Controversial Companies” report.

Analysts also look at employee satisfaction information found on platforms like Glassdoor, which may provide an indication about governance matters and future company performance.

Overall, stakeholders should note that companies with a small market capitalization are vulnerable to ESG risks, says the BofA Global Research report. “For small caps with available ESG scores, we find that the highest-ranking small caps on ESG have been trading at a …growing premium to low-ranking small caps,” write the authors. “The worst-ranking small caps have also seen lower subsequent returns on equity than peers.”

Especially in the retail and department store sector, BofA analysts have found a correlation between metrics such as board diversity — more women executives — and a higher return on investment.

“In a sector that often caters to young women, surprisingly, a majority of the board members are actually older males and so you have a lack of diversity for many companies in that sector,” Hall said.

More importantly, small-cap companies that release ESG metrics that may reflect poorly on the company may still be better positioned to perform well in the future compared with companies that do not track such measures at all, according to BofA’s analysis.

Bank of America has waded into the sustainability metrics field with an ESGMeter offering meant to give investors clear guidelines for how a company has been evaluated amid growing concerns the ESG rating sector does not have a uniform accounting standard, which can lead to widely different scores for companies.

“The goal there is the development of a proprietary scoring system, because there’s a lot of third-party data providers out there that have their own ESG metrics,” Hall told Karma. “But sometimes, when we’ve done analysis on them, some of them either lack of transparency [or it’s not] clear what’s going into certain aspects of the score.”