Executive summary

Sustainability has historically been the focus of large cap investors, but these factors are even more important in Australian small cap investing.

Sustainable companies are typically characterised by strong persistence of earnings streams and offer investors superior risk-reward characteristics over long term periods and across various market cycles.

Small cap investors, however, tend to under-appreciate the link between a company’s sustainability and its long-term business success, and typically adopt simple measures to assess a company’s long-term credentials.

This creates an opportunity for investors who deep dive into industry positioning and a company’s management of sustainability to gain valuable investment insights into opportunities and risks, and potentially earn higher returns.

This is consistent with AMP Capital’s Australian small cap team’s long-standing investment approach of integrating “sustainability” into the process.

The importance of sustainability

The bulk of a company’s value is typically, and increasingly driven by a range of intangible factors, and there are clear links between a company’s sustainability factors and its long-term business success. Over the long-term, we believe sustainability factors are likely to have a greater influence on a company’s value and share price performance than the tangible factors traditionally considered by investors.

This is particularly evident for the S&P/ASX Small Ordinaries Index with its increasing exposure to technology and capital-light business models.

By comprehensively considering sustainability factors, investors are better able to gain insight into how a company manages its intangible asset. This may allow them to better assess a company’s long-term approach to enhancing company value.

In our view, sustainable companies typically have a strong persistence of earnings over long-term periods and across various market cycles. Sustainable companies are typically good allocators of investor capital and generate good shareholder returns because of incremental return on equity improvements, and provide balance sheet optionality through consistent cash flow generation. The ability to forecast sustainability factors increases the likelihood of future earnings delivery and share price performance.

How we assess a company’s sustainability

Researching sustainability factors is vital in Australian small cap investing because many companies lack the necessary consideration, implementation and level of market disclosure around sustainability.

We have seen that small cap managers typically employ simple measures to assess a company’s sustainability credentials. Popular methodologies, such as Porter’s Five Forces analysis of a company’s industry environment, are still relevant, but we believe lack the multi-faceted approach required for today’s dynamic business environment.

Both external and internal forces drive a company’s long-term value.

We believe external forces shape the market in which the company operates in two ways:

• Industry dynamics: The industry structure, growth, profitability and competitive intensity, as well as considering technological disruption and the imminence of this impact.
• Sustainability: Relevant demographic, regulatory and technological change.

We believe internal forces focus on the company’s response to the following considerations:

• Strategic positioning: Does the company have economic moats, multiple growth options and strategic alternatives; and, importantly how is management aligned to shareholders and what is their track record in capital allocation?
• Environmental, Social and Governance (ESG): Environmental considerations include stewardship of the natural environment. Social considerations covers how a company manages relationships with its employees, suppliers, customers and the communities in which it operates. Governance incorporates the quality of its leaders, the fairness of its pay structures, audits and internal controls, as well as the rights of shareholders.

While the specific drivers and their relative importance will tend to vary across industries, we believe there is a clear correlation between how effectively a company manages these forces and financial returns.

We believe sustainability drives long-term performance

Investing in sustainable companies can provide superior risk-reward characteristics over the long-term. A number of offshore industry and academic papers show a positive correlation between sustainability and corporate financial performance. Companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into earnings and cash flows. Additionally, investing in companies demonstrating sustainability has typically met, and often exceeded, the performance of comparable traditional investments on both an absolute and risk-adjusted basis.

These characteristics are evident in the Australian small cap market. Companies exhibiting strong Return on Equity (ROE) have consistently outperformed the S&P/ASX Small Ordinaries Index over the long-term on both an absolute and risk-adjusted basis. The performance is significantly enhanced by assuming three year perfect foresight. This is demonstrated in the following charts with “ROE (Forward 3 Years)” representing perfect ROE foresight, and “ROE (Current Reported)” representing the last reported ROE.

AMP Capital’s dedicated Sustainable Investment Team conducts in-depth research into the environmental, social and governance risks and opportunities that each company faces. The research undertaken has demonstrated a strong correlation between their ESG ratings and the subsequent share price performance of Australian small cap companies.

Corporate governance – the importance of being an active owner

Small cap investors face a balancing act between assessing a company’s entrepreneurial spirit, which has driven the success of many small companies, and determining if the appropriate corporate governance policies are in place to ensure long-term outcomes. Large and small cap companies confront similar corporate governance issues, but we believe an increased focus on three factors – management alignment, management tenure and independence level – is particularly important for successful small cap investing:

1. Management alignment: Senior management bonus structures in our view need to be performance-based and linked to acceptable targets to ensure the right focus. This helps to support the paradigm of entrepreneurial CEOs whose ownership is optimally aligned with performance.
2. Management tenure: Long-serving company management can sometimes be detrimental to a company’s performance in dynamic industries. However, in industries where technology disruption is minimal and/or imminence of change is not near term there are advantages in having quality long term management teams.
3. Independence level: Large board sizes can sometimes be detrimental to performance, although suitable board composition requires a fine balance between accountability and ensuring appropriate skill sets.

A company’s shareholders can be very diverse with differing reasons for investing, risk tolerances, investment timeframes and expectations of return, and expectations of sustainability integration. As an asset manager, AMP Capital must ensure its proxy voting decisions drive better long-term investment outcomes.

As shareholders, it is vital to recognise that we can influence companies through the shareholdings under our management. This includes through exercising proxy votes on all resolutions, and engagement with small cap companies on issues including climate change, board structure, executive remuneration and risk management. Key corporate governance issues that arise for small cap companies include board composition (common issues relate to a lack of independent directors, evidence the board has taken actions contrary to shareholder interests, and poor gender and/or skills diversity) and remuneration reports (poor disclosure, poor alignment with shareholder interests, excessive quantum and poorly structured performance hurdles).

Clients increasingly demand shareholder activism to ensure the best interests of shareholders are considered. In our view, Australian small cap companies face a growing number of shareholder resolutions being lodged by dissatisfied investors. There are two main factors driving the increase. Firstly, shareholders have increasingly come to understand that a company’s ability to generate long-term and sustainable returns will, to a large extent, depend on how that company manages its environmental, social and governance risks and opportunities. Secondly, given the disparate views of the various shareholder groups, traditional avenues for engagement on these risks are losing their impact.

In conclusion

In our view, sustainable companies are typically characterised by strong persistence of earnings streams over long-term periods and across various market cycles.

But unlike most large cap investors, small cap investors tend to under-appreciate the link between a company’s sustainability factors and its long-term business success. By viewing sustainability from multiple lenses - internal and external, investors can typically gain valuable insights into the future direction of the company and the industry in which it operates which can provide an opportunity for stronger returns.

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