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Small caps a strong portfolio diversifier but watch out for emerging ESG factors

ASX small caps have outperformed the top 100 companies over the past year. But investors need to be increasingly aware of ESG factors which often go under-reported. Pendal’s LEWIS EDGLEY and DAMIEN DIAMANT explain

SMALL CAPS provide a chance for investors to diversify portfolios away from the more mature behemoths that dominate the top end of town.

They are often driven by very different themes to the macro factors that typically affect the ASX100.

Pendal Smaller Companies portfolio manager Lewis Edgley points to successful technology businesses, innovative online retailers and companies producing materials used in batteries such as lithium, cobalt and nickel.

 “These are new-world businesses that offer exposure to disruptive business models — much more so than the large cap index,” says Edgley.

Small caps are further up the risk return spectrum relative to their large cap counterparts. But they provide access often to undiscovered companies that can present outsized returns relative to their risk profiles. 

The ASX Small Ordinaries index (which measures companies in the top 300 minus the top 100) — outperformed the ASX100 over the past year.

“Small caps are generally under-researched relative to their large cap counterparts, while offering more attractive growth prospects” he says.

“We find many opportunities to invest alongside business founders and management teams that have significant shareholdings, which creates a strong alignment of interest with investors.”

Find out about

Pendal Smaller
Companies Fund

New opportunities

Small caps also offer a continual flow of new opportunities.

“About 20 per cent of the Small Ords listed in the last five years. That amount of refresh in our investable universe means the small cap sector is never stale.

“In the last two years our team has evaluated literally hundreds of new IPOs, the majority of which don’t make the cut… In the last month alone, we’ve had nearly 10 IPOs worth more than $1 billion each come across our desk.

“Investors need to be discerning about which to participate in. Some are blatantly opportunistic, just trying to take advantage of bull market conditions and the broader market’s willingness to discount risks.

“By sticking to our proven investment process we expect to do well on the select few IPOs we’ve recently supported.”

ESG a factor to watch

For all the opportunities, the sector is not without risk. Environmental, Social and Governance (ESG) issues are a significant emerging factor that small cap investors need to watch.

Unlike large companies, small caps often do not have the resources or expertise to measure and report on ESG risks. They can go unheralded in company reports.

“Most of the companies we talk to are not sufficiently resourced to have a fully enunciated plan in terms of how they are going on their ESG journey,” says Edgley.

“We work with companies to provide our insights on what is important from an ESG perspective. We share what we think is important and help them formulate a framework so they can set sensible and realistic targets.

“We find many small caps are doing a number of things that would already rate them well on an ESG screen — but they’re not actually recording and reporting on them.”

City Chic Collective (ASX:CCX)

Pendal small cap investment analyst Damien Diamant gives the example of fashion retailer City Chic Collective (ASX:CCX), an ecommerce company held in the Pendal Smaller Companies Fund.

“We spent time with the company running through their supply chain and actions they’re taking to ensure they have a positive impact on communities.

For example CCX — which focuses on plus-sized fashion — has moved to ban raw materials sourced from high-risk regions, such as cotton from Xinjiang.

Xinjiang cotton is regarded as high-quality, but human rights campaigners say it is produced by forced labour.

CCX has also focused on water and waste management, sustainable packaging and recycling.

“We’re happy with the progress made to date” says Diamant. “As a smaller company there are obviously limitations to the resources that go into developing a detailed ESG reporting framework. 

“But they have a strong awareness of the risks and are taking a proactive response to ethical trade.”

The small caps team is further integrating ESG into its investment process, says Edgley.

“We’ll continue to work closely with our investee companies to gain a deeper understanding of their priorities in this emerging space,” he says.

“We’re fortunate to have the support of a dedicated Responsible Investment team at Pendal. Their insights and guidance have been invaluable as we embark on this ESG journey.”

About Lewis Edgley

Portfolio manager Lewis Edgley co-manages Pendal’s Australian smaller companies and micro-cap funds and conducts fundamental analysis on a range of smaller companies. Lewis brings 20 years of industry experience with previous roles in equities research, commercial and investment banking

About Damien Diamant

Damien provides fundamental analysis for Pendal’s smaller companies strategies, supporting stock selection through valuation, stock data evaluation and building company investment models.

About Pendal Smaller Companies Fund

This is an actively managed portfolio investing in ASX and NZX-listed companies outside the top 100. Co-managers Lewis Edgley and Patrick Teodorowski look for companies they believe are trading below their assessed valuation and are expected to grow profit quickly. Lewis and Patrick together have more than 38 years of investment experience.

Find out about Pendal Smaller Companies Fund
Find out about Pendal MicroCap Opportunities Fund
Find out about Pendal MidCap Fund

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at .

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