In recent years, Asian companies have felt a greater need to improve their ESG credentials in order to stay relevant, according to Amol Gogate, emerging market fund manager at Carmignac.
“Today, if you are in emerging Asia and have good-quality governance, the valuation multiples you get are so much better. Any entrepreneur who truly wants to create value will adopt good governance standards,” he said.
“This is not a government initiative. It is happening because the markets are evolving. If you want to make money, your governance has to be of higher quality. We don’t see that as much in Europe, where there’s a lot more of a governmental push towards this.”
While this is good news for UK-based fund managers, there are additional hurdles to contend with, however, particularly further down the cap spectrum.
Hicham Lahbabi, deputy head of Asian equities at Amundi, noted that although ESG is a key focus for many younger emerging market small caps, it can be difficult for western investors to determine whether they really are sustainable investments or not.
He said small-cap companies often do not have the same structure in place for areas such as corporate governance, or to formally implement plans for sustainability efforts such as a net-zero transition.
“Also, some of those names haven’t started their net-zero journey. For now, they have to be fully focused on their one product or their niche market, and can’t afford to allocate resources to something other than the business itself.
“So, for investors, if ESG is something that is very important, smaller caps are at a disadvantage versus large caps because they still don’t have the resources internally to work on that and give investors as much comfort as large-cap companies can.”
Gaurav Narain, manager of the India Capital Growth fund, which as of November held 47.8% of its portfolio in small caps and 38.9% in mid caps, said regardless of governance policy, companies of varying sizes are recognising the importance of ESG in order to be seen as a market competitor.
“A lot of the companies are really trying to take it as an opportunity,” Narain said. “We are seeing a lot of our portfolio companies realise it is the biggest risk to their business because they’ve seen that is happening globally. If you’re a supplier, globally, there is a lot of pressure on ESG. I’m seeing it in our portfolios, and a lot of companies want to use that as a strength.
“They are trying to benchmark themselves versus the best in the industry. We’ll see the annual reports, and a lot of them talk about being in the top-five percentile for ESG, and they get themselves ranked by global agencies. They realise that unless you improve, your business is finished.”
Another difficulty facing investors when it comes to small caps, however, is ensuring the accuracy of their reporting data.
“The company will give us some numbers like their market share, and usually what we like to do is cross check that information by meeting with other companies that are either upstream or downstream in the same value chain,” Lahbabi said.
“It’s difficult to do because it’s very niche, or their upstream or downstream clients are not listed. This makes it difficult sometimes to build an investment case.”
Responsibility by region
Alongside market-cap size, region has an important role to play when it comes to ESG credentials.
For instance, since 2001, India started to require reporting from the top 1,000 listed companies on sustainability through the Business Responsibility and Sustainability Report. The report is intended to encompass nine principles of a responsible business, including respecting the environment, promoting human rights and inclusive growth. The report became mandatory for the fiscal year of 2022-23.
“Today you have the numbers, but it is normal to still be slightly sceptical of their accuracy,” Narain said. “My sense is over the next few years it’s just going to get better and better. So in terms of disclosure standards, the numbers are there, but companies have done it because they’ve had to. And I think that is evolving.”
Since 2016, India’s business sector has also been changed by the introduction of the Unified Payments Interface (UPI), which works as an interbank transfer system that was offered by the National Payments Corporation of India as a public good for person-to-person and person-to-merchant transactions. According to a Reuter’s report in early 2024, the e-rupee, which was debuted in December 2022 and linked to the UPI, hit one million transactions a day in December 2023.
“There has been so much disruption because of regulatory changes. In India, it’s becoming very hard to do business the wrong way,” Narain said.
“A lot of digitisation has happened, everything is moving online. Evading taxes is becoming very difficult, simply because the taxation system is digital today. It is becoming a much more sanitised environment to do business, which is beneficial for all of us as risk levels are actually reducing.”
Small-cap China, big problem
Lhababi said he finds markets such as India to be a more supportive environment for small caps than China, though he noted there is some motivation for regulation change in China. He pointed to the Production Linked Incentive schemes in India, a series of initiatives intended to grow manufacturing sectors across the region, as a step forward for small caps.
“If you want productivity gain you need the private sector, which is willing to take risk and innovate,” he said. “The state-owned enterprises don’t have this risk appetite. They are here to run a business, not to build it. If you want your economy to keep growing, you need the private sector to build across new markets, embark on new projects and drive innovation.”
He added: “We want to see the government engineering a level-playing field that is not biased towards state-owned enterprises.”
Gogate concurred with the unfavourable conditions for small caps in China, adding: “A rule of thumb in Asia is that when you go small, you typically see fewer Chinese companies.”
While Gogate said China and Hong Kong-listed large caps account for 30% of the MSCI Emerging Market index, they only account for 7-9% of the MSCI EM Small Cap index.
“If you want to invest outside of China, you naturally go small,” Gogate said. “It shouldn’t be like that, because there are both small and large companies in China, just as there are small and large companies in the rest of Asia. But, that’s how it works.”
He added: “Some people have theories as to why this happens. In China, the system favours large companies, which is not necessarily the case outside of China. So, if you move away from China, you find yourself suddenly with a lot more variety among the smaller companies. It is a weird nuance, but it’s something to keep in mind.”
This article originally appeared in the February edition of Portfolio Adviser Magazine
