ESG isn’t tree hugging, it’s smart finance

July 4, 2024

Modern office building with green leaves reflecting off of the glass panels.

Five longstanding ESG themes that predate responsible investing.

Environmental, Social and Governance (ESG) factors can be seen as idealistic in investing and at odds with business performance and measurable results. However, this view overlooks their financial implications for businesses and investors, with global small caps being no exception. ESG considerations, from board independence to community relations and environmental risks, can be useful to help assess financial stability, risk management and competitive advantage.

This week’s commentary will explore five themes that show how ESG factors can be important to sustainable financial success.

1. Board member independence

Good governance has long been an investor focus. Board independence helps ensure strategic guidance free from internal influences, reducing conflicts of interests. Independent directors provide unbiased oversight on risk management, which can help to avert crises and challenge management assumptions, leading to a more thorough analysis of strategic options and their implications. Independent boards often see higher profitability and navigate risks better, reflected in their market valuation and investor confidence.

An example is our holding Kurita Water Industries, which has 50% board independence, above the average in Japan. Its independent directors bring diverse perspectives, valuable in global expansion, and help Kurita maintain a solid financial position and sustainable growth in a competitive environment.

2. Product quality and safety

High product quality and safety standards fulfill regulatory requirements and boost consumer trust and brand reputation. They can reduce the risk of costly recalls and legal issues, directly impacting sales volume and the bottom line.

For instance, our holding Menicon, Japan’s first and largest contact lens manufacturer, has international quality standard certifications for medical devices, including ISO 13485/EN ISO 13485. Each of its subsidiaries maintains its own quality management system, with general managers in development, pharmaceutics and sales overseeing safety management. There have been no regulatory recalls of Menicon’s products in recent years.

3. Community relations

Strong community relations are vital for a company to obtain a license to operate, potentially increasing project approvals. Community ties can also provide supportive networks during crises and facilitate local cooperation. Conversely, community opposition can lead to project delays, increased costs and even cessation, affecting expected returns.

An example of a company holding that benefits from its community investment is Advantage Energy, from Western Canada. Although community issues are common in the natural gas sector, the company strives to be an active community member, attending monthly meetings to facilitate communication and cooperation regarding energy developments. It has faced no project opposition or delays and operates smoothly.

4. Physical risks of climate events on company assets

Climate change heightens extreme weather events and natural disasters, increasing the risk of damaging company assets, disrupting supply chains and increasing operational costs. These risks can also affect insurance premiums and lead to regulatory penalties, straining financial resources. Companies that mitigate these risks can protect assets and maintain profitability.

For example, our Arena REIT holding in Australia, with 272 social infrastructure properties, faces bushfire and extreme weather risks, leading to potential property damage, operational disruptions and higher insurance costs for tenants. Arena REIT maintains a geographically diversified portfolio and conducts thorough due diligence on bushfire zones and flood overlays during acquisitions. It also ensures adequate disaster insurance for repairs and reinstatement across its properties.

5. Employee relations

High employee morale and fair labour practices create a positive work environment, enhanced job satisfaction and reduced turnover. This boosts productivity and innovation, benefitting a company’s financial health. Conversely, poor employee relations can result in high turnover rates, lost productivity, strikes and reputational damage, negatively impacting financial health.

Our Vital Farms holding exemplifies good employee relations. The company produces and sells eggs, butter and ghee from pasture-raised hens. Certified as a B Corp, one of the highest standards of good corporate practices, Vital Farms has best-in-class initiatives for workers’ wellbeing, such as the ReVITAlize remote crew retreat, inclusive farmer open houses, comprehensive onboarding and an annual employee engagement survey.

The financial imperatives of ESG

These examples highlight how ESG integration can be used in financial decisions. As global small-cap managers, our commitment to incorporating ESG considerations into our investment decisions is one of the inputs for achieving sustainable financial success and aligning with our fiduciary duty to act in our clients’ best interests.

Disclaimer: ESG integration at Global Alpha is driven by taking into account material sustainability and/or ESG risks that could impact investment returns, rather than being driven by specific ethical principles or norms. The investment professionals may still invest in securities that present sustainability and/or ESG risks, including where the portfolio managers believe the potential compensation outweighs the risks identified.

Global Alpha Capital Management Ltd.
July 4th, 2024