How a star small-cap manager uses ESG to find tomorrow’s winners

by Hannah Smith from interactive investor |

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The fund manager of one our Super 60 picks explains why firms that currently score poorly on ESG should not be overlooked.

The manager of the £752 million Henderson Smaller Companies (LSE:HSL) investment trust, one of interactive investor’s Super 60 choices, has outlined his approach to ESG (taking into account environmental, social and governance factors), explaining how even companies that currently score poorly on ESG can improve to become winners in the future.

Neil Hermon uses a process called the ‘4Ms’ to assess companies and industries according to environmental, social and governance factors. The four Ms are model, money, management and momentum.

The first refers to the way Hermon and his team analyse company business models in terms of sustainability. He notes that many factors contribute towards a company’s ability to create enduring franchises. “Companies that have positive impacts on the environment through efficiency gains or otherwise will often thrive as a result,” the manager says.

‘Money’ is the impact of ESG factors on a company’s financial position. Increased regulation or industry-specific tax burdens can affect a business’s ability to generate cash, Hermon notes.

He also looks at the quality of the management team and key decision-makers in a company, believing that those with a long-term focus, track record of shareholder alignment, and a sustainable mindset are most likely to outperform.

Finally, ‘momentum’ refers to the ability of a company to over-deliver against market expectations and grow earnings strongly into the future. “Success here relies heavily on a sustainable strategy being put in place by a strong management team that is overseen by an experienced and independent board,” says Hermon.

Once he has applied this four-pronged assessment, Hermon then considers valuation to ensure he doesn’t overpay for quality stocks.

Shareholder power drives change

The manager explains that this wide-ranging screening process doesn’t mean he excludes those companies that still need to make more progress on their green credentials or board diversity, for example.

We believe how a company is valued tomorrow is in many ways more important than how a company is valued today, which is why we do not automatically exclude companies that do not score well on ESG metrics today,” he says.

If Hermon thinks a board or management team is committed to, say, improving corporate governance or reducing carbon emissions, this could boost earnings multiples in the future as the market reflects on the changes in the business. It also means that the trust can use its shareholder influence to drive positive change within the companies it holds.

“Ultimately, our job is to try to maximise shareholder returns and that means we need to have an investment process which accommodates, not just appends, the importance of ESG analysis and takes into account all the different factors that drive earnings and valuations ‘today and tomorrow’,” says Hermon. “We believe our process does this and has been integral to the performance delivered so far.”

ii’s view

The Henderson Smaller Companies trust is one of interactive investor’s Super 60 choices. Hermon’s ‘growth at a reasonable price’ approach has helped the 100-stock portfolio build an enviable track record of regularly outperforming its benchmark, the Numis Smaller Companies index.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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