The challenge of non-financial analysis for small and mid-caps
" The voting policy at General Meetings is a lever of shareholder engagement. "
On the question of extra-financial analysis, what are the specific characteristics of the small and mid-caps market ?
Marie-Pierre Peillon: In general, we have found that ESG research is more difficult to access in this segment, especially in the case of small caps. This can be explained by two main factors: first, these companies do not always have the resources (organizational, human or simply the time) to collect, formalize and publish their non-financial information; second, they have fewer regulatory obligations in this field than is the case for large companies, although the proposed CSRD (Corporate Sustainability Reporting Directive) will introduce a more extensive and inclusive scope, covering almost 49,000 European companies, compared to 12,000 for the current NFRD (Non-Financial Reporting Directive). So, at present, with relatively little data available, the non-financial rating agencies tend to downgrade the ratings of smaller companies. This “inefficiency” can lead to a form of “rating bias”, where the assessment does not always reflect the reality of the company, with the result that investment funds are diverted away from small and mid-caps.
So, data “scarcity” impairs analysis….
Marie-Pierre Peillon: It acts as a brake. Consequently, the challenge for asset managers and investors is to compensate for this relative scarcity of information, and the associated rating bias, by means of proprietary research and analysis tools. The development of a “house” analysis methodology enables us to establish our own rating system, to supplement the research provided by the non-financial agencies. This approach has proved indispensable when investing in small and mid-caps.
What are the main areas where small and medium-sized companies can make progress ?
Marie-Pierre Peillon: We are witnessing a growing awareness of the importance of non-financial factors by company managers. However, the area where the most progress remains to be made is that of governance. These are companies that are well-managed but where the balance of power within the decision-making bodies is not always sufficiently explicit. The formalization of the guarantees provided to minority shareholders is also inadequate.
What role can the financial industry play with regard to these companies ?
Marie-Pierre Peillon: First, investors and asset managers must support companies in defining and formalizing their ESG risks and opportunities. This should lay the foundation for an approach based on partnership and dialogue to support the progress of companies. For example, we believe greatly in the virtues of shareholder engagement on the part of investors. Our role is to make the Boards of Directors of the companies in which we invest aware of our expectations, and this approach will forcibly involve both shareholder dialogue and shareholder voting policy. However, we should be clear that, for Groupama, “engagement” does not mean “activism”. We always place priority on dialogue rather than penalties to alert managers to best practices.
Stéphane Fraenkel: This shareholder dialogue is the key for us, given that we are long-term conviction investors. We commit ourselves to companies over periods of 3, 5 or 10 years, pursuing a philosophy of partnership and constructive engagement. Non-financial criteria can only be apprehended over the long term.
What form does this engagement take in practice ?
Stéphane Fraenkel We deploy various forms of action. For example, we encourage certain companies to publish a sustainability report or non-financial indicators that we consider essential. From the practical point of view, these indicators can concern energy consumption data per unit of production or personnel training indicators. Also, we can be very active in terms of voting policy at General Meetings. This is the case when we identify problems in the balance of power in corporate governance, which is often a more sensitive subject in small and medium-sized companies with family-held capital.
Marie-Pierre Peillon: To illustrate our approach, there is the case of a company with which we initiated a sustained shareholder dialogue back in 2014, and this has now been transformed into an engagement over the long term. Groupama AM repeatedly expressed its disagreement to the company’s pay policy, board structure, balance of power and, finally, CSR policy. This resulted in votes against resolutions concerning these issues.
Since the company was open to dialogue, it was able to listen to our recommendations and then take corrective action. We observed a rebalancing between fixed and variable pay, the introduction of a “clawback” mechanism, a limitation of golden handshakes and non-compete indemnities and a reduction in the number of performance shares. Governance became more transparent to the outside world, with a more streamlined Board. Finally, a CSR committee (Corporate Social Responsibility) has recently been established, comprising four independent members within the board, two years after the appointment of a head of CSR policy. Today, this company regularly asks for our advice before and after the General Meetings.
What value does non-financial analysis provide to the portfolio manager ?
Stéphane Fraenkel: Far from being a preoccupation that only concerns large caps, the incorporation of ESG criteria helps to ensure that companies are on the right track for sustainable growth. The non-financial domain is an integral part of the day-to-day economic activity of these companies.
Thanks to our cross-disciplinary approach and our experienced teams of analysts – with the unique feature that each analyst studies both the financial and non-financial domains – ESG provides a unique analysis methodology specific to Groupama AM: we use ESG as a filter for apprehending the three main transformations bringing deep-reaching changes to the company business models, namely the environmental and energy transition, the digital transition and, finally, the demographic transition. We are investing in the future. For long-term investors like Groupama AM, the alignment of non-financial and financial interests is no longer merely an option.
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