7/16/2019
Hermes: Industry ESG Scores for Small and Mid-Cap Companies Can Be Misleading
IR Magazine (07/16/19) Galpin, Hamish
Hamish Galpin, lead manager of the Hermes SDG Engagement Equity Fund at Hermes Investment Management, says, "As the integration of ESG factors into investment decision-making becomes increasingly mainstream, over-reliance on simple answers and third-party industry data, rather than assessing complexities and directly engaging with companies, could lead to smaller companies being unfairly penalized by investors on the basis of partially informed ESG criteria." According to Galpin, proactive engagement with company boards is crucial to generate profitable insights given the lack of readily available ESG information in the small and mid-cap segment. Off-the-shelf tools, like published databases, likely will not offer such information. "Given the need to create scale, off-the-shelf ratings are often constructed without analysts forming a fundamental understanding of businesses or specialist industries," Galpin says, "This can result in ESG ratings missing genuinely material factors influencing the performance of companies or taking a kitchen-sink approach and combining the meaningful with the trivial to form a confusing array of data points." There are four key failings of ESG ratings, which are amplified when applied to smaller companies: market cap bias, disclosure/geographic bias, industry bias, and reactivity. "Where it is available, investors should ideally consider ESG information alongside traditional fundamental analysis, with more detail on sustainability issues to be derived through direct contact with management. This latter process requires a rigorous approach aligning and integrating a range of variables, which is not easily outsourced to third parties," he adds.
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