Why it may be time to consider small and medium-sized companies for your Article 9 investment

Imagine investing in a firm making drugs to treat a rare cancer that’s ignored by Big Pharma because there’s not enough profit in it for them; or a company that produces raw materials for paints and binding agents that use sustainably sourced wood rather than the petrochemicals its competitors rely on.

These are just two examples of the small and mid-sized companies (SMIDs) that are taking tangible steps towards achieving the 17 United Nations Sustainable Development Goals (UN SDGs) established almost a decade ago by the 2030 Agenda for Sustainable Development.

Smaller companies are often overlooked by investors because they don’t feature in the standard equity indices that gauge stock performance. From a sustainability perspective, the third-party data available is relatively poor, so Article 9-compliant funds tend to ignore them.

However, amid expectations of central bank interest-rate cuts later this year, we think there are compelling arguments for why the outlook for SMIDs is looking up.

But first, here are four reasons why smaller companies can often make sense on sustainability grounds:

1) Aligned in different ways to SDGs

Smaller firms tend to be more specialised than larger companies. For example, the Italian company mentioned earlier that produces oncology drugs overlooked by other firms. Its products align with SDG No. 3 (Good Health and Well Being).

From a sustainability perspective, the innovation in niche areas that smaller companies excel in can help tackle problems that may otherwise be ignored.

That’s why SMIDs can contribute more directly and substantially to the SDG agenda, benefitting from growing demand for sustainable products and services, as well as the increasing availability of financing and other incentives for green and social businesses.

2) Supporting SDGs for large caps

SMIDs play a critical role in manufacturing value chains that sustain and allow bigger companies to operate successfully. As such, they can act as key facilitators that big companies depend upon to achieve their own SDG ambitions.

It’s important to recognise the indirect sustainability benefits they deliver to the wider sustainability ecosystem. Smaller companies account for some 85% of the global equity investable universe by number of companies. They must be part of any sustainability solution.

3) Closer to communities

SMIDs are more likely to be found at the very heart of local communities, where they can be a critical source of jobs, income, and access to essential goods and services.

In poorer countries, they can help reduce poverty, inequality, and exclusion by empowering marginalised groups and promoting inclusive growth.

With their activities focused closer to home, smaller companies may have a greater incentive to promote better relationships with their customers and employees – who are drawn from the local community.

4) More innovative, adaptable

Simpler business models mean smaller companies can often respond quickly to changing market demands and customer preferences.

This is especially important in a sustainability context – when new regulatory requirements can require corporate agility. This adaptability also allows these firms to quickly grab market opportunities.

SMIDs are often at the forefront of sustainability innovation. You see them offering niche products and services that cater to a specific social or environmental need – such as the wood-based binding agents from the Norwegian firm mentioned earlier (SDG No.12 – Responsible Consumption and Production).

Chart 1: Strong performance post initial interest-rate cut

Another reason for considering smaller companies is the attractive valuations on offer compared to large-cap stocks – by some measures, the disparity between the two hasn’t been this wide for decades.

Finally, investing in smaller companies may help investors with SDG mandates diversify their portfolios. That’s because most Article 9-compliant equity funds tend to be invested in the same handful of larger companies, increasing concentration risk.

Final thoughts

Smaller companies can offer different alignment with sustainability goals, play critical roles in the broader sustainability ecosystem and are more likely to benefit local communities.

As we look ahead to a year in which most central banks are preparing to cut interest rates to support flagging economies, we ought to remember that SMID share performance typically recovers faster during recessions and outperforms over longer periods.

Smaller companies are often considered risker than larger ones, especially during times of slower economic growth. But long-term investors who can stomach the volatility (and periods of cyclical underperformance) are likely to be rewarded.

In fact, the MSCI ACWI SMID Cap Index has historically been lower risk than regional large-cap benchmarks for Europe, Asia Pacific ex-Japan and the emerging markets. Meanwhile, a tilt towards ‘Quality’ factors – robust profits, sound balance sheets and high barriers to entry – also helps reduce some of the traditional risks associated with the asset class.

The bottom line – SMIDs, as tracked by the MSCI ACWI SMID Cap Index, have beaten the MSCI ACWI Index by some 160% since 2001.

Finally, across the financial industry, less resources are allocated to researching smaller companies. This means there are clear opportunities for skilled active managers to identify hidden value.