Top Small-Cap Stocks Widely Owned by ESG Funds

Finding the small-cap stocks that are uniquely owned by sustainable funds can be a good exercise for investors seeking exposure to the carbon transition or other sustainability-related themes.

Many times, the difference between sustainable and traditional funds can be minor. Both types of funds hold stocks that limit risk, have room to grow, and are expected to perform well. Funds that track environmental, social, and governance principles or themes can follow a wide range of approaches. But in practice, many own the same stocks as conventional funds, though to different degrees, as we’ll see below.

What’s a Small-Cap Stock?

We sort stocks by region, such as the United States or Latin America, and then classify them as giant, large, mid, small, and micro based on market capitalization. In the US, small-cap stocks range from a market cap of $2.9 billion to $11.2 billion, and they will be the focus here. (Learn more about Morningstar Categories by downloading the US Fund Category methodology paper.)

Our Methodology

We compiled the holdings of the oldest share classes of all US sustainable small-cap funds. Next, we put the top 200 stocks that are commonly owned in a theoretical portfolio. Then, we calculated what the average weight of each security would be if this portfolio held all 200 stocks. We did the same with traditional funds, defining the universe as the oldest share class of small-cap funds, excluding sustainable funds.

By doing so, we can find stocks unique to sustainable funds in the small-cap universe. Securities that are held in sustainable funds, but not conventional ones, are considered “unique.” We can also gain insight into which stocks are commonly held between sustainable and traditional portfolios.

Stocks Unique to ESG Funds

A number of stocks are owned exclusively by small-cap sustainable funds. Here are the five most commonly held. Two of them, AptarGroup and Wyndham Hotels & Resorts, have 4-star Morningstar Ratings. Three of these five stocks are covered by Morningstar analysts, and they are the most undervalued, based on Morningstar’s price/fair value estimate.

We also ranked the small-cap stocks for cheapness. Here are the three most undervalued stocks unique to sustainable funds, based on Morningstar’s price/fair value estimate.

Five Most Common Small-Cap Stocks in ESG Funds

AptarGroup

Aptar’s portfolio includes lower-margin products such as shampoo and soap pumps and caps for sauce bottles. It has intentionally focused on growing the higher-margin healthcare business over the past decade, which now accounts for about two-thirds of operating profits.

Aptar intends to prioritize international expansion in emerging markets that could have increased regulatory standards, and Aptar may pursue acquisitions to achieve growth in these markets. Aptar is also investing to meet the potential future need for elastomer components in injectable drugs, including biologics and GLP-1 drugs.

—Jay Lee, Morningstar Senior Equity Analyst

Wyndham Hotels & Resorts

With 100% of its 9,000 hotels franchised, Wyndham has an attractive recurring-fee business model with healthy returns on invested capital, as these asset-light relationships have low fixed costs and capital requirements.

—Dan Wasiolek, Morningstar Senior Equity Analyst

Donaldson

Donaldson, a leading manufacturer of air and liquid filtration systems, has built a narrow moat around its large installed base of equipment coupled with a razor-and-blade business model that continues to generate a relatively steady and high-margin stream of recurring revenue from aftermarket parts and consumables.

Over the next five years, we expect to see revenue growth in the high single digits in our explicit forecast, with the pharma business growing in the context of 10%. This segment benefits from strong volume growth across business lines.

—Krzysztof Smalec, Morningstar Equity Analyst

Commerce Bancshares

The stock currently trades at a 7% discount to our quantitative fair value estimate of $58.21 per share; however, caution is warranted due to this estimate’s High Uncertainty Rating. The company’s profitability increases our estimated fair value.

—Morningstar Analytics

Franklin Electric

The company’s narrow economic moat rating suggests it should be able to maintain robust profitability for a decade or longer before competition erodes its advantage.

—Morningstar Analytics

3 Cheapest Small-Cap Stocks in ESG Funds

Bath & Body Works

Under new leadership, Bath & Body Works is pursuing an extensive turnaround plan to restore customer engagement and elevate its brand intangible asset, the basis of our narrow-moat rating. Despite weak recent demand trends, Bath & Body Works has carved out a competitive edge in the sizable addressable markets in which it operates, evidenced by its leading market share position in bath and shower and candle air freshener industries, which has facilitated by BBW’s evolving response to consumer trends.

—Jaime M. Katz, Morningstar Senior Equity Analyst

Sensata Technologies

Despite the cyclical nature of the automotive and heavy vehicle markets, electric vehicles and stricter emissions regulations provide Sensata the opportunity to sell into new markets, which has allowed the firm to outpace underlying vehicle production growth by about 4% historically. We think such outperformance is achievable over the next 10 years, given our expectations for a fleet mix shift toward EVs and Sensata’s growing addressable content in higher-voltage vehicles.

Over the next decade, we expect Sensata to focus on organic growth in electric vehicles and increasingly electrified industrial applications.

—William Kerwin, Morningstar Senior Equity Analyst

Albemarle

Albemarle is one of the world’s largest lithium producers, which generates the majority of total profits. … As electric vehicle adoption increases and utility-scale batteries are built for energy storage, we expect double-digit annual growth in global lithium demand over at least the next decade.

The largest ESG risks come from potential new regulations. Regulations could limit emissions in the bromine business, and the company may not be able to pass along the cost increases. We see this as having a moderate probability and materiality.

—Seth Goldstein, Morningstar Senior Equity Analyst