As 2015 unfolds, we think the stage of the economic cycle in the U.S., as well as what is happening to global competitors, could prove beneficial for small-cap stocks.

After a prolonged period of economic fits and starts, 2014 may eventually be remembered for the domestic economy breaking through and investors recognizing the recovery as having staying power. The year saw persistent declines in the U.S. unemployment rate and a positive-sloping yield curve typically associated with continued growth. The Institute for Supply Management’s much watched Purchasing Managers’ Index (PMI) also paints a steady picture of economic activity with 19 consecutive months of readings above 50, indicating an expanding economy.

As the chart below illustrates, when expansions begin to reach maturity, historically small-caps have outstripped their larger counterparts. The reasons they do well can vary, but include their nimbleness to adapt to changing client needs and their attractiveness to firms looking for acquisition targets to boost sales volume in a maturing environment.

Given the murky global picture, we believe smaller stocks may have an additional catalyst for outperforming larger names. While the U.S. appears to have crossed the hurdle of a sustainable upward trajectory, leaders in Europe are looking to monetary policy to revive a moribund situation. Japan recently slipped back into recession territory after a tax hike in April. China, too, has seen its growth prospects flag, which is having a ripple effect around the world.

Not surprisingly, the relative strength at home has led to a strengthening dollar as foreign investors look for safe havens to put their money to work. Last year, the Euro lost 11.97% of its value relative to the U.S. dollar and the Yen was down 13.74%. As a result, domestic products will likely face competitive headwinds abroad from a pricing perspective. Similarly, revenues generated overseas could contribute less to the bottom line. These trends are likely to have the greatest impact on larger companies.

As represented by the S&P 500, more than 46% of all sales* in 2013 were derived from outside the United States. In contrast, constituents in the Russell 2000® Index generated approximately 16% of their revenues** in 2013 from abroad. During the latest complete fiscal year, Russell 2000® constituents reported 26.4% of their sales*** came from foreign markets. Given the relatively low level of income smaller companies generate outside of U.S. borders, we believe they are poised to benefit from a stronger domestic currency.

*“Bears Stalk the ‘Goldilocks’ Stock Market,” Tom Lauricella, The Wall Street Journal, 10/11/2014
**“Russell Investments Small Cap Perspectives,” Russell 2000® Index Quarterly Analysis, 12/31/2013
***FactSet Research Systems Inc. and Heartland Advisors, Inc., as of 1/20/2015

Disclosure:

Past performance does not guarantee future results.

The statements and opinions expressed are those of the author. Any discussion of investment strategies represent the portfolio manager’s views when presented and are subject to change without notice. Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Economic predictions are based on estimates and are subject to change.

Data sources from FactSet: Copyright 2015 FactSet Research Systems, Inc., FactSet Fundamentals. All rights reserved.

Definitions: ISM Manufacturing PMI (Purchasing Managers Index): is an index based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM). The PMI index is an indicator of the economic health of the manufacturing sector based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. A reading under 50 represents a contraction, while a reading at 50 represents no change. Yield Curve: is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. In a positive-sloping yield curve, short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. A negative, or inverted, yield curve occurs when short-term debt instruments have a higher yield that long-term debt instrument of the same credit quality. Russell 2000® Index: includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Frank Russell Investment Group. S&P 500 Index: is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.

CFA is a trademark owned by the CFA Institute.

©2015 Heartland Advisors

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