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International Fund —
Foreign shares retreat in Q3, as most sectors lose ground
3rd Quarter, 2014
"In terms of where the next generation of new middle class consumers are going to come from, we think it's probably India and Mexico. We continue to look for direct and indirect ways of playing both of those economies. "
– Northern Cross, LLC

International equities declined across a broad front in the third quarter of 2014, with the MSCI EAFE (ND) Index posting a return of -5.88%. The index is a measure of equities in developed overseas markets. Health Care, up by less than 1%, was the only sector not to lose ground. The decline left the index in negative territory on a year-to-date basis; it returned -1.38% for the nine months ended September 30.
The Harbor International Fund recorded a return of -7.00% for the third quarter, trailing the index. Portfolio Manager Howard Appleby reports that holdings in the Consumer Discretionary, Industrials, and Materials sectors hurt Fund performance relative to the index. Investment decisions in the Consumer Staples and Health Care sectors helped relative performance, as did a below-benchmark exposure to Energy, the weakest performing area of the index. From a longer term perspective, the Fund outperformed the index for the latest 5-year and 10-year periods and from its inception in 1987.
Among the Fund's best performing stocks in the third quarter were Japanese robotics company Fanuc, Swiss drug maker Novartis, Danish insulin maker Novo Nordisk, Dutch brewer Heineken, and French insurer AXA. Holdings that weighed most heavily on portfolio returns in the quarter included French energy management firm Schneider Electric, Swiss luxury goods marketer Richemont, global power systems provider Rolls-Royce Holdings, German auto maker Daimler, and Austria-based Erste Group Bank.
Howard Appleby's comments were made in an October 14, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended September 30, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through September 30, 2014.

Interview Highlights

Bottom-up analysis
We are overweight in Industrials but that does not represent a decision, cyclical or otherwise, to be overweight in that particular sector. It is a result of bottom-up analysis of companies we own that we think can improve margins and generate excess returns over time. Obviously, the slowdown in economic conditions in the last six months is testing that thesis. But our analysis suggests that the vast majority of the companies we own in that group should stand the test of time and continue to generate attractive returns.
Improving margins
The margin story on Volkswagen is poor, about 2%. But based on our discussion with the company we think margins could go to 5%, maybe 6%, because a lot of their models are going onto a common platform with common components. They've got about 20% of their total volume on that platform now, going to 40% by 2016. This is a result of capital investment already spent, and we think it should drive Volkswagen margins up over the next two years.
New middle class
We still have a huge interest in places like India and Mexico as emerging market economies. In terms of where the next generation of new middle class consumers are going to come from, we think it's probably India and Mexico. We continue to look for direct and indirect ways of playing both of those economies.
Realistic growth rate
In China, we're looking for further evidence that some of the corruption has been rooted out of the system. We also want to make sure we're not sitting on the precipice of a much lower growth rate in China. By much lower, I mean 4% to 5% rather than 7%. We've already readjusted from the 10%-11% level down to 7%. I think people have accepted that as a more realistic number, and we think there is still encouraging evidence of strength in consumer spending.
Buying opportunities
In this sell-off we're seeing, some of these stocks we're looking at are down 30% to 40% from their peak. We like that atmosphere—down 30%-40%, washed out, everyone's selling, downgrades. There may be some opportunities and we're looking at probably half a dozen of those right now.

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The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions.  These views are not necessarily those of the fund company and should not be construed as such.

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