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Small Cap Growth Fund —
Small cap growth stocks record modest gain for Q2
2nd Quarter, 2014
"Last year was a big year for P/E multiple expansion. This year we think it's going to be earnings that drive performance. "
– Westfield Capital Management Company, L.P.

U.S. equities advanced in the second quarter of 2014, with shares of smaller companies lagging behind large cap and mid cap stocks. The Russell 2000® Growth Index, a measure of small cap growth stocks, posted a return of 1.72%. Energy and Utilities were the best performing sectors in the index; Telecommunication Services was the only sector to record a negative return.
The Harbor Small Cap Growth Fund returned -0.13% in the quarter, trailing its Russell 2000® Growth benchmark. Portfolio Manager Will Muggia reports that stock selection in the Health Care and Industrials sectors hurt Fund performance relative to the index, while selection in the Consumer Discretionary sector helped relative performance.
Top individual contributors to Fund returns included Lithia Motors and Restoration Hardware in the Consumer Discretionary sector, Materials holdings KapStone Paper and Packaging and PolyOne, and Tesoro in the Energy sector. Aegerion Pharmaceuticals and Prothena in the Health Care sector were the biggest detractors.
Will Muggia’s comments were made in a July 16, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended June 30, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through June 30, 2014.

Interview Highlights


Focus on earnings growth
What we are most concerned with is earnings growth. Last year was a big year for P/E multiple expansion. This year we think it's going to be earnings that drive performance. In a way we really like that because we think we're much better at finding companies that can grow at above-average rates than we are at guessing what the right multiple is. We're in secular growth areas such as Information Technology and Health Care, but we also have large exposures in cyclical growth areas like Energy, Industrials, and Materials.
Biotech sell-off
There was a major biotech sell-off starting in March. We avoided a lot of the damage but we got hit on one stock in April and one in May. In our view it wasn't really on fundamentals so much as it was the unwinding of higher P/E, momentum-driven names in the biotech space. Both of these holdings are orphan drug companies that we really like, Aegerion Pharmaceuticals and Prothena. We've added significantly to both in response to the sell-off.
Tight capacity
The trucking industry in the U.S. is enjoying a better pricing environment right now than we've seen in years. You're seeing driver shortages and increased regulation creating very tight capacity, which we think is likely to continue to force supply to grow more slowly than demand. We like trucking and we remain overweight in the Industrials sector.
Pockets of strength
I think the environment going forward should be better for active managers and bottom-up stock picking. The market went from being way undervalued to being fairly valued now, in our view, which makes it especially important to find those companies that can outperform from here. Talking with companies is an important part of our work, and I can tell you that there are pockets of strength in the economy where the CEOs are much more upbeat than they have been in a long time.
Outlook for interest rates
While we do not explicitly make interest rate bets, we feel that our holdings in Financials would definitely benefit from rising rates. Interest rates actually inched lower in the second quarter, defying a lot of market expectations. But we still expect rates to gradually move higher over time.
Top performer
Lithia Motors was our best performing stock. It was up 42% in the quarter. It's an automotive retail business that has pretty consistently exceeded analyst expectations. We've owned it for quite a while. It reported double-digit gains in same-store sales and good margins. They have been working toward consolidating the business and increasing margins.

Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting www.harborfunds.com.

Performance figures discussed reflect that of the institutional class shares.

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.

This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.