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Small Cap Value Fund —
Small cap value shares fall in Q3, with all sectors losing ground
3rd Quarter, 2014
"For us, it's always a question of weighing valuation against prospects. Just because consumers are buying, that doesn't mean that every consumer stock is worth a premium. "
– EARNEST Partners LLC

The third quarter of 2014 saw a sharp decline in shares of smaller U.S. companies, leaving them in negative territory for the year. Small cap value stocks, as measured by the Russell 2000® Value Index, posted returns of -8.58% for the quarter and -4.74% for the nine months ended September 30, 2014. The third quarter decline was broad based, with all 10 economic sectors in the index recording negative returns. Energy was the weakest sector in the index, with a return of -23%.
The Harbor Small Cap Value Fund also posted negative results but outperformed the index. The Fund returned -4.87% for the third quarter and -0.97% for the nine month period. From a longer term perspective, the Fund also outpaced its Russell 2000® Value benchmark for the latest 5-year and 10-year periods and since its inception in 2001.
Stock selection was a key factor in the Fund's outperformance in the third quarter, as companies in the portfolio outpaced those in the index in every sector, Portfolio Manager Paul Viera reports. Sector positioning detracted slightly from relative performance, including an above-benchmark exposure to the weak performing Energy sector, although the Fund's Energy stocks outperformed those in the index. Sector positioning within the Fund typically is a reflection of individual stock selection decisions rather than an active component of investment strategy.
Top performers in the portfolio included engineering services provider URS, wireless communications company SBA Communications, legal software maker Epiq Systems, customized products maker TimkenSteel, and financial services provider Raymond James Financial. Among the bigger detractors from third quarter returns were Energy sector names Bristow Group and Core Laboratories, industrial battery maker EnerSys, railcar leasing company GATX, and Information Technology sector holding Entegris.
Paul Viera'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


Long-term perspective
Although the small cap value market was down for the quarter, it is important to keep in mind that both the benchmark and the Fund have performed very well over the last five years. The Russell 2000® Value Index posted an average annual return of about 13% over that period while the Harbor Small Cap Value Fund returned almost 15%. So despite a fairly dramatic decline in the latest quarter, it is nonetheless true that the last five years have been a great period to be in small cap.
Higher returns
Our portfolio characteristics are consistent with what you've seen in the past. Compared with the broad small cap value universe, as represented by the Russell 2000® Value, the companies we have in the portfolio have less leverage, lower price/earnings ratios, and higher returns on equity. We think it is a good combination because it is reflective of management teams that are earning solid returns and doing it with less leverage. In general we think that translates into a portfolio of quality companies that are perhaps a little safer in down markets.
Sector exposures
Our emphasis is on individual stock selection, not making macro calls, a process that typically leaves us with sector overweights and underweights relative to the Russell 2000® Value benchmark. With regard to specific positioning in the portfolio, we currently have overweights in Information Technology and Industrials, while continuing to have a significant underweight in Financials. Almost 40% of the benchmark is in Financials, while we are a little more than half of that.
Comparing valuations
For us, it's always a question of weighing valuation against prospects. Just because consumers are buying, that doesn't mean that every consumer stock is worth a premium. Valuations in the consumer space have been a bit too rich for us lately. That's the main point with respect to our being underweighted in consumer names. The other point is alternatives: we're seeing alternatives that we think are more attractive. It's not a question of whether consumers have their wallets open because they do. It's about how expensive the stocks are.
Favorable backdrop
There are always areas of caution and concern but I think the environment in which we are operating today is reasonable. GDP growth has been acceptable, the Federal Reserve has been able to wind down its bond buying program without a negative impact, and consumers recently received the equivalent of a tax cut in the form of lower gasoline prices. I think the environment is reasonable; it is not without risk but it's reasonable.

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.