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International Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"One has to wonder how long investors can continue to shrug off material disruption to the well-established order of global trade. "

Economic Overview
The ongoing trade dispute between the U.S. and China, central bank efforts to "normalize" monetary policy (either through interest rate increases or balance sheet reduction), evidence of European economic weakness, and the latest twists in the Brexit saga remained the key macro-level events disturbing markets throughout the final quarter of the year. Additionally, a significant drop in the price of oil during the quarter caused a number of oil price-sensitive stocks to fall. For this reason, the worst affected sector during the quarter was Energy, followed by Information Technology. Despite significant falls earlier in the year, the best performing region in the fourth quarter was Emerging Markets, where Brazil and Indonesia led the turnaround.
Portfolio Review
The Harbor International Fund returned -13.55% during the fourth quarter of 2018, underperforming its benchmark, the MSCI EAFE (ND) Index, which returned -12.54%.
The majority of the Fund’s underperformance came from Europe, where the market was pushed lower by a whole range of factors including the heightened global trade dispute between the U.S. and China, the ongoing Brexit saga, and general fears of a global growth slowdown combined with higher interest rates in the U.S. The Fund’s exposure to the United Kingdom once again weighed on relative returns, and stock selection within that market was also notably negative. Conversely, the Fund’s more defensive and domestic-orientated holdings within Japan were a key positive driver of performance, as many export-orientated firms within the Japanese market suffered from heightened trade tensions.
During the quarter, Japan and Denmark were the top overall contributors to performance on an individual country basis, while leading detractors included the United Kingdom and Italy. On a sector basis, Consumer Discretionary and Industrials aided relative results, while Health Care and Utilities weighed on returns. The largest country overweights entering 2019 were the United Kingdom and Denmark. The largest underweights were France and Australia. The largest sector overweights at the end of the fourth quarter were Industrials and Consumer Discretionary. The largest underweights were Financials and Real Estate.
Industrials holding Vestas Wind Systems, Information Technology company Bandai Namco, and Consumer Discretionary holding Intertek were among the largest individual Fund contributors. Based in Denmark, Vestas Wind Systems benefited from newly announced growth plans and a long-term margin target of 12%. Bandai Namco has performed well due to the commercial success of a number of recent game title releases, as well as being buoyed by recent gaming legislation changes in Japan. United Kingdom-based testing group Intertek was a strong positive contributor, reporting improving organic growth of 4.5% in the 4 months to October.
Several leading detractors included Health Care company Fresenius Medical Care, Energy name Saipem, and Consumer Discretionary holding Thomas Cook Group. Shares of Germany-based Fresenius Medical Care declined following two profit warnings relating to unexpectedly high costs in the U.S. market as well as much higher investment. Shares of Saipem, based in Italy, declined because of sharply weakening oil prices and a set of third quarter results that missed expectations. United Kingdom-based global travel provider Thomas Cook Group’s stock price fell heavily due to deterioration in trading and concerns over the company’s debt level leading to the suspension of its dividend.
In Europe, there were a couple of new positions added to the Fund. One of these was DS Smith, the U.K.-listed packaging manufacturer. This company is benefiting from consolidation in the industry and the significant growth in packaging required for the e-commerce world in particular. The company has now expanded into the U.S., where the packaging sector is less developed. The other new acquisition was Alten, an entrepreneurial French company that provides outsourced engineers for industrial groups in France and around Europe. The company is still managed by the founder and has continued to grow at a steady rate over a number of years. The company generates double-digit earnings before income and tax (EBIT) margin, and its share price does not reflect ongoing growth prospects.
After some relative weakness over the last quarter and year-to-date, international equity markets look reasonably valued (to a degree), as the near-term growth outlook remains positive and companies continue to exceed expectations. There remain, however, geopolitical risks in Europe, while the U.S.-initiated trade dispute is becoming increasingly unsettling for both developed and developing international equity markets. One has to wonder how long investors can continue to shrug off material disruption to the well-established order of global trade.
In Europe, the significant fall in markets during the fourth quarter has left valuations looking more attractive than they have for some time with the forward price-to-earnings (P/E) multiple for the U.K. market at its lowest in five years while European markets sell on a low double-digit multiple with an attractive yield. These valuations reflect a more uncertain outlook due to ongoing Brexit-related risks, concerns over a potential downturn in the U.S. and China, and the ongoing trade dispute between the U.S. and the world’s second largest economy.
In Japan, the market has now fallen to near record-low valuation levels (only being beaten by the extreme post-Lehman lows), and the key issue is what investors will focus on as longer term return drivers once current turbulence has died down. We believe the global macro environment will remain challenging in many areas, although there are opportunities to focus on positive developments in domestic governance. This is already visible in terms of the nature of the relationship between management and shareholders as well as shifts in management objectives towards wealth creation (driven by the necessity of breaking the lifetime labor "pact" as Japan’s demographics structurally ratchet up the need to allocate labor effectively). These changes should have the potential to unlock the unique value that lies in corporate Japan’s balance sheets, company structures, and industry structures.
As the Fund invests in Asian Emerging Markets, we believe slowing economic growth is seen as an opportunity for the management of companies to reassess their capital allocation policies and, more broadly, the market structures in which they operate. We believe improvements in profitability and cash generation in those companies that comprehend this shift will more than make up for slowing economic growth. As always, Emerging Markets investors should continue to be disciplined about valuation.
The developed Asian markets remain highly influenced by Australia and Hong Kong, particularly the banking, insurance, and real estate sectors within these markets. Australian financials, dominated by the big four Australian banks, make up 30% of the MSCI Australia index. The Fund does not currently own any of the Australian banks, primarily due to valuations, increasingly onerous capital commitments, and heavy reliance on residential mortgages.
Also, worth noting for the quarter was that the portfolio remained in transition and continued to hold legacy names. This transition was substantially complete by the end of quarter, with only a few legacy positions remaining.

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