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Large Cap Value Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"Rather than focus on analyzing short-term events or 'top-down' views, we will continue to direct our time and energy toward understanding the fundamentals of businesses. We believe that is the best way to serve our clients. "

Economic Overview
In the fourth quarter of 2018, U.S. equity markets suffered their worst quarter in over seven years as concerns over the pace of interest rate increases, continuing trade tensions, and slowing global growth weighed heavily on investor sentiment, testing the strength of the nearly 10-year-old U.S. bull market. A post-Christmas bounce, however, erased some of the losses. Overall, the S&P 500 Index fell 13.52% during the fourth quarter. Despite the market’s selloff, U.S. economic and corporate data released during the quarter, while moderating, were still generally strong.
The economy grew at a 3.4% annual rate in the third quarter, exceeding expectations and pushing 12-month corporate profit growth to 10.4%, a six-year high. With unemployment near 50-year lows, consumer spending remained strong, increasing at a 3.5% annualized rate. Inventories also provided a substantial boost. Strong consumer sentiment carried over into the fourth quarter as shoppers spent an unprecedented amount during the holiday season. Black Friday and Cyber Monday pulled in record online sales of $6.2 billion and $7.9 billion, respectively, increases of 23.6% and 19.3% from a year earlier, according to Adobe Analytics. Meanwhile, according to early data from Mastercard SpendingPulse, which tracks retail spending both online and in-store, holiday sales from November 1 to December 24 saw the strongest growth in the past six years, increasing 5.1% to more than $850 billion.
As measured by Russell indexes, large-cap stocks broadly outpaced both mid and small caps during the quarter and the calendar year. Value stocks held up better than growth stocks in the fourth quarter but lagged significantly for the year.
Portfolio Review
During the fourth quarter of 2018, the Harbor Large Cap Value Fund (Institutional Class) returned -12.58%, underperforming its benchmark, the Russell 1000® Value Index, which returned -11.72%.
Relative to the benchmark, stock selection detracted overall, while sector allocation had a modest positive effect. Stock choices in Financials was the key driver of underperformance. Overall, weakness in Financials, Utilities, and Consumer Discretionary outweighed relative strength in Materials, Consumer Staples, and Energy. In terms of sector allocation effect, an underweight in Energy, the index’s worst-performing sector for the period, was a notable positive in relative terms. A position in cash also bolstered relative results. Conversely, below-benchmark exposure to Utilities, the only sector to advance in the benchmark, detracted. The Fund’s sector weightings are a residual outcome of the bottom-up stock selection process.
A position in Ameriprise Financial was the largest individual detractor from relative performance. The company’s stock price suffered amid increased market volatility and declining equity prices, which likely translated into lower assets under management (AUM). Over the past decade, Ameriprise has shifted its business from predominantly insurance to be centered around investment advice, growing to more than $900 billion in AUM and over 9,000 advisors. Long-term, we believe the company’s diversified model, strong free cash flow generation (and balance sheet), and its ability to retain/attract advisors, while providing a compelling value proposition to clients, positions it well as Ameriprise shifts toward more fee-based business and continues to be a natural consolidator of independent advisors pressured by increased regulation.
Global oilfield services provider Halliburton was also a notable detractor. While the company has made admirable progress improving its market position internationally, an important catalyst in our view, Halliburton’s North America segment is facing a combination of what we believe will prove to be short- term headwinds. Some of the headwinds include temporary offtake capacity constraints and an exhaustion of its customers’ capital expenditure budgets earlier in the calendar year than anticipated. As a result of these headwinds (and others), Halliburton’s 2018 earnings forecast was reduced, leading to a decline in the stock price. Despite near-term challenges, we remain encouraged by Halliburton’s progress internationally and strong market position in North America, both of which provide what we believe to be a favorable backdrop for management to execute over the long term.
Conversely, Coca-Cola, the world’s largest nonalcoholic beverage company, was the main contributor during the quarter. A few years ago, Coca-Cola embarked on a transformational change that included restructuring its bottler and executive incentives to place greater emphasis on pricing/mix and profitability in developed markets, while maintaining volume growth focus in emerging markets. This has allowed better price-pack architecture, more innovations in non-sparkling beverages and, consequently, what we view as one of the best organic growth profiles in Consumer Staples. The company also returned to an asset-light model. Bottling operations around the world were refranchised (i.e., China, Europe, and North America). This has enabled greater agility and local decision-making by bottlers who are closest to consumers while reducing complexity and driving margin expansion.
Digital payments company PayPal Holdings also added relative value. The company continues to deliver on its strategic initiatives, including new partnerships with American Express and Walmart, as well as growing payment volumes in excess of 20%, year-over-year, during the third quarter of 2018. PayPal now boasts 254 million active accounts, representing a 9.1 million increase during the quarter. Lastly, the company recently closed its previously announced acquisition of iZettle, a leading small business commerce platform in Europe and Latin America. The newly announced partnerships and continued value-enhancing M&A transactions are two important catalysts we believe have the potential to drive increased intrinsic value growth for shareholders.
We added Parker Hannifin to the portfolio during the fourth quarter. The global manufacturer of motion and control technologies and systems has embarked on years of acquisitions and generates more than $14 billion in annual revenue. We believe Parker is now beginning to see the benefits of a renewed focus on business processes. In our view, the 2017 acquisition of industrial filtration company Clarcor will have a beneficial long-term impact. Parker possesses numerous characteristics we deem to be high-quality, including its global distribution network, with over 13,000 outlets that provide engineering support and customer service, creating a key barrier to entry; its diversification by geography, product offering, supplier and customer bases; its history of innovation protected by intellectual property; and its financial strength, as evidenced by 15 years of free cash flow conversion greater than 100% of net income and over 60 years of annual dividend increases. In our analysis, the current stock price provides a material discount to the company’s intrinsic value. We identified catalysts, such as efforts to improve operating margins and excess free cash flow, which could be deployed for mergers and acquisitions, dividends, and share repurchases.
Down markets are a natural part of investing that cannot be avoided entirely. Every down period brings its own set of news, which may seem like the most important pieces of information. In our view, these typically short-term events rarely affect the long-term fundamentals of the businesses we study. In 2018, we witnessed four rate hikes, trade war rhetoric and geopolitical rancor, contentious U.S. mid-term elections, and renewed market volatility, all of which weighed on market sentiment. Rather than focus on analyzing short-term events or “top-down” views, we will continue to direct our time and energy toward understanding the fundamentals of businesses. We believe that is the best way to serve our clients. As we enter 2019, our view of the domestic equity markets remains constructive.

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