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Mid Cap Growth Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"Coming off a volatile end to 2018, we welcomed a strong start to 2019. In general, we have become more optimistic in our outlook for equity markets going forward. "

Economic Overview
U.S. equities rallied to their largest quarterly gain since 2001 in the first quarter of 2019, buoyed by a dovish shift in Federal Reserve (Fed) policy and guidance, optimism for a U.S.–China trade deal, relatively strong fourth-quarter 2018 earnings, and corporate buybacks. The Fed left its benchmark interest rate unchanged during the quarter, signaling a more patient approach toward future policy-rate adjustments in response to slowing economic growth and muted inflation. The Fed also announced that balance-sheet normalization will begin to slow in May and conclude in September. Fourth-quarter earnings and forward guidance from U.S. companies were encouraging relative to the market’s subdued expectations. The blended year-over-year earnings growth rate for the S&P 500 Index was 13.1% in the fourth quarter of 2018, down from 28.4% in the third quarter. Corporate buybacks represented the largest source of demand for U.S. stocks, as U.S. companies continued to purchase record quantities of their own shares on the back of solid U.S. economic growth and last year’s tax cuts.
Portfolio Review
In the first quarter of 2019, the Harbor Mid Cap Growth Fund (Institutional Class) returned 24.49%, outperforming its benchmark, the Russell Midcap® Growth Index, which returned 19.62%.
Relative outperformance for the quarter was driven primarily by favorable security selection, particularly within Consumer Discretionary, Health Care, and Information Technology. In contrast, security selection was weak in Financials and Materials. Sector allocation, a result of our fundamental stock selection process, detracted from relative results. The Fund’s overweight allocations to Communication Services and Consumer Staples were large detractors from relative results, as was underweight exposure to Information Technology. Conversely, the Fund’s underweight exposure to Financials contributed. U.S. mid-cap equities advanced during the quarter, while U.S. mid-cap growth equities rallied to their largest quarterly gain since 2001. High growth stocks outperformed their lower growth counterparts, an environment which is typically favorable for our style of investing. From a style perspective, our style factors have been a tailwind year-to-date.
While it is always difficult to measure exactly how much macroeconomic-level events affect the Fund given our fundamental investment process, we focus our investments on companies that we believe can provide growth in various macroeconomic environments and are insulated from potential trade tensions (to a certain degree). Macroeconomic events can affect short-term performance, but we typically believe security selection will drive the Fund’s performance over the long-term. In terms of risk factors, our style was a tailwind for the first quarter as growth stocks rebounded from their sell-off to end 2018.
In terms of individual contributors to relative results, online home furnishings provider Wayfair was the top contributor to relative performance during the period. Wayfair reported a very strong fourth quarter of 2018, with both revenue and earnings coming in ahead of consensus expectations; 40% sustained growth in the U.S. was fueled by investments the company has made throughout the business. We continue to think Wayfair remains a leader in the online furniture market and will continue to gain a share of this very large, addressable market, but we reduced our position as the stock rallied over 60% in the first quarter.
Floor & Décor, a retail hard surface flooring provider, was another top contributor in the Fund. The company reported fourth-quarter earnings that exceeded expectations, with strong margin performance demonstrating the company’s ability to manage in a tough sales environment. Following a difficult 2018 for the company, these encouraging results gave investors confidence to return to this name. We continue to hold a significant position.
In terms of individual detractors from relative performance, Haemonetics, a provider of hematology (blood) products and solutions, was most significant during the period. The share price dropped after the company reported a slight revenue miss in its fourth-quarter results. These results were caused by a faster decline in its blood business and slowing growth in its thromboelastography hemostasis management system. The company’s plasma business performed well, however, and we believe it is a key growth driver and important to our investment thesis. We continue to favor the name and took advantage of the recent weakness to add to our position during the quarter.
Video game developer Take-Two Interactive also weighed on relative results. We initiated a position in Take-Two in late 2018 on the thesis that its recent video game release, Red Dead Redemption 2, would help diversify its business away from its core Grand Theft Auto franchise going forward. Despite Red Dead Redemption 2 showing strong sales in 2018, the company does not appear to have gained meaningful traction for this game online, where competitors have shown the ability to successfully monetize games. Despite the company’s releasing strong quarterly numbers, its stock was down in the first quarter after weak guidance for the next quarter. Management attributed the guidance to its belief that some demand for Red Dead Redemption 2 was pulled forward to last quarter and to delays for the company’s online content releases.
The largest sector overweight exposures entering 2019 were Health Care, Communication Services, and Consumer Staples. The largest underweights were Industrials, Financials, and Real Estate. Sector positioning is an indication of where we are finding our most compelling investment ideas. During the first quarter, active exposures to Consumer Discretionary, Health Care, and Industrials increased, while active exposures to Materials and Information Technology decreased. Health Care was our largest overweight relative to the benchmark as of the end of the first quarter, while Industrials was the largest underweight.
Our style tilts and investment themes remained relatively constant throughout the first quarter. We trimmed some strong performing names in the Fund and rotated into high conviction names that we believe continue to present attractive risk/reward opportunities.
Fast-casual restaurant operator Chipotle Mexican Grill was the largest addition to the portfolio during the first quarter. We believe Chipotle’s recent delivery and loyalty initiatives have been successful and have led to significantly better sales growth for the restaurant chain for the first time since the E. coli scare the company faced a few years ago. Chipotle delivered exceptional fourth-quarter 2018 results, with earnings coming in 22% ahead of consensus expectations and strong sales growth. Results were aided by a free delivery promotion that started in mid-December 2018 and lasted through the first week of the first quarter of 2019. We believe these promotional efforts have led to a more permanent change to consumer behavior that could benefit the company going forward.
We added to Zendesk, a customer support software provider. We view the reward-to-risk ratio on this company as attractive. We believe the company has several new products that are creating an inflection in sales, including suite offerings, incremental products in customer relationship management, and new additions in its enterprise segment.
We trimmed a handful of strong performing software-as-a-service companies that have been long-term Fund holdings, including Workday, ServiceNow, and Guidewire. In addition, we eliminated the Fund’s position in software company Autodesk. We continue to have a long-term bullish outlook for the software industry, and we used the proceeds from Autodesk to initiate positions in software names that have lagged the peer group. We also trimmed positions in other strong-performing names, including Wayfair and Shopify. Another notable transaction was reducing the Fund’s position in online brokerage services provider TD Ameritrade. In our opinion, benefits from the company’s acquisition of Scottrade, tax reform, and rising interest rates have largely played out, and we think there are more compelling opportunities elsewhere.
Coming off a volatile end to 2018, we welcomed a strong start to 2019. In general, we have become more optimistic in our outlook for equity markets going forward. However, we used the rally during the first quarter as an opportunity to trim holdings when valuations were starting to look frothy and add to high conviction names that lagged the recent strength. We have identified opportunities where we are waiting for a pullback before we initiate a position. As usual, we are looking for opportunities where we hold a differentiated view that present an attractive risk-reward ratio using our fundamental investment process.

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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.