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Mid Cap Growth Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"We have been adding to high-conviction holdings that we think are overly discounting a negative scenario. "

Economic Overview
During the fourth quarter of 2018, U.S. mid-cap growth equities suffered their largest quarterly decline since 2011. Volatility was elevated, as markets contended with a confluence of moderating economic growth, tighter liquidity and monetary policy, trade uncertainty, swelling fiscal deficits and political turmoil. Despite rising corporate headwinds and a challenging macro environment, third-quarter corporate earnings were relatively solid. As expected, the Federal Reserve (the Fed) raised short-term interest rates by 25 basis points in December. Fed Chair Jerome Powell highlighted the sustained level of economic growth and robust labor market but acknowledged that signs of softening growth have emerged, creating significant uncertainty about the course of monetary policy in 2019. He also noted that the central bank will maintain its balance sheet reduction plan. On the political front, the Democrats regained control of the House of Representatives, while the Republicans expanded their majority in the Senate. Defense Secretary James Mattis resigned following President Donald Trump’s decision to withdraw troops from Syria and Afghanistan.
Portfolio Review
During the fourth quarter, the Harbor Mid Cap Growth Fund returned -18.59%, underperforming its benchmark, the Russell Midcap® Growth Index, which returned -15.99%.
Relative underperformance was driven primarily by unfavorable security selection. In particular, stock selection in Consumer Discretionary hindered relative results, as did security selection in Communication Services. In contrast, stock selection in Financials benefited relative performance. In Industrials, an underweight position and security selection contributed to relative results. Sector weights are a residual outcome of the bottom-up stock selection process.
Individual detractors from relative performance during the quarter included Spotify Technology SA, a streaming music provider. The company’s shares were hit by the “risk-off” environment as investors rotated out of strongly performing growth stocks and into more defensive names during the quarter’s volatility. Spotify announced solid third-quarter results at the beginning of November, with subscriber additions, revenue and gross margins all above, or in line with, consensus expectations. However, management slightly lowered fourth-quarter guidance on the basis of ramping investment in 2019 and upcoming contract renegotiations, and the stock declined in response. We have high conviction that the company can exceed market expectations longer term as the ad-supported business scales, the economics of the marketplace continue to develop, and the customer experience continues to improve.
Conversely, Workday, Inc., a software-as-a-service provider for finance and human resources, contributed to relative performance. The company delivered strong third-quarter results at the end of November, reporting upside to all major metrics. Workday displayed accelerated new business signings across its product platform, strong growth in its international and financials segments, and a significant increase in subscription revenue. Additionally, guidance was increased meaningfully, and the stock rallied as a result. We continue to have a high conviction in Workday, as its management team has continued to impress us.
At the beginning of 2018, the Fund’s largest overweights relative to the Russell Midcap® Growth Index were Information Technology and Consumer Discretionary, while the largest underweight was Materials. Sector positioning is an indication of where we are finding our most compelling investment ideas. During the year, we increased our relative exposure to Health Care the most. In contrast, we meaningfully reduced our active weight in Industrials, as well as in Information Technology, which moved from an overweight to an underweight.
Many of the changes to Fund positioning are idiosyncratic in nature and not driven by specific themes. Recently, we have been using the heightened market volatility to try to “upgrade” the quality of the Fund’s portfolio, and we have been adding to high-conviction holdings that we think are overly discounting a negative scenario. We are particularly focused on companies we believe can succeed in an environment of slower economic growth. We have been eliminating companies that are reliant on cyclical growth to perform well.
During the fourth quarter, we initiated a position in Square, Inc., a payments and credit card processing company, which quickly made a positive impact as one of the largest contributors to relative performance for the quarter. We believe Square’s strong product offering can continue to lead to healthy adoption of its products, particularly in the e-commerce space.
We eliminated our position in Baxter International, Inc., a health care equipment provider focused primarily on renal care, hemophilia and immune disorders. We reduced our estimates for Baxter, as slowing growth we once viewed as temporary due to hurricane-related supply constraints in the U.S. seems to be more structural in nature. Our differentiation versus consensus expectations narrowed, and we saw less upside potential for earnings.
We are less optimistic on the outlook for the coming year than we were at the start of 2018. We became incrementally more cautious on global markets during the fourth quarter. In our view, the recent trade rhetoric between the U.S. and China has caused a further deceleration in global growth and is starting to have a material impact on U.S. companies. Near-term, we believe the recent market volatility is likely to continue, but we do not view a recession as inevitable. We acknowledge, however, that a recession is a possibility.

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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.