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Small Cap Growth Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"We continue to find exciting opportunities in areas that offer secular growth and innovation and maintain our preference for quality businesses with clean balance sheets. "

Economic Overview
The first quarter of 2019 bore witness to a stock market advance of historical significance, as equities had their strongest start to a year since 1998 and posted their largest quarterly gains since the stock market bottomed 10 years ago. While in isolation these gains would appear emblematic of economic acceleration, the true narrative includes the steep declines and sentiment extremes experienced at year end, which provided the backdrop for the rapid advance.
With growth slowing and yields falling, expectations for further rate hikes quickly evolved with a more dovish tone, culminating in the Fed’s “pause” of further hikes. This evolution in thinking also coincided with falling volatility and tightening credit spreads, both of which flashed early warning signs of trouble at year end but have since receded to less-concerning levels.
As in quarters past, trade remained a headline throughout the first quarter as uncertainty surrounding the U.S.-China negotiations was cited as the single biggest driver of the global growth slowdown, and expectations for a resolution rose despite an uncertain timeline. Pockets of slowing growth were also evident in the U.S. in manufacturing, housing, and retail sales, but early indications suggest stabilization is already taking place. Improving trends combined with continued labor market strength and a lack of current inflation risk provided additional support as the market climbed higher.
Portfolio Review
In the first quarter of 2019, the Harbor Small Cap Growth Fund (Institutional Class) returned 21.62%, outperforming its benchmark, the Russell 2000® Growth Index, which returned 17.14%.
Most sectors added to relative returns. Investments within Health Care, Information Technology, and Industrials were particularly strong, offsetting weakness within Energy.
Health Care, the largest absolute position in the Fund, was the top contributor to relative performance for the quarter. We continue to find opportunities within the Health Care sector but are also always cognizant of managing any outsized risk exposure to the binary outcomes that often come with concentrated pipelines. Given that backdrop, we are broadly diversified across industries to gain exposure to the different sources of innovation within the sector. Stock selection accounted for the vast majority of relative outperformance within the sector, with notable strength in pharmaceuticals and biotechnology.
Ascendis Pharma, a development-stage orphan drug company, was the sector’s and Fund’s best relative performer. The company reported success in a key Phase 3 trial for a children’s human growth hormone treatment, which sent the stock soaring. The trial demonstrated that their offering was comparable in experience for the current market offering but resulted in a superior outcome. We continue to maintain high conviction in this name, as the company generates impressive cash flow, offers lower risk exposure to the space following their latest trial success, and can either continue to grow organically or could find themselves as an attractive merger and acquisition target.
Evolent Health underperformed during the quarter. The stock was dragged down on concerns around partner Passport Health's solvency and slower-than-expected enrollment for new Medicaid partners in Florida. The Passport Health fears have already been assuaged, and we believe the enrollment speed in Florida is a transitory issue for the stock. In our view, Evolent Health is well positioned heading into the rest of the year.
Within Information Technology, the Fund benefited from exposure to Ultimate Software Group after the company announced they planned to go private. Shares of this cloud payroll and human capital management provider rose on the deal, and we have since exited the position.
Fair Isaac Corporation was another strong relative contributor as the stock climbed consistently throughout the quarter. The data analytics software provider reported promising growth in both their traditional and new data analytics and SaaS-based business lines. We maintain conviction in the stock believing that this high quality, competitively advantaged franchise has a visible runway to strong top- and bottom-line growth.
Energy was the largest source of relative weakness within the Fund. During the period, there was a marked dispersion between the performance of the sector and its constituents and the price of crude oil, particularly among companies focused on refining and marketing. Concerns around slowing global growth also served as a headwind for the sector, and the market strayed from rewarding fundamentals. This was notable among exploration and production companies, which were not compensated for strategic reinvestment for growth, but rather for returning capital to shareholders.
Amid this macroeconomic backdrop, weak stock selection drove the underperformance, primarily due to an overweight position in PBF Energy, a small capitalization, independent refiner. While refiners were weak as a group, PBF was no exception. The stock fell on soft gasoline margins, which troughed in February but proceeded to improve significantly at the end of the quarter. With improved spot price differentials between gasoline and crude oil and strengthening (or at least stabilizing) macro data, we continue to hold conviction in this name and believe it is one of the best ways to play the upcoming International Maritime Organization (IMO) 2020 regulations.
The Information Technology sector was the Fund’s greatest overweight relative to the benchmark at the beginning of the year, with the software industry accounting for the sector’s greatest absolute and relative exposure. The Fund’s position in Information Technology remained largely unchanged during the quarter, decreasing slightly overall with four buys and four sales. We continue to believe the sector offers some of the highest quality organic growth companies in our universe.
The Consumer Discretionary sector was the Fund’s greatest underweight relative to the benchmark entering the year, and the Fund’s exposure was relatively unchanged during the quarter with three buys offsetting three sales. We continue to avoid many of the traditional retail areas of the sector, focusing on experiences over things—specifically, those companies insulated from e-commerce and education. It is important to note that the Fund’s sector weightings are purely a residual outcome of the bottom-up stock selection process.
We purchased Topbuild Corp. during the quarter, which added to relative returns. The company is the largest installer of insulation in the country, primarily for new home construction. The shares have been overly punished over concerns of a housing market slowdown that started in the fourth quarter, creating an attractive entry point. With mortgage rates now declining coupled with a recovery in the stock market, and unemployment and consumer confidence remaining firm, we think the housing market can recover in 2019. As the largest scale buyer in the industry, we believe the company has by far the best purchasing advantage relative to peers, resulting in more compelling margins.
We sold Cantel Medical Corporation during the quarter. Cantel manufactures medical equipment and infection control products. The stock traded lower after missing earnings, which led investors to question whether management’s previously announced growth plans were achievable. As a result, we decided to exit the position in favor of investments with better risk-reward profiles.
Outlook
Over the balance of the year, we may see an acceleration in U.S. and global growth after the recent soft patch. While it remains too early to say with certainty that a slowdown is behind us, some green shoots are beginning to emerge, such as the earliest leading indicator: policy changes. The Fed’s more dovish signaling, a marked departure from the monetary policy of mid-December, was well received by equity markets and should continue to support growth in the U.S. economy.
Global growth may also see a boost as the Chinese government announced a stimulus package to shore up their economy against further slowing. Additionally, survey data suggests that a bottoming process is already underway for growth in both the U.S. and China. With the Fed on hold and the U.S. Dollar weakening, we could see small caps and cyclicals perform better into accelerating growth trends. We continue to find exciting opportunities in areas that offer secular growth and innovation and maintain our preference for quality businesses with clean balance sheets. We believe that our growth-at-a-reasonable-price (GARP) philosophy will be rewarded in this environment.

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 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.