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Mid Cap Value Fund —
Fourth Quarter Manager Commentary
2nd Quarter, 2019
"While the environment for value stocks has been challenging over the last 12 to 18 months, we believe the Harbor Mid Cap Value Fund is well positioned given its valuation, combined with the strong fundamentals of our holdings. "

Market in Review
U.S. equities finished the second quarter of 2019 in positive territory with the S&P 500 Index setting a record high. The S&P 500 returned 4.30% in the second quarter, but it was a volatile ride, as the index advanced 3.93% in April, declined 6.58% in May, and rebounded in June, returning 7.05%. The Russell Midcap® Index advanced 4.13% during the second quarter. Year to date, the S&P 500 has posted its best start since 1997, advancing 18.54%, while the Russell Midcap® Index was up 21.35%. During the quarter, value stocks as measured by the Russell Indices continued to lag growth stocks across all market cap ranges. Low-volatility stocks also posted strong returns in the quarter, as the MSCI USA Minimum Volatility Index returned 4.99%. From a sector perspective, Industrials, Communication Services, and Financials outperformed in the Russell Midcap® Value Index, while Energy and Consumer Staples lagged.
Economic data was mixed in the quarter. On the positive side, unemployment remained at historically low levels and first quarter Gross Domestic Product (GDP) growth was strong at 3.1%. However, manufacturing and business surveys weakened around the world. U.S. equities declined significantly in May as trade rhetoric intensified—not only with China but also, temporarily, with Mexico, as the Trump administration threatened tariffs on Mexican goods amid the immigration crisis on the border. However, in June, the administration backed off the Mexican threat and progress with China also emerged. These developments, combined with central banks around the world indicating a willingness to pursue accommodative policies, helped push markets higher.
Portfolio Performance
In the second quarter of 2019, the Harbor Mid Cap Value Fund (Institutional Class) returned 0.94%, underperforming its benchmark, the Russell Midcap® Value Index, which returned 3.19%.
Growth stocks continued to lead the market and low-volatility stocks also posted strong returns. The headwind for value and the continued outperformance of low volatility stocks had a negative impact on Fund performance. The Fund outperformed the Russell Midcap® Value Index in April and June but lagged significantly in May, as trade disputes with Mexico and China negatively impacted our holdings.
Performance attribution indicates that poor stock selection contributed to the underperformance during the quarter. From a sector perspective, the portfolio’s overweight to Financials and underweight to Energy added value. The Fund’s sector weightings are a residual outcome of the bottom-up stock selection process. Stock selection detracted particularly among Consumer Discretionary, Materials, and Information Technology stocks. Fund holdings among retailers and department stores as well as auto parts companies in the Consumer Discretionary sector struggled in the quarter. In addition, our holdings in the aerospace and defense and chemical industries lagged and contributed to underperformance.
Contributors and Detractors
The largest detractors from relative performance were holdings in the Consumer Discretionary sector, including retailers Kohl’s, Foot Locker, and Gap, which all had share-price declines of 30% in May alone. All three retailers reported disappointing first quarter results. Kohl’s revenue and same-store sales suffered in the first quarter, while Foot Locker missed profit and revenue forecasts. Other detractors included Spirit Aerosystems in the Industrials sector and Materials holding Chemours.
Top relative contributors included Group 1 Automotive, an auto retailer with operations in the U.S., U.K., and Brazil. Group 1 shares advanced nearly 30% during the period, after first quarter earnings and revenues exceeded expectations. Industrials holdings Wabash National and Cummins also contributed on a relative basis. Both companies reported strong first quarter results, exceeding expectations despite continued uncertainty surrounding tariffs, which has weighed on both stocks over the last 18 months. Asset management holdings Ameriprise Financial and Legg Mason also added value during the quarter. Legg Mason shares advanced more than 20% as activist investors reportedly pushed management for changes to help turn around the struggling investment firm.
Buys and Sells
We initiated a position in McKesson, a health care distribution company, during the second quarter. McKesson is attractive on multiple indicators of value, particularly price-to-earnings and price-to-cash flow measures, our two most important sets of indicators. The company is generating strong cash flow and while it does not pay a high dividend,McKesson is aggressively buying back shares at current prices, which we view as positive sign. Long-term past performance of the company has been poor, which is also a positive indicator in our ranking model. Both price and operating momentum are strong, as the stock price has started to improve over the last three months; our measures of operating momentum, including earnings growth and analyst revisions, are showing significant improvement.
We sold General Mills in the Consumer Staples sector during the quarter. We bought General Mills in June 2018, and the stock has done well, advancing nearly 25% since the purchase. As a result, General Mills has become less attractive from a valuation perspective. The company has become less attractive on earnings and cash flow measures in particular, as the stock price has increased over the last year. While price and operating momentum remain strong, the deterioration in the valuation score led to the sale of General Mills.
Outlook
While we do not develop an outlook or use any macroeconomic forecasts in our investment decision-making process, we can comment on the relative attractiveness of the Fund. The Fund continues to trade at attractive valuations relative to the benchmark and relative to history. The Fund is trading at 10.1 times forward earnings, compared to 17.1 times for the Russell Midcap® Value Index, as well as 6.6 times cash flow, compared to 10.0 times for the index. The Fund is yielding 3.0%, even though the Fund is underweight to traditional high-yielding sectors, including Utilities and Real Estate. The Fund’s sector weightings are a residual outcome of the bottom-up stock selection process.
While the environment for value stocks has been challenging over the last 12 to 18 months, we believe the Fund is well positioned given its valuation, combined with the strong fundamentals of our holdings. The valuation spread between growth and value stocks is as wide as we have observed since the Information Technology bubble in 1998 and 1999. As a result, we find many attractively priced stocks generating strong cash flow and earnings, which the market seems to have ignored in favor of ‘new economy’ stocks trading at lofty multiples, or expensive low-volatility stocks that are perceived to be safe havens or bond substitutes in the current low-interest-rate environment. We are confident that valuation will be rewarded eventually and we continue to adhere to our disciplined investment process, which has proven successful over our firm’s 25-year history.

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.