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Small Cap Growth Opportunities Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"We continue to believe that stock prices will ultimately reflect the fundamental performance of the underlying businesses, and market behavior over the short-term generally tends to be technical in nature, rather than fundamental. "

Economic Overview
U.S. equities started 2019 with a powerful rally that surprised many of the market’s participants. Since the end of last year, investors’ economic concerns receded dramatically, and sentiment improved significantly. With favorable domestic macroeconomic data, stock prices in the first quarter of 2019 regained much of the ground that they lost in the fourth quarter of 2018. Additionally, sentiment regarding a trade deal with China improved, and as optimism on that issue gained traction, fears over a trade-induced global slowdown faded.
Investors received a bit of jolt in early January when Apple released preliminary revenues for the December quarter that came in significantly below expectations. However, other corporate earnings reports were generally more favorable, and investors’ concerns were broadly assuaged during reporting season. Since most companies are on a calendar year cycle and year-end financials take longer to finalize, fourth-quarter earnings reports stretched into early March, with the majority of our small-cap holdings reporting results in February.
On monetary policy, the Federal Reserve (the Fed) signaled a pause and lowered expectations for future potential interest rate increases. Market pundits broadly interpreted the Fed’s stance as dovish. A component of investors’ concerns last quarter was that the Fed would continue to raise interest rates into softening economic conditions, making a policy mistake that would thereby exacerbate weakening conditions. Between domestic data and improving sentiment over global trade, investors’ concerns about a monetary policy mistake waned, and that change contributed to rising equity prices.
Global economic concerns did reappear late in the quarter as some European data, especially in Germany, disappointed investors and renewed anxiousness regarding slowing economic growth. Domestically, the yield curve inverted early in the year, and this phenomenon became more pronounced in March. Stocks posted mixed results in March, with large-cap stocks producing a positive month while small-cap stocks retraced some of their earlier gains during the final month of the quarter.
Portfolio Review
In the first quarter of 2019, the Harbor Small Cap Growth Opportunities Fund (Institutional Class) returned 14.94%, underperforming its benchmark, the Russell 2000® Growth Index, which returned 17.14%.
Relative weakness in Consumer Discretionary, Financials, Industrials, and Information Technology outweighed relative strength in Communication Services and Consumer Staples. On a sector basis, the Fund’s holdings underperformed their benchmark counterparts in seven of the nine sectors in which the Fund was invested, resulting in negative stock selection effects overall. Sector allocation effects contributed to relative performance, due in large part to an overweight position in Information Technology—the best performing sector in the index during the period. The Fund’s sector weightings are purely a residual outcome of the bottom-up stock selection process.
Evolent Health, a leading provider of health solutions to hospitals and health systems, was a top detractor from relative performance during the period, primarily because investors became concerned about one of the company’s larger clients. We believe investors have overstated the magnitude of the company’s exposure to this client, and, further, recent regulatory developments for that client have been favorable. Additionally, we believe Evolent Health’s new business wins and recent acquisition bode well for the company’s growth prospects. Finally, we believe the company’s core value proposition of helping hospitals and health systems control costs could drive strong revenue and margin growth. We continue to own our position in these shares.
Integrated satellite manufacturer and service provider Maxar Technologies was also weak during the period, as one of the company’s reconnaissance satellites failed. The company will receive insurance proceeds for the loss, and we believe that, with its other satellites, Maxar Technologies could be able to recover roughly 10%-15% of the failed satellite’s revenues. New satellites are currently under construction, with deployment scheduled in the 2020/2021 timeframe. While the failed satellite was certainly disappointing news, the rest of the business is growing, and we believe operating cost reduction programs could result in margin expansion this year. We modestly added to this position on the price weakness.
Quotient Technology, the leading digital coupon company for grocery and retail stores, was another detractor during the quarter. The shares fell in value when fourth-quarter results missed expectations. Given the market turmoil and economic concerns last quarter, one of the company’s larger customers reduced spending. Digital budgets are more readily adjusted than print spending, due to the longer lead times for print. Quotient Technology retains its leading position, and we believe this customer’s decision does not alter the growth opportunities for the market as digital coupons have continued to grow, while print coupons have shrunk. Further, Quotient Technology’s media and data businesses are growing rapidly, and we believe that investors do not fully appreciate the significance of these segments to the company’s market position and growth prospects. We added to this position on the price weakness.
In contrast, genetic therapy company Spark Therapeutics benefited relative results during the quarter, initially from solid performance from the company’s sales of Luxturna, the only approved therapy for inherited retinal disease. What subsequently drove the company’s strong share price performance was Roche Holding’s acquisition of the company at a substantial premium, and we completely exited this position on that news into the end of the quarter.
Invacare, a manufacturer and distributor of medical equipment, also contributed to relative performance during the quarter, as the company reported better revenues and earnings than anticipated. We wrote about this stock last quarter as a laggard, and our patience was rewarded with these results. We continue to believe the company’s manufacturing recovery could drive continued revenue growth.
MaxLinear, a communications semiconductor company, benefited relative performance, as the company reported results that were better-than-expectations. As we discussed in several letters last year, we believe the stock had underperformed because investors had overestimated the impact of the company’s business exposure in China. Recent results confirmed our fundamental view and rewarded our patience. We believe revenues could benefit from continued and growing demand for data infrastructure in wireless backhaul and 5G applications since MaxLinear’s products, in our view, are well positioned in those markets. We trimmed this position into price appreciation toward the end of the quarter.
During the period, we initiated a position in Acadia Healthcare, although it is too early for it to have had a meaningful impact on the Fund. The Fund’s sector weightings did not dramatically change during the quarter, with a majority of the Fund’s portfolio invested in the following four sectors: Health Care, Information Technology, Industrials and Consumer Discretionary, which represent a majority of the growth in the Russell 2000® Growth Index. We had no exposure to the index’s non-growth Real Estate and Materials sectors.
Clearly, the market recovery is encouraging, and sentiment has distinctly improved from the dismal levels seen during the fourth quarter of last year. Yet, there seems to be some fragility to investor confidence despite the recent lift in stock prices. In some ways, it is almost like investors are unsure if the market’s sell-off last year was based on fundamental or technical conditions. As a result, when investors’ concerns reappeared in March, the market became relatively narrow in the face of some uncertainty surrounding global economic growth and domestic data, like the inverted yield curve.
Our longstanding investment style and process remains the same, and, over time, we have found that volatility presents opportunities for our process. We continue to believe that stock prices will ultimately reflect the fundamental performance of the underlying businesses, and market behavior over the short term generally tends to be technical in nature, rather than fundamental. Our belief is that the change in investor sentiment could be a broadly positive event for the equity markets, and we believe that the recent narrow market could broaden to reward more stocks and sectors.

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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.