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Strategic Growth Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"Any material decline in stocks is psychologically uncomfortable, but the lower prices provide opportunities for both higher expected returns and less risk. "

Economic Overview
During the fourth quarter of 2018, equities experienced their second correction in 12 months. The rolling bear market significantly affected Information Technology stocks, emerging markets and energy prices amid fears that the U.S.-China trade war and rising interest rates will cripple corporate earnings. There were few places to hide during the quarter. Energy and Information Technology registered their worst quarterly declines since the start of the bull market. Many of the market’s dearly valued and fast-growing companies experienced double-digit stock price declines, despite reporting healthy earnings results. For the first time in years, risk aversion seemed to be creeping into stock prices, and the quarter marked a notable transition to elevated volatility.
Portfolio Review
In the fourth quarter of 2018, the Harbor Strategic Growth Fund (Institutional Class) returned -13.41%, outperforming its benchmark, the Russell 1000® Growth Index, which returned -15.89%.
During the quarter, our cash position contributed to relative performance, as did Information Technology, due to stock selection and an underweight position. Real Estate also benefited relative results, due to security selection and an overweight position. In Financials, an overweight position and stock selection supported relative performance. Conversely, security selection in Industrials and Energy detracted from relative results. The Fund’s sector weightings are a residual outcome of the bottom up stock selection process.
In Real Estate, American Tower Corporation appreciated during the quarter as wireless data consumption further increased the need for denser networks around the globe. The company’s scale and geographic diversity provide broad exposure to accelerating wireless infrastructure investments, from 3G in developing markets to 5G in the U.S.
Consumer Discretionary holding O’Reilly Automotive, Inc., benefited relative results as its shares declined just slightly during the quarter. The company rebounded strongly during the past 12 months after the perceived threat of hurt the stock in 2017. We believe O’Reilly Automotive is being viewed as having an advantage over and its peers in fast delivery to professional repair shops and is better positioned to benefit from the increasing number of vehicles from six to 10 years old.
PepsiCo, Inc., in Consumer Staples, contributed to relative performance and has continued to perform in line with our investment thesis. In broad market corrections, less economically sensitive businesses tend to hold up better than other companies, which PepsiCo did during the quarter. As a global leader in beverages and snacks, the company owns a diverse portfolio of consumer products with broad geographic exposure.
Detractors from relative performance in Industrials included XPO Logistics, Inc. We believe two primary events led to the sharp decrease in XPO’s stock price during the quarter: 1) XPO lowered its 2019 growth forecast to reflect concerns over a slowing global economy, especially as pertains to shipping companies, which are bellwethers for the health of the economic cycle, and 2) A hedge fund focused on short selling released a scathing report accusing XPO of dubious accounting practices, underreporting of bad debts, phantom income and aggressive amortization assumptions. Most of the accusations have been refuted by the company, are inaccurate in the report itself or were adjudicated in prior years. Although we believe XPO’s barriers to competition and long-term intrinsic growth remain intact, the company’s recent guidance reduction came shortly after meeting with us in our offices and reaffirming the higher range, which created uncertainty with the company’s fundamental performance and messaging to its shareholder base.
In Information Technology, Apple, Inc., preannounced negative earnings revisions, confirming investor fears that iPhone sales were not meeting expectations. The source of the shortfall was pinned on a tougher macroeconomic environment in emerging markets, particularly in China, and replacement cycles getting longer in developed markets. We believe the market is underestimating the strength of Apple’s brand and its ability to monetize its installed base. Therefore, we continue to maintain our investment in Apple, which we believe can grow intrinsic value over our investment horizon.
Consumer Discretionary holding, Inc., hindered relative results. The company’s investment narrative has been evolving from revenue growth to margin expansion. We believe this transition will slowly shift’s valuation analysis from multiples of revenue to earnings and cash flow. For the first time since 2014, the company’s quarterly revenue results recently missed market expectations for two consecutive quarters. Meanwhile, we believe’s profit growth could slow over the intermediate term due to management’s decision to increase the company’s minimum wage to $15 per hour. During the quarter, the optics of weakening profitability and slowing revenue growth pressured shares of this high-multiple stock.
During the quarter, no new positions were added to the Fund; however, we sold our minor positions in Garrett Motion, Inc., and Resideo Technologies, Inc., both spinoffs from the Fund holding Honeywell International, Inc. We liquidated the positions for failing to meet our investment criteria. Additionally, we sold our investment in Kansas City Southern after the stock price achieved our estimate of intrinsic value.
Over time, our outlook reflects two components: (1) the intrinsic value growth of businesses, and (2) the discount we are paying for those businesses relative to fair value. For the last several years, our average margin of safety was notably narrow, muting expected returns. During the fourth quarter, however, we witnessed the return of investor fear and skepticism, as well as lower stock prices. The unwinding of financial liquidity and synchronized global growth leaves the nine-year corporate profit boom in jeopardy. If corporate revenue growth continues to slow into the year ahead, we believe an earnings recession becomes a real possibility. We believe the spike in market turbulence could continue until uncertainties surrounding interest rates, global trade and corporate profits are resolved. Any material decline in stocks is psychologically uncomfortable, but the lower prices provide opportunities for both higher expected returns and less risk. With our average margin of safety widening materially, our outlook for long-term returns has improved relative to the start of 2018.
While the cloudier outlook for global trade, U.S. Federal Reserve policy, Brexit’s impact and China’s economic health creates questions around near-term growth trajectories, we believe the businesses we own, which typically have significant competitive advantages, are well suited for volatile periods. We believe we have partnered with effective stewards of capital that can exploit competitive advantages and increase long-term shareholder value growth during these challenging periods.

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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.