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Strategic Growth Fund —
Fourth Quarter Manager Commentary
2nd Quarter, 2019
"We continue to believe that future returns will benefit less from discounts to fair value and more closely correlate with our companies' abilities to compound intrinsic value. "

Market in Review
The bull market celebrated its tenth anniversary with large cap stock indexes reaching all-time highs in the second quarter of 2019, and the S&P 500 Index posting its best first-half performance (an 18.5% return) since 1997. Investor optimism was notably broad as all eleven S&P 500 Index sectors rose year-to-date with Information Technology stocks (+26%) once again leading the gains. After a dip in May as U.S.-China trade talks abruptly ended, stocks recovered in June with the help of dovish central bankers and a Trump-Xi truce to end the quarter. The benefit of plummeting interest rates more than compensated for concerns about an inverted yield curve, anemic earnings growth, and mounting evidence of a weakening global economy.
One area that has been gathering headlines is the Justice Department and FTC assigning authority over potential antitrust investigations into platform technology companies (Alphabet, Apple, Amazon and Facebook). The probe will also review current antitrust laws and enforcement measures. Our view is that free services are good for consumers, while monopolies tend to be bad for them. Technology platform companies have elements of both. This combination is vexing policy makers around the world. We recognize that antitrust scrutiny will remain an investment overhang, and we will continue to include excessive regulatory expenses for Alphabet and Facebook in all of our financial scenarios. We will update our intrinsic value calculations with any new material information.
Portfolio Performance
In the second quarter of 2019, the Harbor Strategic Growth Fund (Institutional Class) returned 6.01%, outperforming its benchmark, the Russell 1000® Growth Index, which returned 4.64%, and the S&P 500 Index, which returned 4.30%.
Positive stock selection and relative outperformance in Health Care, Industrials, Materials and Consumer Discretionary contributed to performance during the quarter, while Information Technology, Communication Services, Energy, and an overweight in cash detracted from results.
Entering 2019, our largest overweights relative to the Russell 1000® Growth Index were Financials (17% vs. 4%) and Industrials (16% vs. 12%). Our largest underweights were in the traditional growth sectors of Information Technology (19% vs. 32%), Consumer Discretionary (7% vs. 15%), Health Care (9% vs. 14%), and Communication Services (7% vs. 12%). At the end of the second quarter, the largest underweighted and overweighted sectors remained somewhat the same. Our largest overweights were Financials (16% vs. 4%) and Industrials (15% vs. 12%); however, we also ended the quarter overweight the Real Estate and Materials sectors by 300 basis points relative to their index weights. Our largest underweights continue to be in the traditional growth sectors of Information Technology (19% vs. 33%), Consumer Discretionary (7% vs. 15%), Health Care (9% vs. 13%), and Communication Services (8% vs. 12%).
Our portfolio construction process focuses on bottom-up factors independent of benchmark weights. The resulting portfolio’s sector exposures represent the areas where we are finding skewed risk-reward opportunities in serial compounders, and are not an expressed opinion on the sectors from a macro level.
Contributors and Detractors
Contributors to relative performance for the quarter included Facebook, Ecolab, Honeywell International, Markel, and Microchip Technology. Facebook reported strong first quarter earnings. The stock was oversold in the fourth quarter of 2018, and investors returned to it earlier this year as they recognized the moat that Facebook has created with its high-return-on-investment advertising platform. Ecolab, a water, hygiene, and energy technology and service company, reported stronger than expected first quarter results and announced that it was spinning off its more volatile energy businesses. Honeywell International continued to deliver strong revenue and earnings results as its new CEO, Darius Adamczyk, is very focused on the growth of the company’s business. Honeywell recently spun off two more capital-intensive businesses, resulting in higher margins for the company. No material news was disclosed for Markel, an insurance and investment holding company. Nevertheless, the stock rebounded in the quarter as investors recognized the potential value of Markel’s insurance-linked securities managers, and its equity portfolio rebounded with the more favorable stock market in the first half of the year. Microchip Technology’s stock has been volatile for the semiconductor company with the uncertainty surrounding U.S.-China trade tensions. However, within the quarter, Microchip beat earnings expectations and met revenue estimates and quarterly guidance, as the company works through excess inventory in its distribution channel.
Detractors included Core Laboratories, Alphabet, O’Reilly Automotive, Fortive, and First Republic Bank. The oversupplied energy market has resulted in lower oil prices and less demand for Core Labs’ services. The company still possesses a competitive advantage, but with the volatile pricing of oil, energy exploration has slowed down, decreasing the anticipated intrinsic value growth. Alphabet, the parent company of Google, has been caught around the rumors of antitrust regulation. In addition, for the first time in the company’s existence, quarterly revenue fell below 20%. O’Reilly Automotive had no significant news within the quarter. O’Reilly has had strong stock performance over the last few years. The pressure on the stock was likely more a result of valuation and an allocation to more cyclical areas of the market. Fortive saw a slight miss in organic growth reported in the quarter; however, the bigger reason for the negative performance was that investors allocated capital away from Fortive as the stock has significantly outperformed the indexes over the past few years. First Republic Bank’s stock declined in the second quarter after an unusually strong first quarter (+21%). A flattening yield curve and evidence of softening high-end real estate trends in California and New York dampened investor enthusiasm during the quarter.
Buys and Sells
No new positions were added to the Harbor Strategic Growth Fund (“Fund”) in the quarter.
During the quarter, we sold two small positions in the oil field services industry, Schlumberger and Core Laboratories. Oil supply has proven to be more resilient than we expected despite an approximate 40% reduction in exploration and production investment. The oversupplied energy market has resulted in lower oil prices and less demand for Schlumberger and Core Labs’ services. With less energy exploration, Schlumberger and Core Labs are compounding intrinsic value more slowly than we anticipated. Both companies still possess economic moats and are operated by proven capital allocators, but their ranges of outcomes are wide and their ability to grow shareholder value is directly correlated to the volatile price of oil. Because of our substantially lower expectations for growth and declining estimates of fair value, we eliminated our positions in both businesses.
Outlook
The Fund’s average discount to intrinsic value (3%) declined to the smallest margin of safety in the history of our strategy. This compares to a near 20% margin of safety after the correction experienced at the end of 2018. We continue to believe that future returns will benefit less from discounts to fair value and more closely correlate with our companies’ abilities to compound intrinsic value. Cash levels are above historical ranges as we continue to reduce exposure to businesses that trade above our fair value estimates while, at the same time, remain prudent in redeploying the capital only into opportunities that fit our criteria. As always, we will remain diligent, conservative and patient as we deploy capital in our wide-moat universe.

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.