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Strategic Growth Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"The pause in central bankers' tightening of interest rates helped equity valuations expand, propelling the best quarterly start to a year for equities in almost three decades. "

Economic Overview
A sharp reversal in the Federal Reserve’s hawkish interest rate policy and optimism on U.S.-China trade relations fueled a stock rally in the first quarter of 2019, with economically sensitive businesses outperforming those with less cyclicality. The pause in central bankers’ tightening of interest rates helped equity valuations expand, propelling the best quarterly start to a year for equities in almost three decades. Major market indices recouped almost all of the losses suffered in the final months of 2018, with the S&P 500 Index gaining 13.65%. Asset price appreciation was broad based, with all eleven S&P 500 sectors ending higher for the first time since 2014.
Portfolio Review
In the first quarter of 2019, the Harbor Strategic Growth Fund (Institutional Class) returned 14.69%, underperforming its benchmark, the Russell 1000® Growth Index, which returned 16.10%.
In the first quarter, the equity market returned to an environment similar to what we saw before the fourth quarter of 2018, with the majority of returns coming from Information Technology, Communication Services, and Consumer Discretionary. Although we do own businesses in each of these sectors, the risk-reward dynamic does not warrant an exposure to these businesses equivalent to that of the growth benchmarks, in our view. ?
The Fund’s cash position, its stock selection and overweight in Financials, and its underweight in Information Technology detracted from relative sector performance. Health Care, Real Estate, Industrials, and Energy were the top sector contributors on a relative basis as Fund holdings outperformed their benchmark counterparts in each of these sectors.
Contributors to relative performance in the quarter included American Tower, Intuit, Roper Technologies, TransDigm Group, and Moody’s.
American Tower’s scale and geographic diversity provides broad exposure to accelerating wireless infrastructure investments, from 3G in developing markets to 5G in the United States. Concerns over a slowing global economy and the precipitous drop in the U.S. 10 Year Treasury to 2.4% helped push up the valuations for acyclical, long duration assets like American Tower. Speculation that Sprint and T-Mobile’s merger would not be approved also helped drive the company’s stock gains.
Intuit is transforming into a platform company with the One Intuit ecosystem that connects accountants, small businesses, and tax providers with the tools they need to operate their businesses. These tools include tax software, with TurboTax for consumers, professional software tools for accountants, as well as Enterprise Resource Planning solutions, such as QuickBooks Online for small businesses. Intuit shifted its business model to a cloud- and mobile-first strategy, which expanded its market opportunity, leading to increased customer adoption in the U.S. and opportunities for the traditionally domestic focused business to expand internationally.
Mini industrial conglomerate Roper Technologies has continued to execute well in acquiring and integrating asset-light businesses into its four different business segments. For the fourth quarter of 2018, all four of Roper’s segments reported near 30% operating margins, exceeding the company’s own revenue and earnings estimates as well as those of Wall Street analysts. Organic top-line growth of 9% and 12% EBITDA (earnings before interest, tax, depreciation, and amortization) growth outperformed already bullish expectations.
TransDigm Group, an aviation electrical and mechanical components supplier, was up significantly in the first quarter after surpassing earnings and revenues estimates as well as raising guidance for the upcoming fiscal year. In addition to the company’s strong execution, its acquisition of Esterline is expected to close before the end of the fiscal year, which we believe should further boost revenue and profits.
Credit rating and analytics company Moody’s saw its stock rebound in the first quarter as global debt issuance recovered after a moribund fourth quarter and as concerns about an overly hawkish Fed subsided.
Detractors from relative performance in the quarter included XPO Logistics, Markel, Berkshire Hathaway, Sensata Technologies, and Unilever.
Three primary events caused a sharp decrease in the stock price of XPO Logistics in the past several months. First, during the fourth quarter of 2018, XPO lowered its 2019 EBITDA growth forecast from 15%-18% to 12%-15%, reflecting concerns over a slowing global economy, especially for shipping companies that are bellwethers for the health of the economic cycle. Next, a hedge fund focused on short selling released a scathing report accusing XPO of dubious accounting practices, underreporting of bad debts, phantom income through M&A earn-outs, and aggressive amortization assumptions. Most of these accusations have either been refuted by the company and the sell-side, are inaccurate in the report itself, or have been adjudicated in prior years. Finally, XPO’s loss of its largest customer in mid-December led to another reduction in sales growth and EBITDA guidance. We sold the position in the first quarter.
In 2018, the insurance industry endured the second year in a row of large catastrophe losses, mostly occurring during the fourth quarter. Markel was not immune to the material claims, as its insurance business reported $100 million in losses. At the same time, Markel’s other key driver of value, its equity portfolio, which accounts for 65% of its book value, declined in double digits along with the rest of the stock market in the fourth quarter. As a result, reported book value for that quarter declined 7% compared to the prior quarter.
Similar to Markel, Berkshire Hathaway suffered large catastrophe losses that affected its stock in the first quarter. In addition, the effects of a declining stock market on Berkshire’s investments in Apple and Kraft Heinz in the fourth quarter of 2018 pressured Berkshire’s book value.
For Sensata Technologies, exposure to weakening Chinese and European auto markets caused investors to sell shares in the quarter. The global auto markets are expected to decline 1%-2%, while the Chinese auto market decline is expected to be more than double this amount. With 60% of its revenue in automotive-related products, Sensata is in the direct line of fire of these weakening trends.
There was nothing specific to Unilever in the quarter that led to its relative underperformance. The slowdown in Latin America had a slight drag on the company’s bottom line, but Consumer Staples companies lagged the momentum market in general.
During the quarter, we added Booking Holdings, the world’s leading online accommodation reservation platform. The company has built an economic moat around the industry’s largest network of hotel properties and other services. The online travel agency (OTA) model is a two-sided network that efficiently connects supply and demand. As more hotels and unique accommodations join the platform, more travelers shift their offline purchasing online. The OTA market is a duopoly controlled by Booking Holdings and Expedia. These two companies individually control over 30% of the market, which makes it difficult for new competitors to gain customer traffic or supplier scale.
Booking’s travel platform has achieved a dominant position outside the United States. The company’s international markets represent 80% of intrinsic value. In Europe, independent hotels represent 65% of rooms available versus 30% in the United States. This is an important distinction because independent hotel operators lack the financial and marketing capabilities to acquire customers directly. These shortcomings encourage heavy reliance on OTA platforms for property demand. As the European leader, Booking Holdings profits from the marketing needs of independent hotel operators.
We expect Booking Holdings to compound intrinsic value by low double-digit rates over our investment horizon. The company’s network effect should drive healthy growth in both developed and emerging markets, in our view, as the platform expands its presence in vacation rentals and restaurant bookings. With the OTA market still growing at double-digit rates, Booking only needs to maintain industry leading market share to deliver attractive investment returns.
Under the leadership of Chairman Jeff Boyd and CEO Glenn Fogel, shareholders have meaningfully benefited from their capital allocation decisions. Their stewardship has transformed Booking Holdings into one of the most capital-efficient companies in the world. We anticipate that the company will likely continue to make opportunistic investments and return Booking’s 6% cash flow yield to shareholders via share repurchases. We used the stock price decline to invest in Booking Holdings at a multi-year low valuation.
We sold our investment in Mondelez International after the stock price exceeded our estimate of intrinsic value. Over the past six years, Mondelez has been an above average serial compounder despite secular challenges in the food and beverage industries. The company’s intelligent capital allocation toward developing its brands in faster-growing emerging markets created significant shareholder value over our investment tenure. We look forward to partnering with Mondelez in the future if its stock price and intrinsic value disconnect.
The strong equity market appreciation in the quarter decreased the average discount to intrinsic value of the Fund’s holdings to 5%, by our estimates, from 20% at the end of 2018. This is lower than the typical discount we receive when investing in new companies. As a result, we anticipate that future returns should closely correlate with our companies’ abilities to compound their intrinsic values. Our focus on owning compounding business models is well suited for turbulent times. We will continue to allocate capital to these competitively advantaged businesses when they trade below our estimates of intrinsic value.

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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.