News & Commentary

View all Commentary headlines

Small Cap Value Opportunities Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"In our view, excess returns will likely come to those investors who are best able to carefully navigate between the 'news' and the 'noise,' selecting stocks with a disciplined process that identifies companies with overlooked return potential. "

Economic Overview
The broad, global surge in equity prices during the first quarter of 2019 brought most markets almost back to their September 30, 2018 levels, as the S&P 500’s best January performance since 1987 followed the index’s worst December since 1931. In our view, the reasons for the first quarter turnaround were clear, positive fundamental surprises. The U.S. Federal Reserve (Fed) moved from decidedly hawkish, or seeking rate hikes, in December to dovish in January. During the first quarter, government bond rates declined and credit spreads narrowed, making equities more attractive on a relative basis. A positive resolution of U.S. trade talks with China began to look likely. U.S. corporate earnings were strong, and oil prices surged. Investor sentiment briefly soured in March as the yield curve inverted (the U.S. 10-year Treasury rate fell below the three-month rate), which has historically been a lead indicator of a recession.
Though we are not narrowly focused Fed watchers, this change in monetary policy demands consideration. Six weeks after raising the federal funds rate and signaling at least three more rate hikes in 2019, the Fed announced a pause in rate hikes. In our view, this was big. Investor sentiment shifted toward a mindset that economic and credit cycles would be extended. Educated interpreters suggested that the shift was driven by a number of possibilities, including the appointment of the historically dovish Richard Clarida as Fed Vice Chairman, new data showing that inflation had stopped rising toward the Fed’s 2% target, President Trump’s efforts to influence the Fed, and concerns over trade talks and slowing growth in Europe, China, and Japan.
Portfolio Review
In the first quarter of 2019, the Harbor Small Cap Value Opportunities Fund (Institutional Class) returned 17.79%, outperforming its benchmark, the Russell 2000® Value Index, which returned 11.93%.
Market conditions during the first quarter were favorable for our investment approach. Stock selection was the primary contributor to relative performance, particularly within the Information Technology sector. Stock choices in Financials and Industrials also added value. Conversely, stock selection in the Consumer Discretionary sector detracted. To a lesser extent, Communication Services and Materials also weighed on relative returns. Overall, sector allocation detracted, driven largely by an underweight to Information Technology, the benchmark’s strongest-performing sector. All sector weights are a byproduct of our bottom-up stock selection process and are not tactical allocation decisions.
The largest individual contributors for the first quarter included Diebold Nixdorf, which continued a margin recovery trend that started in the third quarter of 2018. Share prices rose as the company reported better-than-expected fourth quarter operating profits, riding on the back of improved services margins and better-than-expected revenues. During the earnings call, management provided guidance for expanding long term margin expectations for 2021, improving profitability for 2019, and reducing the company’s debt level. In our view, the company’s new management and cost savings program is likely to improve operating performance, reduce leverage, and refinance expensive debt, driving Diebold’s stock price.
Syneos Health shares also bolstered relative returns, despite trading down twice in February 2019 – first on disappointing results from a competitor, and then when a Securities and Exchange Commission (SEC) investigation of Syneos’ revenue-recognition policies pushed back the company’s earnings call. We meaningfully added to our position, believing that the competitor was impacted by several company-specific issues, and that the reaction to the SEC notification was too severe. Indeed, by the end of the first quarter, Syneos shares had recovered most of the prior weeks’ decline. The accounting issue was deemed not material, and during the delayed earnings conference call, Syneos provided solid guidance for 2019.
A position in Stericycle also had a positive impact. Shares advanced, in our view, in response to a change in the company’s top management, together with an associated reset in profit expectations. As part of its fourth quarter 2018 earnings call, Stericycle announced a new CEO. The company is also replacing its CFO. The CEO designee has also recruited new people for the company’s second tier of leadership. Additionally, management reset profit guidance for 2019, lowering from previous expectations due to heavy expenditures from enterprise resource planning (ERP) implementation and business transformation initiatives. We believe in the underlying strength of Stericycle’s business, especially its medical waste hauling segment. We also believe Stericycle’s profitability is likely to improve in the coming years, on the back of the ERP implementation and business transformation initiatives.
Conversely, Ascena Retail Group – a national specialty apparel retailer for women and home to brands such as Ann Taylor, Dressbarn, Lane Bryant, and Justice – was one of the largest detractors during the first quarter. Shares declined sharply as the company announced weaker-than-expected performance at Lane Bryant and Justice, as well as bleak guidance. The company has been going through a major turnaround to reduce its cost structure and be more responsive to its customer base, and we believe management is not getting enough credit for the improvements they have delivered. The company announced plans to sell a 50% interest in Maurices and use the proceeds to reduce debt, and media reports suggested that Ascena is also trying to sell Dressbarn. We welcome management’s decision to divest the value segment and focus on the healthier parts of their portfolio. We believe that the intrinsic value of Ascena’s premium and kids segments, along with Cacique (part of the plus segment), is far greater than the current enterprise value.
MEDNAX, a new position during the first quarter, also detracted. The company has been under pressure from a variety of factors, including a shift toward lower rate reimbursement from the company’s anesthesiology payor mix. A decline in the number of births at MEDNAX-covered hospitals has further pressured margins in the neonatology business, and a lost anesthesiology contract in mid-2018 will continue to have an impact in 2019. Despite these headwinds, we believe MEDNAX retains a strong position in neonatology and anesthesiology while building out a radiology franchise. The company has a solid balance sheet and a long history of generating free cash flows, which we view as underappreciated.
Natus Medical also weighed on returns, after the company provided initial sales and earnings guidance for 2019 that was well below expectations. We believe that under a fairly new CEO, management is taking action to improve profitability, including pruning several smaller product lines and exiting several others that were expected to be unprofitable. While these changes are likely to result in lower sales going forward, management is also changing its management structure and consolidating its facilities, which we believe will likely result in meaningful cost reductions and margin improvement. In our view, while Natus has operational issues, management is being proactive in rectifying them, and the company remains the leader in most of its key markets.
One position we eliminated during the first quarter was EVERTEC, as the company’s stock price approached our target price.
Much of the fear, doubt, and uncertainty that weighed upon investors in late 2018 appears to have dissipated, at least temporarily. While macro factors and projections are not a major part of our process, we care a lot about achieving a clear perspective when the potential for significant economic change becomes likely. Each company we follow has an idiosyncratic sensitivity to the economy, which we factor into our bottom-up estimates and valuations. While we are currently cautious about a potential slowdown, we are not bearish on the economy. A big part of our strategy, especially in the fourth quarter of 2018, has been to increase positions of holdings that have fallen in price. While many are pointing to the inverted yield curve as a strong indicator of an upcoming recession, we do not believe that U.S. monetary policy is restrictive enough to induce a recession. We believe that the inversion has more to do with the state of overseas markets than what is occurring in the U.S. Our intensive, bottom-up research, which includes detailed discussions with corporate managers, suggests that the economic environment is moderating rather than spiraling towards a recession.
We value businesses on a forward looking fundamental basis and seek to own above-average to high quality companies when market prices are below the investors’ estimate of intrinsic value. In our view, excess returns will likely come to those investors who are best able to carefully navigate between the “news” and the “noise,” selecting stocks with a disciplined process that identifies companies with overlooked return potential. We delivered good performance in the first quarter; however, complacency is a quality that we as a team perpetually avoid. That said, we are optimistic about the portfolio the Fund owns at this time, as we believe that the quality value relationship within equity markets has become more rational over the past several months.

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

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.