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Small Cap Value Opportunities Fund —
Fourth Quarter Manager Commentary
2nd Quarter, 2019
"We believe our time tested, bottom-up investment process, focusing on sound businesses that are selling below their intrinsic value due to transient factors, could enable us to weather a variety of economic outcomes over the medium term. "

Market in Review
Fixed income markets are signaling an onslaught of a recession, while the S&P 500 Index is implying smooth sailing ahead. In the past year, the 10-year U.S. Treasury Bond yield has fallen approximately 80 basis points. Long-term interest rates, at approximately 2.0% at the end of the second quarter of 2019, were lower than short-term interest rates (2.25% to 2.5%), and money market investors were discounting a 50- to 75-basis-point reduction in official rates before year end. Normally, these types of developments are associated with a substantial contraction in economic activity. Meanwhile, the S&P 500 touched new highs in late June. Resolving this puzzling contradiction between the bond and equity markets is difficult.
By the end of the quarter, the news and investor behavior had shifted more toward normalization, to which we have underwritten the Harbor Small Cap Value Opportunities Fund’s ("Fund") strategic positioning. The U.S. and China reached a trade truce at the G-20 Summit, and the Organization of the Petroleum Exporting Countries (OPEC) announced continuing production cuts for six to nine more months, in an effort to firm up oil prices. The last week of June saw some large equity price moves to the upside. Despite the trade-related weakness in May, the S&P 500 advanced more than 4% for the quarter; however, more than one-third of index constituents generated negative quarterly returns. Within the Russell 2000® Value Index, the Energy, Consumer Staples and Communication Services sectors were the largest laggards during the quarter. Industrials, Utilities and Financials were the strongest performers.
Portfolio Performance
In the second quarter of 2019, the Harbor Small Cap Value Opportunities Fund (Institutional Class) returned -2.16%, underperforming its benchmark, the Russell 2000® Value Index, which returned 1.37%.
From a relative perspective, stock selection was the primary detractor. More specifically, compared with the index, security selection in the Consumer Discretionary, Energy, and Information Technology sectors subtracted value. An overweight in Consumer Discretionary further hindered relative performance. Meanwhile, stock selection and an overweight in Industrials enhanced relative returns.
Contributors and Detractors
The three largest individual detractors during the quarter were Ascena Retail Group, Diebold Nixdorf, and Forum Energy Technologies. Ascena declined on news of weak guidance and a challenging environment for apparel retailers. Despite better-than-expected results, Diebold’s stock price declined. We believe the stock sold off because management did not raise guidance for the company. Forum’s stock price declined after oil prices plunged during the quarter.
The three largest individual contributors during the quarter were Kar Auction Services, e.l.f. Beauty, and Beacon Roofing Supply. Solid earnings results drove near-term performance for each.
Buys and Sells
We initiated a position in Gates Industrial. Headquartered in Denver, Colorado, Gates manufactures and sells engineered power transmission and fluid power solutions worldwide. Gates operated as a family business (Gates Rubber) for 85 years. In 1996, Tomkins acquired Gates and in 2010, the company was taken private. Gates was then sold to Blackstone in 2014, and made public again in early 2018. As of March 31, 2019, the company generated annual revenue of $3.3 billion. We identified several sustainable business model characteristics for Gates, including high return on investment capital and low fixed costs, market share in both power transmission and fluid power products at or near the top of the industry, significant ownership by Blackstone—which, in our view, provides oversight of and discipline to management—and extensive distribution relationships with approximately 9,000 partners. We also identified numerous value drivers for the company. We believe Gates can utilize free cash flow to reduce leverage, that capital expenditures are likely to decline once the company completes its new facilities in Poland and Mexico, and what we view as a likely normalization of revenues over the next three to five years. Meanwhile, we sold Oasis Petroleum in favor of what we view as better risk/reward opportunities.
Outlook
Financial conditions have eased substantially since the turn of the year. In our view, U.S. Federal Reserve policy makers have clearly signaled that a drop in their policy rate is imminent, most likely in the July Federal Open Market Committee (FOMC) meeting. We believe this expectation has lowered the cost of capital in the bond and equity markets, reduced risk premiums for corporate borrowers, and prompted banks to ease lending conditions. In our view, the stimulative effects of these developments have been partially offset by a transitory increase in geopolitical tension, due to the China-U.S. trade war and the potential of an actual war with Iran. We believe that in the absence of an exogenous shock, investors are likely to remain in “risk-on” mode until the Fed takes away the proverbial “punch bowl.”
Navigating the current economic and financial environment is challenging, in our view. The next recession will most likely catch many investors off guard, giving them little time to shift their asset allocation. Our comparative advantage is not in the precise identification of macroeconomic inflection points. Rather, we believe our time tested, bottom-up investment process, focusing on sound businesses that are selling below their intrinsic value due to transient factors, could enable us to weather a variety of economic outcomes over the medium term. As fundamental value investors with an absolute return mindset, we resist paying euphoric prices for perceived “pristine quality” businesses, and instead embrace solid businesses that could be going through temporary challenges.

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.