"We believe the secular growth opportunities and industry-leading positions of many companies held in the Harbor Capital Appreciation Fund will lead to strong long-term performance."- Jennison Associates LLC
Market in Review
U.S. equities markets remained volatile in the third quarter of 2019, unsettled again by trade discord. At the end of June, investors appeared relieved that no additional tariff increases had been announced or implemented. The respite was short-lived, however, as the lack of tangible progress in U.S.-China negotiations, followed by new threats and escalating rhetoric, rekindled worries. Despite the trade tension and uncertainty, U.S. markets managed modest gains during the quarter.
Industrial, agricultural, and transportation activity, adversely affected by already implemented tariffs, deteriorated increasingly over the summer. On second-quarter earnings calls, companies across almost every sector cited trade tensions as the cause of growing caution and uncertainty. Declining interest rates once again led to an inversion of the yield curve. At its September meeting, the Federal Reserve eased monetary conditions for the second time this year, reducing the federal funds rate by 25 basis points, to 1.75% to 2.00%. Consensus projections of U.S. Gross Domestic Product ("GDP") growth – of 1.5% to 2.0% for the year – were essentially unchanged.
U.S. economic activity was largely stable during the quarter. The tight labor market showed signs of moderating from its strongest job growth earlier in the year. Modest wage gains and positive consumption indicated a still-healthy consumer heading into the important year end holiday season, although consumer confidence showed signs of weakening. Economic growth in Europe softened. The United Kingdom’s ongoing Brexit negotiations saw little headway toward resolution, as the putative October 31 deadline for leaving the European Union drew near. Germany, Europe’s largest economy, stood on the brink of recession. China’s GDP grew close to the country’s 6% target but not without months of stimulative measures designed to mitigate the impact of the trade war with the U.S. unrest in Hong Kong remained an issue, and concerns about the form and force of possible intervention grew.
In the third quarter of 2019, the Harbor Capital Appreciation Fund (Institutional Class) returned -2.12%, underperforming its benchmark, the Russell 1000® Growth Index, which returned 1.49%. The S&P 500 Index rose 1.70%. In the growth index, smaller sectors Real Estate, Consumer Staples, and Materials posted the biggest gains. Among the growth benchmark’s major sectors, only Information Technology and Industrials outperformed the overall index; Energy, Health Care, and Consumer Discretionary declined.
Information Technology, Communication Services, Health Care, and Consumer Discretionary positions detracted from absolute and relative Fund returns. Holdings in Health Care, Communication Services, Information Technology, and Consumer Discretionary – the Fund’s heaviest-weighted sectors – lost ground. Fund gains were biggest in Consumer Staples, Real Estate, and Financials. Financials and Consumer Staples holdings contributed to positive absolute and relative performance.
Contributors and Detractors
Contributors to performance during the third quarter included Costco, Estée Lauder, S&P Global, Apple, Alphabet, Nike, and Edwards Lifesciences. Costco’s consistent membership fee income allows for low prices and broad product selection, which lead to high inventory turnover. Estée Lauder has enhanced its strong brand portfolio in the fast-growing luxury beauty care market with complementary acquisitions and subsequent brand development. S&P Global is benefiting from debt market development abroad, disintermediation of securities markets, and passive investing. Apple’s fundamental strength reflects the proliferation of the iOS platform across the global mobile phone, tablet, and personal device landscape. The stock has been rising in anticipation of a new product cycle that incorporates 5G wireless standards. Alphabet continues to grow revenue through monetization of its globally dominant platforms through enhanced advertising solutions, and growth is coming from an enterprise cloud solutions suite. Nike’s product innovation, use of social media, and business digitization initiatives are further strengthening the brand. Edwards Lifesciences’ strength reflects continued innovation, expanding indications, and a growing portfolio of technologies to treat a variety of heart valve diseases.
Detractors included Workday, Adobe, Square, Adyen, Netflix, Amazon.com, and Illumina. “Software as a service” (SAAS) holdings Workday and Adobe lost ground even though their fundamentals remain compelling, in our view, and their financial results have continued to surpass estimates. Square fell on disappointing financial results. Adyen declined despite strong business trends. Square and Adyen offer innovative, low-cost, secure, easy-to-use commerce solutions, especially for mobile and online transactions. Netflix continues to enhance its long-term competitive position with the industry’s largest investment in exclusive and original content. We attribute a downturn in subscriber metrics to the seasonal weakness of the second quarter, the effect of the company’s highest-ever price increase in the first quarter, and a content slate lacking in popular new titles. Amazon.com’s stock fell as operating profit came in below forecasts, reflecting the aggressive rollout of 1-day shipping. The company continues to benefit from economies of scale and its platform-based business model. The AWS web services business is an additional driver of revenue and profit for Amazon. A delay in population sequencing studies weighed on Illumina. We believe the company’s growth should continue to be driven by building demand for its next-generation gene-sequencing technology and new end markets.
Buys and Sells
A position was initiated in Adidas, the world’s second-largest company in the growing sporting goods industry, with leading market share in Europe and the number two position in the U.S. and China. The company is experiencing strong, renewed brand momentum, especially in highly profitable China. We believe Adidas is approaching an inflection point in momentum as supply constraints fade and product tailwinds build. We expect the e-commerce channel to drive structurally higher profitability and accelerating market share gains. Margins should continue to benefit from centralization of the business model, cost and process rationalization, and technology systems upgrades.
The position in Alexion Pharmaceuticals was eliminated on concerns about patent expirations, and to deploy funds to more attractive investment opportunities
We are not forecasting a U.S. recession. However, the trade war has already claimed casualties in industries most directly exposed to existing tariffs. Without clarity or a new agreement with China, we believe that the fallout from trade restraints already implemented will increasingly weigh on business confidence and consumer spending, as moves are taken to mitigate and pass on the increased costs of doing business. With this uncertainty, business planning and investing are likely to be hampered, with delays and hesitancy in spending probable. The U.S. political landscape is likewise unsettled and apt to weigh on confidence and activity, in our view, as impeachment proceedings against President Trump begin and the 2020 election cycle ramps up. The most powerful offset to these headwinds is the health of the U.S. consumer. Employment remains strong, and incremental wage gains continue.
As always, we are focused on the growth outlook for companies held in the Fund. Driven by powerful secular trends, the growing revenue streams of fund companies in industries such as e-commerce, software as a service, and payments should be durable against the uncertain backdrop. We believe the Fund’s earnings growth could remain above market average for the balance of this year and next. Dramatic short-term moves in the market, driven by the significant uncertainty in the macroeconomic environment, are leading to material near-term valuation swings. With Fund share prices essentially flat over the past 12 months, Fund absolute and relative valuations are more modest today than they were a year ago. We believe the secular growth opportunities and industry-leading positions of many companies held in the Fund will lead to strong long-term performance.
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.