"Looking ahead to the fourth quarter of 2019, we believe prospects for convertible securities appear positive and could remain so for the indefinite future barring any material macro developments."- Shenkman Capital Management, Inc.
Market in Review
The financial markets weathered several disruptive events in the third quarter of 2019. Surprisingly, market volatility was relatively low, given the magnitude of the developments. Investors were forced to cope with a disappointing U.S. jobs report, a hostile political environment, the Federal Reserve (Fed) injecting emergency cash into the repurchase (repo) market, oil futures soaring following a drone attack on Saudi oil facilities, resurgent global recession fears fueled by lingering trade disputes, and sputtering manufacturing activity. Although U.S. Treasury and investment grade bonds faltered in September, high yield bonds and loans showed modest gains, reflecting the positive returns in the equity markets. The central question confronting investors is how long the U.S. economy can contend with these damaging forces without stalling the consumer-driven growth engine and slipping into a recession. A cooling U.S. economy may spur both the Fed and investors to recalibrate their outlook for the next several quarters, we believe.
Given the background of a variety of macro events balanced by the Fed continuing to reduce interest rates, the Fund was range bound during the quarter. There has been no change to our outlook as a result.
In the third quarter of 2019, the Harbor Convertible Securities Fund (Institutional Class) returned -0.83%, underperforming its benchmark, the ICE BofAML US Convertible Ex. Mandatory Index, which returned -0.03%.
The Harbor Convertible Securities Fund’s (the Fund) disparity with the benchmark can primarily be attributed to its having no exposure to banks, which on average comprise 6.15% of the benchmark and which returned 11.50%. The two primary bank constituents in the benchmark are deep out-of-the-money perpetual preferred securities of Wells Fargo and Bank of America. Stylistically, we avoid securities of this type due to their deeply subordinated nature, lack of underlying equity sensitivity, and their extreme correlation to changes in interest rates. An underweight in semiconductors also was a source of Fund underperformance. The industry, which tends to be highly sensitive to sentiment surrounding news or rumors concerning the "trade war," continues to see strong earnings. The Fund, with an average semiconductor weight of 7.83%, returned 4.76%, versus the benchmark return of 5.82% and an average weight of 11.94%. In addition, an overweight in entertainment was a negative contributor, primarily as a result of the Fund’s out of benchmark position in iQiyi, the Chinese online entertainment service. The Fund also had a negative disparity with the benchmark in communications equipment, primarily the result of having no exposure to Infinera in the highly volatile optical telecommunications space.
The Fund benefited from positive security selection in software, the largest industry in both the Fund and the benchmark, with an average weight of 15.76% and 15.64%, respectively. The Fund also benefited from positive security selection in Information Technology services and Real Estate as well as having no exposure to metals and mining and Health Care, which had benchmark returns of -16.32% and -15.92%, respectively.
The Fund, throughout the quarter and full year, has consistently maintained software and semiconductors as its two largest industries. This is consistent with the makeup of the benchmark over the same time period.
In addition, through active management, the Fund endeavors to maintain a positive risk-reward profile at all times, as noted by the relationship between the underlying investment and conversion premiums.
Contributors and Detractors
The five largest contributors to absolute Fund performance were Insulet, Microchip, Extra Space Storage, Invitation Homes (Starwood Property Trust Inc.), and Restoration Hardware. Insulet, a medical device company that manufactures an insulin infusion system, continues to benefit from increased patient usage and positive physician feedback. Microchip, a semiconductor company focused on microcontrollers, has reiterated improved earnings guidance. The company is also beginning to benefit from synergies related to its acquisition of Microsemi in 2018. Extra Space Storage, a real estate investment trust (REIT) that manages self-storage properties, has been the direct beneficiary of the lower interest rate environment. Invitation Homes, an owner and operator of single-family home rentals, continues to benefit from the macro trend of positive single-family home demand given the increasing housing needs of the millennial population. Restoration Hardware, a luxury brand in the home furnishings marketplace, has benefited from strong earnings and a continuation of common stock buybacks.
The five largest detractors from absolute performance were Exact Sciences, Zillow, iQiyi, New Relic, and Wright Medical. Exact Sciences, a life science company focused on noninvasive screening for colon cancer, has seen recent sector weakness and profit taking. Fundamentals remain strong, we believe, as the company has recently received FDA approval to extend screening for colon cancer from age 50 to 45. Zillow, an internet provider of real estate listings, has seen recent weakness despite strong second quarter results, due to concerns regarding the company’s transition from an agent-only model into a homebuying and reselling model. iQiyi, the Chinese online entertainment service, reduced guidance due to an expectation of continued content delay. We will monitor the situation closely. New Relic, a cloud-based software-as-a-service analytics company, has recently seen a slowdown in existing customer spend amid the introduction of a new product cycle. Wright Medical, a medical device company, is a provider of joint replacement products for shoulders, hips, knees, and ankles. The company reduced its sales forecast, citing greater than expected sales force turnover. Long-term prospects remain positive, we believe.
Buys and Sells
Etsy is a global online marketplace for unique and creative goods. It has a seller-aligned business model that provides a technology platform that allows sellers to turn their handmade, specialty goods into an economic opportunity. Etsy has more than 42 million buyers and 2.3 million sellers on its platform. We believe Etsy’s 0.125% convertible notes due October 1, 2026, are attractive for the following reasons: 1) The company has many opportunities for growth, including payment processing and additional seller services, and is focused on driving new buyers to the platform through incentives; 2) despite being focused on growth, Etsy currently generates $175 million of annual earnings before interest, tax, depreciation and amoritization (EBITDA) as well as solid free cashflow, providing a strong credit base in times of equity volatility; 3) while the management team only joined in 2017, they have performed well, achieving their stated goals; we view them favorably.
We sold our position in IAC/Interactive due to speculation surrounding the potential sale or spinoff of its primary assets ANGI Homeservices and Match Group.
Looking ahead to the fourth quarter of 2019, we believe prospects for convertible securities appear positive and could remain so for the indefinite future barring any material macro developments. Our positive view is based on the following factors: a growth-oriented equity environment, positive overall credit conditions, a historic non-correlation to Treasury rates, and increased new issue activity.
As we experience a period of interest rate and economic uncertainty, with associated intermittent periods of volatility, we believe that the market is likely to favor more balanced convertible securities with a positive credit profile, placing a premium on reward versus risk.
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.