U.S. equities finished the third quarter of 2019 in positive territory, with the S&P 500 advancing 1.70%. Mid and larger cap stocks outperformed smaller caps during the quarter, as the Russell 1000® Index was up 1.49% while the Russell 2000® Index declined 2.40%. The Russell Midcap® Index advanced 0.52% in the third quarter. Year to date, the S&P 500 is now up 20.55% while the Russell Midcap® Index is up 21.93%.

U.S. equities continued to post positive results in the third quarter. The U.S. Federal Reserve cut interest rates twice during the quarter, providing support for the equity rally. While economic numbers were mixed, the U.S.-China trade dispute continued to weigh on markets and expectations for global growth. On the economic front, unemployment remained at historically low levels and wage growth continued to be strong. However, consumer confidence indicators weakened and manufacturing data continued to soften. Markets declined in August as trade tensions escalated. The U.S. announced additional tariffs and China retaliated with tariffs and a devaluation of their currency. Additional talks were scheduled for early October, leading to some optimism an agreement can eventually be reached.

Value stocks recovered in September and finished ahead of growth stocks among mid cap stocks but still trailed significantly for the year. The Russell Midcap Value® Index advanced, while the Russell Midcap Growth® Index declined. Defensive and low volatility stocks posted strong returns during the quarter, and the MSCI USA Minimum Volatility Index has outperformed the S&P 500 on a year-to-date basis. It is highly unusual for low volatility stocks to outperform significantly in periods when the overall market rallies. Defensive sectors including Utilities, Real Estate, and Consumer Staples led the market while Energy, Health Care, Materials, and Communication Services lagged.

In the third quarter of 2019, the Harbor Mid Cap Value Fund (Institutional Class) returned 0.89%, underperforming its benchmark, the Russell Midcap® Value Index, which returned 1.22%.

Lower volatility and defensive stocks continued to do well in the quarter. Value stocks finished the quarter strong, recovering in September after trailing considerably during the first eight months of the year. The Fund outperformed the value benchmark in September by more than 250 basis points after lagging earlier in the quarter.

Performance attribution indicates that both stock and sector selection were mixed in the quarter. From a sector perspective, the Fund’s underweight to the Energy sector added value, but this was offset by the underweight to defensive sectors Utilities and Real Estate. We find stocks in these sectors expensive, particularly after the strong recent performance of low volatility stocks. The Fund’s underweight to oil & gas exploration and production stocks contributed positively in the Energy sector. Stock selection was positive in the Energy, Information Technology, and Consumer Discretionary sectors. However, this was offset by poor selection in Industrials, particularly airlines, aerospace & defense, and air freight and logistics companies.

Lam Research, a long-term Fund holding in the semiconductor equipment industry, continued to contribute positively in the third quarter. Lam Research advanced sharply for the quarter and year-to-date, as semiconductor equipment stocks recovered after struggling somewhat in 2018. Even though the stock has done well, it remains highly ranked on our valuation and momentum indicators. Other Technology stocks that did well included Seagate Technology and Amkor Technology. The Fund held several homebuilders in the Consumer Discretionary sector that did well, including Meritage Homes and PulteGroup. Other positive contributors in the quarter included grocer Kroger in the Consumer Staples sector and specialty chemical company Celenese. While the Fund is underweight Utilities due to their excessive valuations, the Fund did benefit from holding First Energy and Entergy in the sector.

The most significant detractors during the quarter were stocks that either reported disappointing earnings, guided lower, or both. Owens-Illinois reported disappointing quarterly results and also lowered guidance, and the stock declined sharply. Atlas Air Worldwide, in the cargo industry, missed earnings citing continued disruption to their business from tariffs and trade uncertainty. DXC Technology, in the IT services industry, reported decent earnings but guided lower and the stock was punished. Other detractors included Meritor and ManpowerGroup in the Industrials sector and health care service provider HCA Healthcare.

We initiated a position in Diodes, in the semiconductor industry. We find many semiconductor and semiconductor equipment manufacturers attractive. In our view, Diodes is attractive on multiple indicators of value, particularly on price-to-earnings and price-to-cash flow measures, our two most important sets of indicators. The company is generating strong cash flow and while Diodes does not pay a dividend, we believe the company is attractive on other valuation indicators. Long-term past performance of the company has been relatively poor, which is a positive indicator in our stock ranking model. Both price and operating momentum are strong as the stock price has started to improve over the last six to 12 months and our measures of operating momentum—including earnings growth and analyst revisions—are showing significant improvement.

We sold or trimmed several stocks in the Utilities sector that have done well. While the Fund is underweight to Utilities given their relatively high valuations, several holdings have done very well but are no longer attractive enough to hold in the Fund. We began to sell Entergy in the electric utilities industry. Entergy is up over 40% in 2019 and is no longer attractive on our valuation measures. While price momentum for Entergy is strong, the company ranks poorly on our cash flow and earnings measures, and as a result the stock became a candidate for sale.

While we do not develop an outlook or use any macroeconomic forecasts in our investment decision-making process, we can comment on the relative attractiveness of the Fund. The Fund continues to trade at attractive valuations relative to the benchmark and relative to history. The Fund is trading at 10.4 times forward earnings, compared to 16.5 times for the Russell Midcap® Value Index, as well as 6.6 times cash flow, compared to 10.3 times for the index. The Fund is yielding 3.0% despite being underweight to traditional high yielding sectors, including Utilities and Real Estate.

While value stocks staged a comeback in September and the Fund benefited accordingly, the environment for deep value investors has been challenging over the last 18 months. We continue to find many attractively priced stocks that are generating strong cash flow and earnings, which the market seems to have ignored. While it is difficult to predict changes in the macro environment, including interest rates or shifts in the trade wars, we find the discounts at which many of the Fund holdings are trading to be unwarranted. Typically, when we have seen such discounts in the past, value stocks tend to do well going forward. While it is difficult to determine what will happen in the short-term, we believe long-term investors will be rewarded for holding a diversified portfolio of stocks that are cheap but healthy in terms of their ability to generate strong cash flows and earnings going forward.