"As fundamental investors, we continue to view company-specific business fundamentals as the most important aspect of long-term investment returns."- Elk Creek Partners, LLC
Market in Review
U.S. equity markets were choppy during the third quarter of 2019. As the quarter began, equities traded relatively well and posted positive gains in the month of July. The U.S. Federal Reserve (Fed) lowered short-term interest rates by 25 basis points in July, as investors both wanted and expected. Corporate earnings and macroeconomic data were generally fine and didn’t alter investment sentiment.
Investors’ moods darkened dramatically as the calendar turned to August, and it is difficult to point to one individual catalyst. Summer doldrums often hit during the month of August as market liquidity typically fades, investor participation wanes with vacation schedules, and corporate news usually dries up after earnings season. This August was a bit more frantic as multiple concerns seemed to grip market participants. Equities declined for the month, with smaller cap stocks falling significantly harder than larger cap stocks. Certainly, the overseas economic news was weaker than expected, there wasn’t any apparent progress on trade negotiations with China, and Brexit resolution seemed evasive despite a change in leadership in the U.K. It was a bleak month for equities.
September brought momentary relief early in the month, and then the market became more volatile into quarter end. Simplistically, momentum stocks got sold hard while others, mainly year-to-date laggards, were bought. Recession fears intensified, and by month’s end, small cap stocks finished in the red while large cap stocks finished on the plus side. This dynamic ended up being representative of the entire quarter, as smaller cap stocks declined for the period with larger cap stocks advancing.
In terms of monetary policy, the Fed cut interest rates again in September, for the second time during the quarter. Initially, the market reacted positively to the Fed’s action, yet those positive feelings gave way to recession angst as time passed. The market certainly seems worried about growth.
Politically, the situation also became less certain as the House of Representatives began pursuing impeachment hearings in late September. At quarter end, political instability didn’t seem to be directly impacting equity prices, though our expectation is that the longer this uncertainty lasts, the more likely it will become a destabilizing factor. Most political pundits don’t believe that the Senate would remove the President if the House eventually holds an official vote; still, a long and drawn out process is unlikely a positive for equity prices.
In the third quarter of 2019, the Harbor Small Cap Growth Opportunities Fund (Institutional Class) returned -7.65%, underperforming its benchmark, the Russell 2000® Growth Index, which returned -4.17%.
Amid the September volatility, it was rather remarkable how violently sectors traded, and it isn’t clear what precisely unleashed the rotation. The financial media referred to the rotation as one from growth to value. From our perspective, broad labels on these groups tend to be inaccurate, though we think that the two buckets are more accurately described as price momentum (instead of growth) and non-price momentum (instead of value).
The Fund outperformed in September, and the interesting aspect of this outperformance is that the bulk of it occurred during this violent rotation between those two buckets. Having been associated with this investment style and process for a very long time, we have a hard time recalling this magnitude of relative outperformance in such a short period of time, with essentially no fundamental news that would explain the price volatility.
Over the past several months and even years, we’ve been hearing anecdotes from longstanding market participants alluding to non-fundamental factors driving stock selection, such as price momentum and volatility. Interestingly, both of those factors are backward-looking, in addition to being non-fundamental. These non-fundamental factors, as referenced above, led to the Fund’s relative performance lag for the first two months of the quarter.
Contributors and Detractors
Three of our largest contributors for the quarter were Invacare, Infinera, and Gogo. Invacare, a manufacturer and distributor of medical equipment, rebounded as revenues and operating margins were better than expected. We continue to see growing demand for the company’s specialty wheelchairs. We believe that tariff concerns are overdone, and the shares continue to be attractive, in our view, as the company improves operations. Revenues for Infinera, an optical networking equipment company, were better than expected. We believe that Infinera is in the process of establishing itself as the clear number-two player for telecommunications network equipment, and we believe the shares could continue to appreciate as Infinera demonstrates the company’s capabilities, leading to recognition by other market participants. At Gogo, a leading in-flight connectivity and wireless entertainment company, revenues were a touch ahead of plan. Operating margins improved as the company’s operational performance dramatically exceeded expectations, which we believe could continue to drive strong share price performance. Additionally, Gogo’s largest airline customer is testing free WiFi on its flights, which could be a significant positive for Gogo if the service becomes broadly available.
Three of our largest detractors for the quarter were Synchronoss Technologies, Clovis Oncology, and Quotient Technologies. Synchronoss Technologies, a software company focused on applications, including cloud management solutions for telecommunications carriers, declined despite posting better than expected quarterly revenues and margins. The company created investor anxiety by disclosing some terms from a contract with a large customer that showed falling price points for a five-year period, beginning in 2018. However, the largest of those price declines occurred in 2018, and thus have already passed. We added to the Fund’s position on this decline, as we have seen strong new customer wins and solid execution. Clovis Oncology, a cancer-focused biotechnology company, declined despite posting revenues consistent with investors’ expectations. The company’s lead drug, Rubraca, treats ovarian cancer and is in clinical trials for prostate cancer. In our opinion, investors have become overly concerned that salvage treatment options for both cancers are becoming too competitive. We believe Rubraca is in a class of effective drugs that will continue to be used as cancer patients fail other therapies and look to compounds. We added to our position amid the price weakness. Revenues at Quotient Technology, a leading digital coupon provider for retailers, disappointed investors. A large consumer package goods (CPG) company cut back its promotional efforts. We believe that impact will be temporary, as we have seen CPG companies decrease their promotional cadence in the past, only to lose volume and market share and return to prior promotional levels. In our view, Quotient’s leading position in digital coupons provides the company with valuable consumer behavioral data that could be monetized further, and we added shares on the price weakness.
Buys and Sells
We initiated a position in Karyopharm Therapeutics, a biotechnology company focused on the oncology market. The company received FDA approval for Xpovio to treat highly-refractory multiple myeloma, a cancer that kills approximately 13,000 people in the U.S. annually. This approval was surprising and widely unexpected, and in our view, current consensus estimates are fairly conservative. We estimate peak sales for this indication could yield annual sales of $300 million to $400 million, along with an expansion into other oncology indications that could expand peak sales to $700 million to $900 million. On initiation of the position, Karyopharm Therapeutics had an enterprise value of roughly $500 million.
In early August, we sold off a position in Natera—a molecular diagnostics company focusing on non-invasive prenatal testing, transplants, and oncology—after the company reported a solid quarter and hit our price target. We recognized that momentum factors could propel the shares higher, yet we sold the stock, remaining disciplined to our investment process.
As the fourth quarter begins, investors seem to be in relatively foul moods, and equities have materially declined early in the period. Given rising concerns regarding growth, weak manufacturing activity data led to a sharp sell-off in stocks. Still, we have a lot of data yet to come, especially from companies themselves, when earnings reports commence. As fundamental investors, we continue to view company-specific business fundamentals as the most important aspect of long-term investment returns.
Over time, we believe that fundamental factors rather than technical factors are the most important attributes that drive investment returns, and we believe that September’s volatility was an important development. We believe in our longstanding investment style and process, and while the last several months have been frustrating, we are encouraged that the market’s recent behavior represents an important change. We look forward to the rest of the year and the upcoming earnings reports in the Fund’s holdings.
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.