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Sydnee Gatewood
Sydnee Gatewood
Articles (1780) 

Spiros Segalas' Harbor Capital Appreciation Fund 4th-Quarter Commentary

Discussion of markets and holdings

"Most companies in the Fund’s portfolio met our above-average-growth expectations in 2019, and many of the largest holdings made robust stock price gains, reflecting their healthy operating fundamentals."

Jennison Associates LLC

Market in Review

Global equities markets advanced solidly in the fourth quarter of 2019. Gains early in the period reflected market reaction to the U.S. Federal Reserve’s rate cut in October, an implicit assertion that while the U.S. economy remained near full employment, the benign inflation outlook allowed for another 25-basis-point reduction in the federal funds rate to help offset uncertainty about ongoing U.S.-China trade negotiations. In mid-December, the announcement of a framework agreement brought relief from trade war anxiety. Dubbed Phase I, the plan rolls back a portion of the U.S. tariffs on Chinese manufactured goods initiated earlier this year and removes planned increases on a range of consumer-focused products that were set to take effect on December 15. In exchange, China purportedly is agreeing to boost agricultural imports, enforce intellectual property agreements, and alter business practices to level the playing field for non-Chinese companies looking to compete on the mainland. The trade armistice gave markets another boost and a strong finish for the year. Major indexes surpassed previous records and the levels achieved before last year’s fourth-quarter trade-war-induced setback.

December also saw a decisive victory for the Conservative Party in U.K. parliamentary elections. With the Tories now holding a solid majority in the House of Commons, near-term realization of Brexit appears likely. In the U.S., the House of Representatives approved articles of impeachment against President Trump, one for abuse of power and another for obstruction of Congress. The votes along party lines confirmed deep U.S. political divisions. The U.S. economy proceeded along a steady path of 1.5%-2.0% growth, with unemployment holding at record low levels and the U.S. Dollar stable against major international currencies. Pro-democracy protests in Hong Kong persisted through the quarter, leading to disruptions and a sharp decline in the administrative region’s economy. Growth in major economies outside the U.S. appeared stable, with signs that Europe may be bottoming. A range of purchasing managers’ data pointed to a manufacturing upturn beginning in the first half of 2020.

Portfolio Performance

In the fourth quarter of 2019, the Harbor Capital Appreciation Fund (Institutional Class) returned 12.43%, outperforming its benchmark, the Russell 1000® Growth Index, which returned 10.62%.

Consumer Discretionary, Information Technology, and Communication Services positions were strong contributors to Fund absolute and relative performance. Stock selection was also strong in Financials. Health Care holdings posted a double-digit advance but lagged the benchmark sector. Industrials positions detracted from absolute return.

Contributors and Detractors

Apple (NASDAQ:AAPL) and Tesla (NASDAQ:TSLA) were among the Fund’s top contributors during the fourth quarter. Apple’s fundamental strength reflects the proliferation of the iOS platform across the global mobile phone, tablet, and personal device landscape. With its huge installed base, Apple is now benefiting from rapid growth in service business subscriptions (apps, music), which are a key source of recurring revenue. The services business is the company’s fastest-growing and highest-margin business segment. Investor sentiment about Apple seems to have become less focused on near-term declines in the flagship iPhone business and more defined by a growing willingness to discount near-term lackluster top-line results in anticipation of a potentially robust product cycle that incorporates 5G wireless standards in 2020. Tesla’s strong earnings and free cash flow reflected strong demand and higher margins, driven by solid sales of higher-priced Model 3 variants. In addition to the strong financial results, Tesla moved up the launch of its Model Y and seems to be tracking ahead of schedule on the ramp of a new factory in Shanghai.

Detractors included Boeing (NYSE:BA) and Sage Therapeutics (NASDAQ:SAGE). Boeing declined on news that it is halting production of the Boeing 737 Max 8 jet as it waits for recertification. The aircraft has been grounded since two tragic accidents, the most recent in March 2019. We continue to gauge the impact of the shutdown, but without more detail on the duration of the suspension and the supplier terms, it is difficult to quantify the economic impact to Boeing and its suppliers. The recertification process is taking longer than anticipated, but we expect that once the issues are resolved, Boeing’s strong brand, market position, long-term order backlog, and balance sheet will come to the fore. Sage Therapeutics fell on disappointing data from a Phase 3 clinical trial of its drug SAGE-217 in major depression (MDD). The promise of SAGE-217 in the MDD market was a key element of our investment rationale.

Buys and Sells

We added Eli Lilly (NYSE:LLY) to the Fund in the fourth quarter. Lilly’s core focus has historically included diabetes and central nervous system (CNS)/psychiatric treatments. In recent years, the company has diversified its business, adding immunology and oncology products. Margin expansion, driven by product mix shifts and management’s commitment to improving the margin profile, is a key element of our investment thesis. We anticipate stability in Lilly’s diabetes franchise despite new entrants to the market, and we believe the long-term potential for Jardiance, another Lilly product, outside of diabetes is underestimated. We believe Lilly’s immunology franchise could see strong sales growth over the next several years. In our view, the company’s recent oncology acquisitions could continue to bear fruit, and its early-stage pipeline, particularly in oncology, is underestimated.

Coupa Software (NASDAQ:COUP), another acquisition, is a leader in cloud-based spend-management software that simplifies corporate procurement, invoicing, and expense management. The markets in which Coupa competes are large and well established, and the company has acquired new customers at an accelerated rate over the past several years. We like Coupa’s recurring revenue and favorable supplier pricing model. With opportunities to increase its penetration rates in the estimated $20 billion-plus expense-management market, the company, we believe, is in the early stages of growth that we expect will persist for many years.

We eliminated the Fund’s positions in Tencent (HKSE:00700) and Sage Therapeutics during the quarter. Slowing Chinese economic growth, Chinese government efforts to tighten control of gaming, and increased competition have caused significant slowing in advertising revenue growth for Tencent. Sage Therapeutics reported disappointing data from a Phase 3 clinical trial of its drug SAGE-217 in major depression (MDD). The drug’s statistically significant efficacy and strong safety profile in post-partum depression (PPD) were thought to bode well for its commercial applications in MDD. MDD represents a much larger unmet medical need than PPD, and the promise of SAGE-217 in the MDD market was a key element of our investment rationale.

Outlook

The resolution of trade and other issues affecting U.S.-China relations remains uncertain, but progress is likely to create a more stable backdrop for business investment planning and reduce the threat of recession. Given the stop-and-go trajectory of the negotiations over the past couple of years, the details and timing will be watched carefully. The U.S. economy remains on firm ground. Unemployment is low, wage gains are driving consumption, housing activity is improving, and corporate profits are forecast to grow in the mid to high single digits in 2020. Politics and the U.S. elections are likely to be front and center in the minds of investors in 2020. The presidential campaigns are generating various policy and regulatory proposals. We are paying particular attention to proposals targeting Information Technology and Health Care, as these sectors are major components of the Fund. The health care policy differences between the parties are well delineated, and debate will likely center on approaches to health insurance coverage and drug pricing. We expect that technology proposals will be more unpredictable, given the rapid evolution of the technological landscape. Data privacy, market power, and national interest are among the issues affecting the sector; corporate breakups and business practice reform are among the proposed remedies. Several regulatory actions are already underway or contemplated, and investigative activity is sure to increase. Understanding how they might challenge growth expectations for affected companies remains a key focus for us; regulatory scrutiny has already resulted in valuation discounts in the equity values of many major tech companies.

Most companies in the Fund’s portfolio met our above-average-growth expectations in 2019, and many of the largest holdings made robust stock price gains, reflecting their healthy operating fundamentals. In 2020, we believe that mid-teens earnings growth is possible for the Fund, once again surpassing the earnings growth projected for the S&P 500 (mid-single digits) and the Russell 1000® Growth (low teens) indexes.

Performance data shown represents past performance and is no guarantee of future results. Past performance is net of management fees and expenses and reflects reinvested dividends and distributions. Past performance reflects the beneficial effect of any expense waivers or reimbursements, without which returns would have been lower. Investment returns and principal value will fluctuate and when redeemed may be worth more or less than their original cost. Returns for periods less than one year are not annualized. Current performance may be higher or lower and is available through the most recent month end at harborfunds.com or by calling 800-422-1050.

The views expressed herein may not be reflective of current opinions, are subject to change without prior notice, and should not be considered investment advice.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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