1st Quarter, 2020
“We have eliminated a handful of holdings that face headwinds created by the current uncertain environment that challenge our longer-term growth forecasts. Our efforts to upgrade quality at the margin is typical of the approach we have taken in past periods when the global outlook has been significantly challenged and uncertain.”
Jennison Associates LLC
Market in Review
The first quarter of 2020 was one of the most disconcerting periods in recent history, as the COVID-19 outbreak spread rapidly around the globe, disrupting markets and life virtually everywhere. By the end of the period, more than 900,000 cases had been reported in 180 countries with more than 45,000 deaths. Realization of the scope and gravity of the situation changed the course of global markets. U.S. equities had advanced strongly at the beginning of the year, extending 2019’s robust finish and gathering momentum with the signing of the U.S.-China Phase One trade agreement. Stocks peaked at new highs on February 19, then dropped more than 30% in only 25 trading days. Exacerbating the turmoil, Saudi Arabia and Russia declared an oil price war. Having failed to agree on reduced production levels to address weak demand, the two countries ramped up production to drive higher-cost producers out of business. The price of West Texas Intermediate crude oil dropped more than 65%, to $20 per barrel.
Policy makers responded to the collapse in asset prices with historic monetary and fiscal actions. The Federal Reserve’s “whatever it takes” approach provided liquidity and lending facilities behind virtually every U.S. financial instrument. Congress moved rapidly to pass the largest single fiscal stimulus legislation in U.S. history, which includes loans and grants to alleviate pressures on small businesses, payments to individuals, expanded unemployment insurance, fiscal aid to states, and spending for hospitals. The experiences of China and South Korea late in the period suggest that aggressive steps taken early to test populations broadly for the virus, combined with enforced lockdowns, can flatten the infection curves and allow human and economic activity to stabilize. However, the disease-progression trajectories of Italy and the U.S. suggest that the situation could get worse before it gets better.
Portfolio Performance
In the first quarter of 2020, the Harbor Capital Appreciation Fund (Institutional Class, “the Fund”) returned -11.83%, outperforming its benchmark, the Russell 1000® Growth Index, which had a negative return of -14.10%.
The Russell 1000® Growth benchmark’s -14.10% negative return in 2020’s first quarter had two distinct periods: pre- and post-COVID-19 outbreak.
Through the February 19 market peak, the benchmark advanced 9.3%. After the peak, it fell 21.4%.
Positions in the Fund’s heaviest-weighted sectors—Information Technology, Consumer Discretionary, Communication Services, and Health Care —outperformed largely on favorable stock selection. Conversely, Industrials holdings in the aerospace industry, declined materially, resulting in negative stock selection. The sectors most affected by the market’s drawdown—Energy, Financials, and Materials—have relatively small or no weights in the Fund. These factors helped the Fund to outperform the benchmark during the quarter.
Contributors and Detractors
Netflix and Amazon were among the Fund’s top contributors during the first quarter. Both companies have secular growth profiles that look even stronger in the current environment, as social-distancing and shelter-in-place directives are drawing renewed attention to the value, utility, and now, resilience, of ecommerce and video streaming business models.
Netflix (NFLX, Financial) continues to enhance its long-term competitive position with the industry’s largest commitment of investment dollars in exclusive and original content. Given its still-low global penetration and the accelerating shift from linear TV, Netflix still has significant room for growth. We expect the ramp up in original shows with established audiences and new series will lead to a reacceleration in subscriber growth. In the fourth quarter, the company’s global subscriber base grew 20% to 167 million, and global average revenue per user increased roughly 9%. Global net subscriber additions, at 8.8 million, surpassed consensus expectations. In an expected tough quarter from a competitive standpoint, given the launch of Disney+ in the U.S., Netflix grew its U.S. subscribers by roughly 1% at prices nearly 20% higher than a year ago, indicating, we believe, the resilience of the Netflix business model.
Amazon (AMZN, Financial) continues to benefit from economies of scale and its platform-based business model. Through reinvestment in its business, it continues to strengthen its competitive edge. The AWS web services business is an additional driver of revenue and profit. Amazon’s fourth-quarter earnings, revenue, and operating income exceeded consensus forecasts. First-quarter guidance likewise surpassed expectations.
Detractors included Boeing and Mastercard. The longer-than-anticipated 737 Max 8 jet recertification process weighed on Boeing’s (BA, Financial) shares early in the quarter. While the COVID-19 outbreak has severely restricted air travel in the near term, we added marginally to the position during the quarter given the long-term strength of the company’s business model. While Mastercard (MA, Financial) has a strong market position with high barriers to entry, pricing power, and solid operating leverage potential, the company was hurt in the quarter by significantly slowing commerce and cross-border transactions. However, with its strong secular growth positions, we believe that Mastercard remains well positioned over the long term.
Buys and Sells
We added Goldman Sachs and Humana to the Fund in the first quarter. Goldman Sachs (GS, Financial) has a strong capital base and leading global positions in investment banking, capital markets, trading, and asset management. It has what we consider to be excellent liquidity, reasonable leverage, and numerous businesses that can generate profit during periods of distress, which should help the company weather the current economic storm. At current levels, the stock is trading at a significant discount to its book value.
Humana (HUM, Financial) is one of the largest providers of Medicare Advantage (MA, Financial), the fastest-growing segment of the U.S. health care insurance market. We believe the company is poised to benefit from the increased use of private Medicare plans, in part, because of the aging of the population. With Democratic primary voters appearing to have coalesced around moderate former Vice President and U.S. Senator Joe Biden, making Medicare for All and elimination of private insurance increasingly unlikely, we are becoming more comfortable with the prospects of the U.S. managed care industry. In December 2019, the U.S. Congress permanently repealed a health insurer fee. This could potentially boost MA enrollment, as insurers keep premiums flat and reinvest into supplemental benefits. The fee repeal could also bolster the bottom lines of MA insurers like Humana. We believe the stock’s revaluation during the current market drawdown presents an attractive entry opportunity.
We sold positions in Disney and Airbus during the quarter. While the recent Disney+ subscription video-on-demand (SVOD) service launch has exceeded expectations and should ease concerns about Disney’s (DIS, Financial) ability to transition into the future SVOD-dominant world, we believe materially increased expectations for subscriber growth could result in investor disappointment. Material restrictions on travel, related to the COVID-19 pandemic, are creating financial strains on airlines, leading to airline order cancellations and deferrals as well as balance sheet concerns. We eliminated the position in Airbus (XPAR:AIR, Financial) based on the company’s exposure to this airline industry challenge.
Outlook
The pandemic and efforts to contain it are causing a spike in unemployment and a sharp drop in Gross Domestic Product (GDP) worldwide. The result will likely be a global slowdown of historic proportions. Policy makers have confronted the threats with unprecedented stimulus and liquidity enhancements, and additional policy steps will surely follow in the coming weeks and months. However, social- distancing and sheltering-in-place, adaptations crucial to containing the virus’s spread, might hinder the activity fiscal measures are seeking to stimulate. Underlying economic conditions before the outbreak were largely solid, and when the crisis subsides, fundamentally healthy economic structures would be expected to support resumption of economic activity. However, we do not expect recovery to be uniform, and vulnerable businesses may not survive.
We are attempting to assess the impact of COVID-19 on our holdings by speaking with the management teams of companies held in the Fund. Although these discussions are helpful to understanding company responses to current conditions, it is impossible to know the real-, near-, and intermediate-term impacts. The Fund includes the stocks of businesses that lead their industries and grow at substantially faster rates than the market average. Companies held in the Fund also generate significant cash flow, allowing them to weather difficult times and sustain the competitive advantages necessary to create true economic value over the long term, in our view.
We have eliminated a handful of holdings that face headwinds created by the current uncertain environment that challenge our longer-term growth forecasts. Our efforts to upgrade quality at the margin is typical of the approach we have taken in past periods when the global outlook has been significantly challenged and uncertain. We expect to make further adjustments as we gain a fuller understanding of the changing landscape and individual company circumstances.
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.
