“While our portfolio companies are not insulated from the macro backdrop, we believe their market-leading positions, strong cash-flow generation and reinvestment, and often-disruptive business models should allow them to deliver growth that is higher and lasts longer than the market currently expects.”
Jennison Associates LLC
Market in Review
U.S. equity markets continued to advance over the course of the summer, with major indices posting all-time highs along the way. U.S. economic growth remained well above trend, although it was tempered by increasingly widespread supply-chain bottlenecks and labor shortages, which have generated cost pressures. Bond yields moved higher in September, reflecting the potential for protracted inflation, while the Federal Reserve indicated its intention to begin tapering asset purchases before year-end. Consumer confidence took a step back from the higher levels of earlier this year. The onset of new COVID-19 variants and breakthrough infections over the summer reversed the positive trends in hospitalizations and fatalities. In addition, while corporate and government efforts have helped raise the U.S. vaccination rate, the population has not reached herd immunity, and COVID-19 variants are likely to remain a threat. This is also true outside the United States, where vaccination rates are relatively low, due to a lack of vaccine supplies and coordinated inoculation efforts.
U.S. and Chinese government policies continued to be a source of uncertainty. Congress returned to session in September, with little change in the contentious political environment. Legislators faced a busy calendar of deadlines, including raising the debt ceiling to fund the government and moving forward on policy proposals for infrastructure and social spending. The Chinese government took further steps to rein in the activities of many of its largest consumer-facing companies, citing concerns over privacy, unintended usage of consumer data, and the deleterious health effects of excessive amounts of time spent online. The emerging maxim of “Common Prosperity” formed the basis for these fiat policy changes. Chinese stocks sold off on the back of these moves and the elevated risk of further intervention. At the same time, Evergrande, a leading domestic property developer, teetered on the brink of default.
Portfolio Performance
In the third quarter of 2021, the Harbor Capital Appreciation Fund (Institutional Class, “Fund”) returned 0.40%, underperforming its benchmarks, the Russell 1000® Growth Index, which returned 1.16%, and the S&P 500 Index, which returned 0.58%. Sector returns were mixed for the period. The Health Care and Communication Services sectors outperformed the overall index. Information Technology, Financials, and Industrials underperformed the broader index.
The Fund’s stock selection in Consumer Discretionary and Communication Services were important sources of returns during the quarter. Stock selection in Information Technology, however, was a headwind to performance.
Contributors & Detractors
At the issuer level, continued pressure from comparisons to strong growth in 2020 has been a headwind to stock performance for Twilio and other SaaS companies, as well as for Amazon.
We met with Amazon’s (AMZN, Financial) senior management for an in-depth review in August and remain very confident in the long-term prospects for the company. Amazon has reinvested much of its significant cash flow into expanding logistics, specifically distribution centers and freight capacity. These ongoing investments give the company greater control and efficiency in last-mile package delivery.
Two top contributors to relative Fund performance were Tesla and Atlassian.
Tesla (TSLA, Financial) benefited, as expectations solidified around its ability to produce 800,000 vehicles in 2021 versus 499,000 in 2020. Interestingly, Tesla produced a record number of vehicles in China during September. Overall demand for electric vehicles remains very strong, and we remain confident that Tesla can increase its annual vehicle production at a 50% rate over the next several years.
Atlassian (TEAM, Financial) is a leading provider of collaboration software that helps software teams organize, discuss, and complete projects. We view Atlassian as a unique software as a service (SaaS) company with an enormous addressable market and long-term opportunities to add new customers and upsell its existing customers. We expect the company’s expanding product portfolio to drive expansion beyond its core software-developer customer base, which should help maintain strong growth for years. In the past year, the company has significantly reduced its debt and increased cash, indicating a strong and improving balance sheet.
Buys & Sells
We established a position in BioNTech (BNTX, Financial) in the third quarter. BioNTech is focused on harnessing the power of the immune system to develop novel therapies against cancer and infectious diseases. The company has a validated and leading mRNA platform with underappreciated COVID-19-vaccine, cash-flow- generation potential, as well as broad pipeline-optionality with multiple catalysts ahead. We feel that cash-flow generation from the vaccine and the potential upside from the need for additional booster shots are still underappreciated. Additionally, BioNTech is working on additional vaccines to combat future COVID-19 variants, and it offers exposure to a broad pipeline of therapies to treat cancer and a variety of infectious diseases, including flu., flu, and other infectious diseases. A final, underappreciated revenue opportunity is the expected recommendation that the general population should be vaccinated at least annually.
We initiated a position in OKTA (OKTA, Financial) during September. OKTA is a leading identity-management platform, providing customers with detailed knowledge and analysis of application usage within their enterprise. As companies increasingly realize the competitive importance of being able to analyze and understand the applications being used by their employees and customers, they can better position advertising and sales opportunities. We believe OKTA is still in the early stages of long-duration growth and has a competitive advantage with its access management services, which are designed to protect user identity and enhance security and user mobility. The company recently won Adobe’s business, which preferred OKTA’s security solution to developing its own.
We exited our position in Union Pacific (UNP, Financial) because earnings per share growth did not meet our expectations and due to disappointing share-price performance, year to date, and over the past twelve months.
We also sold out of Spotify (SPOT, Financial), as the streaming music company has continued to face challenges with subscription growth and content costs.
Outlook
Investors are facing a complex landscape heading into year-end. Interest rates are responding to elevated wage- and goods-price inflation, exacerbated by supply-chain bottlenecks and shortages of critical components. While the direct disbursement of fiscal stimulus is winding down, liquidity remains abundant, sustaining high levels of demand and contributing to inflationary pressures. GDP growth expectations have moderated in recognition of these supply constraints, although growth should continue to outpace pre-pandemic levels in the short term. We expect corporate profit growth to return to pre-pandemic trend levels over the course of next year. While these levels are respectable in absolute terms, they represent a meaningful slowdown from the pandemic-driven highs reached over the past 18 months. Many companies that reported strong operating results during the pandemic, due to the shift to online shopping and work-from-home business models, are facing challenging, year-over-year financial comparisons. While this may be a headwind to share prices in the short term, we believe the developments of the past 18 months have accelerated trends in consumer and enterprise behavior that were already in place prior to the arrival of the pandemic, and that the step-up in growth in these areas will persist for some time.
Elsewhere in the market, the cyclical companies hit hardest by the shutdowns of 2020 appeared poised for a recovery in operating performance earlier in 2021, as the economy reopened. However, the Delta variant, supply-chain issues, and labor shortages have resulted in an uneven recovery in their financial performance and clouded the outlook for revenue and margin improvement. While our portfolio companies are not insulated from the macro backdrop, we believe their market-leading positions, strong cash-flow generation and reinvestment, and often-disruptive business models should allow them to deliver growth that is higher and lasts longer than the market currently expects.
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 harborcapital.com or by calling 800-422-1050.
Views expressed herein are drawn from commentary provided to Harbor by the subadviser and may not be reflective of their current opinions or future actions, are subject to change without prior notice, and should not be considered investment advice.
This information should not be considered as a recommendation to purchase or sell a particular security. The weightings, holdings, industries, sectors, countries, and returns mentioned may change at any time and may not represent current or future investments.
As a result of changing market conditions, total net asset levels, expenses and other statistics may change at any time and may differ from those shown.
