Harbor Large Cap Value Fund’s Alpha Edge

Key Takeaways

• There is significant variability in defining what makes a stock growth vs. value
• A quality value approach may help investors avoid “value traps”
• Harbor Large Cap Value’s quality portfolio seeks to offer exposure to companies with healthier balance sheets, higher earnings and cash flow growth, and more defensible competitive positions versus the benchmark

In recent years, the topic of value investing has been ubiquitous in our industry. Harbor has completed extensive research on the topic as we aim to understand past, current, and ultimately, future market environments and implications for our manager’s performance expectations. It is a topic with a lot of gray area, and it seems each investor has a different definition of what “value” investing is. Investment professionals are in the business of buying shares of companies that they believe are trading at a discount to their intrinsic value. If expectations are high enough, any “growth” stock can look cheap.

Even the commonly followed indices display a lot of variability in defining what a growth versus value stock is, which is concerning to us considering many strategies start their process based on these constituents. When looking at the makeup of the Russell 1000® Value and Russell 1000® Growth indices, the variability in the number of constituents over time stands out. Interestingly, the number of companies within the Russell 1000® Growth is at a multi-decade low at 499. And, as seen in Figure 1, only 177 of the 499 companies currently in the Russell 1000® Growth are exclusive to that index (meaning not also held in the value index), indicating most companies have both growth and value characteristics.

Source: FactSet, Q1 2022

Importantly, Aristotle Capital Management, LLC (Aristotle), subadviser to the Harbor Large Cap Value Fund, does not start its process based on narrowly defined index constituents. Rather, they begin by determining whether companies represent quality businesses, which in their view is defined as companies with long term competitive advantages, sound management teams and capital allocation strategies, financial strength, and an ability to consistently earn returns in excess of their cost of capital. In turn, companies with these attributes may also show pricing power, high recurring revenue, margin expansion, and high free cash flow generation.

Despite the variability of index constituents shown in Figure 1, we often receive questions from clients about how Aristotle can hold certain Information Technology names that are not currently held in the benchmark. The short answer is that Aristotle’s process is not tethered to its benchmark as a starting point, and a more nuanced answer may include the fact that many of the long-held Information Technology companies in the Harbor Large Cap Value Fund have spent meaningful time within the Russell 1000® Value index over the last 10 years (Figure 2). Given Aristotle’s long-term approach, they do not react as quickly to shorter term changes in fundamentals that migrate companies between indices.

Source: FactSet, Q1 2022. This information should not be considered as a recommendation to purchase or sell a particular security. The weightings & holdings mentioned may change at any time and may not represent current or future investments.

Another common definition of what constitutes “value” investing deals with exposure to cyclical areas of the market like Financials, Industrials, Materials and Energy that tend to be most correlated with GDP growth. Cyclical areas of the market have performed well as the world has emerged from the COVID-19 pandemic and experienced strong economic growth. While the U.S. has recently experienced strong economic growth, this has been fueled by unprecedented levels of monetary and fiscal stimulus. We believe the U.S. will settle back down to a more normalized annual growth rate of ~2% in the coming years and these industries will go back to an environment absent of many catalysts for a cyclical upswing. The “catalysts” Aristotle seeks are not tied to cyclicality, rather, they’re related to business specific factors within management control that they believe will propel a company to meet its full potential. Examples include market share increases, margin improvements, and sound business divestitures among others.

More tactically, investors are currently grappling with an unusual environment of both slowing economic growth and above trend inflation. We believe a portfolio of companies that are both financially stable and competitively advantaged with pricing power will be better positioned amidst this uncertainty. Looking back to the years following the resurgence of economic activity post tech bubble, U.S. GDP growth slowed from 3.4% to 2.2% from 2004 and 2007. During this period, investors focused more on company fundamentals and rewarded those with stronger levels of profitability and healthier margins.

Source: FactSet

We also believe that we are in a world that is rapidly being disrupted by new technologies and effects will expand from the Information Technology sector into other areas of the market. An important characteristic of value companies going forward will be how innovative they are and what they are doing to fend off competitive forces to avoid becoming “value traps”.

For these reasons, we believe investors would be best served by a more quality value approach.

We believe that Aristotle is a manager that is building portfolios based on a more modern approach to value investing, namely one that emphasizes quality companies trading at a discount to their estimate of intrinsic value with catalysts that are not yet realized by the market. With its quality value portfolio, investors typically pay a slight valuation premium relative to the index. In return, they get exposure to a portfolio of companies that Aristotle believes have healthier balance sheets, higher earnings and cash flow growth, and more defensible competitive positions versus the benchmark (Figure 3). This has historically translated into superior returns on equity and margins.

Source: FactSet, May 2022

What does this mean for investors? We believe that Aristotle’s portfolio has the potential to generate an attractive return profile given the compounding effects of owning high-quality, well-managed businesses, while keeping risk in line with the index and peers due to their focus on businesses with durable business models and strong fundamentals.

Source: Morningstar, May 2022

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 on our website or by calling 800-422-1050.

The net expense ratios for this Fund are subject to a contractual management fee waiver through 2/28/2023.

Important Information

Investors should carefully consider the investment objectives, risks, charges and expenses of a Harbor fund before investing. To obtain a summary prospectus or prospectus for this and other information, visit our website or call 800-422-1050. Read it carefully before investing.

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. There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. Since the Fund typically invests in a limited number of companies, an adverse event affecting a particular company may hurt the Fund's performance more than if it had invested in a larger number of companies. Since the Fund may hold foreign securities, it may be subject to greater risks than funds invested only in the U.S. These risks are more severe for securities of issuers in emerging market regions.

The Russell 1000® Value Index is an unmanaged index generally representative of the U.S. market for larger capitalization value stocks. The Russell 1000® Value Index and Russell® are trademarks of Frank Russell Company.

The Russell 1000® Growth Index is an unmanaged index generally representative of the U.S. market for larger capitalization growth stocks. The Russell 1000® Growth Index and Russell® are trademarks of Frank Russell Company.

The Russell 3000® Index is an unmanaged index that measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 3000® Index and Russell® are trademarks of Frank Russell Company.

Indices listed are unmanaged and do not reflect fees and expenses and are not available for direct investment.

As of March 31, 2022, the Top Ten Holdings of the Harbor Large Cap Value Fund are Microsoft Corporation., Corteva Inc., Adobe Inc., Danaher Corporation, Sony Group Corporation Sponsored ADR, ANSYS, Inc., Capital One Financial Corp., Qualcomm Incorporated, Microchip Technology Incorporated, and Martin Marietta Materials Inc. Click here to see the most current list of holdings.

Aristotle Capital Management, LLC is a third party subadviser to the Harbor Large Cap Value Fund.

Past rankings are no guarantee of future rankings. Morningstar Ranking for the fund’s respective category Quarterly as of 5/31/2022 for the Institutional Class Shares; other classes may have different performance characteristics. The Morningstar Rankings are based on the Annualized Total Return performance, with distributions reinvested and operating expenses deducted. Morningstar does not take into account sales charges.

Harbor Large Cap Value Fund was ranked against the US Fund Large Blend over the following time periods: 203 out of 1,368 in the category over one year, 237 out of 1,232 in the category over three years, 946 out of 1,116 in the category over five years, and 14 out of 818 in the category over ten years.

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