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A Great Growth Fund but No Smooth Ride

Gold-rated Harbor Capital Appreciation's veteran managers seek firms with strong management, sustainable competitive advantages, and significant runways for growth.

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The following is our latest Fund Analyst Report for Harbor Capital Appreciation (HACAX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Harbor Capital Appreciation's (HACAX) seasoned management team, consistent process, and below-average fees inspire confidence that it will outperform over a full market cycle. The fund earns a Morningstar Analyst Rating of Gold.

At the helm are comanagers Kathleen McCarragher and Sig Segalas, veteran growth-managers who have worked side by side for nearly two decades. Their investment decision-making leans heavily on an experienced analyst team that feeds them ideas that can help distinguish the fund from its Russell 1000 Growth benchmark.

The duo seeks firms it believes have strong runways for growth. The companies should have great management and sustainable competitive advantages and be trading at levels that don’t fully reflect their growth potential. The managers are willing to pay a premium for stocks they like, so the portfolio tends to have higher average price multiples than the index, putting it far out on the growth spectrum.

Most of the team’s recent secular growth ideas have sprung from technology stocks such as Tencent Holdings and  NVIDIA (NVDA). The portfolio has historically favored tech-related names but not typically to this extent: As of August 2017, technology stocks consumed more than half the portfolio’s assets. That positioning has provided significant tailwinds to the fund’s returns during the first eight months of 2017, during which it did better than 93% of its large-growth Morningstar Category peers. It was a different story in 2016, when the fund failed to deliver positive returns and ranked in the category’s bottom 15%. These short-term streaks and retreats have always been hallmarks of this strategy, which tends to capture more of its benchmark’s upside and downside. Since Segalas took the reins in 1990 through August 2017, the fund’s 11.6% annualized gain outpaced the benchmark’s 9.7% and the large-growth category’s 8.8%.

The management team’s experience and consistent execution through the years help the fund maintain an edge. With its highly competitive fees, this fund remains a standout.

Process Pillar: Positive | Robby Greengold 09/29/2017
Managers Sig Segalas and Kathleen McCarragher scour the market for companies they believe will generate economic value over a multiyear horizon. Applying a bottom-up, fundamental-research-driven approach, the team focuses on the durability of a company's growth by favoring businesses with solid balance sheets, strong research and development capabilities, and defensible franchises. The managers prefer businesses that are dominant in their industries with expected growth rates 50% greater than the market. To find these firms, the managers leverage the fundamental research of Jennison Associates’ talented group of analysts. As sector specialists, the analysts conduct in-depth assessments of the companies’ business models by meeting frequently with company management, suppliers, competitors, and customers.

The managers construct the portfolio independently from the fund's benchmark, the Russell 1000 Growth Index, but implement some risk parameters. For instance, individual holdings rarely become more than 6% of assets, and sector weightings tend to stay below 45% of assets. Meanwhile, foreign equities can take up one third of the portfolio but historically have been near 10% of assets. The fund's turnover has ranged between 35% and 45% since 2012, roughly half the category norm. This well-tested approach earns the fund a Positive Process rating.

At 56 stocks as of June 2017, the fund is the slimmest it has been in a decade. In Sig Segalas’ view, this reflects a shifting opportunity set across the large-growth landscape; industry consolidation and increasingly fortified competitive barriers have reduced the number of high-potential secular-growth firms available for his team to buy. The most attractive names have been coming from the tech sector, which has grown steadily since 2014 to comprise more than half the portfolio’s assets as of June 2017. Much of this sector bet is due to capital appreciation from winners such as Facebook (FB) and Alibaba (BABA), which have become top-four positions.

The team often allows successful stocks to run. Apple (AAPL) was first bought in 2004 at around $1.50 a share (split-adjusted) and now is the fund's largest holding, trading at over $150 per share as of late September 2017.

This fund pushes the envelope a bit more than its benchmark. The portfolio's average price multiples have been steadfastly higher than those of the Russell 1000 Growth Index, showing that the team is willing to pay more for growth than its counterparts. For instance, the portfolio's June 2017 average price/earnings ratio was 32.0, noticeably above the index’s 25.4, which is itself high by historical standards. This embrace of valuation risk is on par with what this fund has always done, and the team has consistently managed it well.

Performance Pillar: Positive | Robby Greengold 09/29/2017
This fund has been a strong long-term performer, earning it a Positive Performance rating. Through August 2017, its 15-year returns ranked in the large-growth category's top 23%. Its 10-year returns look even better, outperforming 89% of its peers by delivering an annualized 10.0% versus the category’s 7.3%. Since Sig Segalas began managing the fund in May 1990 through August 2017, the fund beat its peers in 93% of the five-year rolling periods. During that stretch, the fund’s annualized 11.4% gain outpaced the benchmark’s 9.7% and the large-growth category’s 8.8%.

The fund has been a mostly solid performer during the past few years, including a 38% gain in 2013 that crushed the benchmark and put it in the category's top quartile. But this fund courts volatility that leads to short-term surges and drags. It slumped in 2016, hit hard by double-digit losses in stocks such as Bristol-Myers Squibb (BMY) and Nike (NKE). That year, the index gained 7.1% while the fund lost 1.1%. Recent bets on high-flying technology stocks such as Alibaba and Tencent Holdings have powered the fund’s recovery in 2017, putting it back in the category's top decile through the year's first eight months.

Given the portfolio's above-average price multiples, overweighting in technology, and minimal cash cushion, these undulations in performance should be expected.

People Pillar: Positive | Robby Greengold 09/29/2017
Jennison's seasoned growth team has served shareholders well over the long term. The team's lead, Sig Segalas, has been manager or comanager of this fund since 1990. He co-founded the fund's subadvisor, Jennison Associates, in 1969 and serves as its chief investment officer.

Segalas comanages the fund with Jennison’s head of growth equity, Kathleen McCarragher, who joined the firm in 1998. Another key person is director of research Michael Del Balso, who has served as the day-to-day manager of this fund’s clone, Prudential Jennison Growth (PJFZX), since 2000. The firm’s portfolio managers average 33 years of industry experience and 24 years at Jennison. The 11 growth-equity analysts average 19 years of industry experience and 13 years at Jennison. This stable, long-tenured team helps earn the fund a Positive People rating.

While the managers rely heavily on the growth team for investment ideas, they also get ideas from across Jennison's research staff through an official "cross-team" sharing system. The other professionals contributing ideas include the value team’s two portfolio managers and 10 analysts. All the teams attend daily morning research meetings together.

Manager ownership is substantial, with both managers investing more than $1 million.

Parent Pillar: Positive | 05/08/2017
Harbor Capital Advisors is known for hiring best-in-class subadvisors to run its funds. Harbor is a wholly owned subsidiary of Dutch asset manager Robeco Groep N.V., which has remained hands-off as a parent since first acquiring Harbor in 2001. Robeco was sold in mid-2013 to the Japanese financial-services firm ORIX, but Harbor has reported enjoying the same independence that it has had all along.

Harbor will continue to select and monitor managers on its own terms. (It has chosen not to use any Robeco managers, for instance.) A 10-person research team favors managers with a history of consistent risk-adjusted performance and repeatable strategies. Most of those managers invest alongside shareholders, with the majority holding more than $1 million in the strategies they run. Subadvisor changes have been rare, as evidenced by an average manager tenure of 8.2 years and a five-year manager-retention rate of 94%.

The firm's small target-date series is on the expensive side, but Harbor also offers access to topnotch managers at prices cheaper than are available elsewhere. For example, the institutional share class of the small Harbor Real Return fund (HARRX) has a 0.54% expense ratio. Yet  PIMCO Real Return (PARRX)--the fund on which it is modeled--is roughly 110 times its size, and its comparable share class charges 0.85%.

Price Pillar: Positive | Robby Greengold 09/29/2017
Below-average fees earn the fund a Positive Price rating. The Institutional shares (roughly 80% of the fund’s assets) are 13 basis points cheaper than the large-cap institutional median. The Retirement share class, which holds another 10% of the fund’s assets, is also competitive; it is priced below average relative to similarly sold peers. The fund's Administrative and Investor shares are priced near the averages of their respective peer groups.

Robby Greengold does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.