An Excellent--and Aggressive--Choice for Growth Seekers

The following is our latest Fund Analyst Report for Harbor Capital Appreciation HCAIX

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A topnotch team, a well-executed process, and Morningstar's enhanced ratings methodology underpin the upgrade of Harbor Capital Appreciation's Morningstar Analyst Rating to Gold from Silver for its institutional and retirement shares. Pricier share classes remain Silver.

This large-growth strategy is the flagship of subadvisor Jennison Associates; its growth-oriented investment team is among the industry's strongest. Staffed by roughly a dozen sector specialists, the team scrutinizes companies' competitive positioning to find those whose future growth is underappreciated by the market. Six managers leverage that research to construct a 55- to 70-stock portfolio often dominated by fast-growing giant caps trading at relatively high price multiples. Four have been managers at the firm for at least 20 years; the remaining two--Rebecca Irwin and Natasha Kuhlkin--became named managers here in 2019.

Irwin and Kuhlkin are not as new as they look; both have spent at least a decade as part of the investment team and have meaningfully contributed to the strategy's excess returns over their tenures as analysts of consumer and Internet stocks. They have capably overseen day-to-day decisions at this strategy's more-concentrated offspring, PGIM Jennison Focused Growth SPFAX, since April 2017.

The firm's managers don't make their calls in isolation. A culture of collaboration ensures that multiple pairs of eyes follow each of the firm's strategies and that the merits of all portfolios' interests are continuously debated.

Consistently good stock selection over the long haul has made for an enviable track record. No narrow period nor a few home runs account for a disproportionate share of the fund's excess returns over the past 15 years. Its cumulative alpha has derived from a steady course of success stories that have unfolded across time and portfolio holdings. The team's stock-picking strengths within the consumer discretionary, communications-services, and technology sectors have been notable advantages in recent years as those sectors have handily outperformed.

Process | Above Average A well-tested, consistently applied approach earns an Above Average Process rating.

Managers Blair Boyer, Michael Del Balso, Kathleen McCarragher, Sig Segalas, Irwin, and Kuhlkin look for market leaders with above-average top-line growth prospects. Focused on the durability of a company's growth, they favor businesses with healthy financials; strong research and development capabilities; and defensible, if not dominant, franchises.

Central to the approach is the fundamental research of Jennison Associates' talented group of analysts that hunts exclusively for growth stocks and supports the firm's small-, mid-, and large-cap products.

The team's multi-cap scope helps maintain a fresh and thoroughly vetted pipeline of new investment ideas for this large-cap portfolio. Several of this fund's biggest winners in recent years, such as Coupa Software COUP, Shopify SHOP, and ServiceNow NOW, originated in Jennison's mid-growth strategy.

Turnover has ranged between 35% and 55% since 2012, implying average holding periods of two to three years. But some of the managers' favorite stocks have been owned much longer than that: They bought top holding Amazon.com AMZN in October 2007 and have held it with conviction virtually every month since.

People | High Subadvisor Jennison Associates' growth-oriented investment team is among the industry's strongest, earning the fund a High People rating.

Veteran managers have a long shared history at this strategy. Firm co-founder Segalas has been at this fund's helm since 1990. Comanager Del Balso joined Jennison in 1972 and has served as the team's director of research since 1994. That's roughly the time that managers Boyer and McCarragher--now co-heads of growth equity--joined the firm. Irwin and Kuhlkin are relatively new to the management ranks, but they are hardly neophytes. Irwin's industry experience stretches more than 20 years, 14 of which have been spent as a consumer- and Internet-focused analyst at the firm. Kuhlkin is also an expert in those areas, having covered them for 16 years at Jennison and nine years before that. They continue to cover those sectors as analysts.

A seasoned and stable team of sector specialists lays the foundation of the process. Eleven growth-focused analysts--Irwin and Kuhlkin among them--boast an average of 22 years of industry experience and 15 years at Jennison.

Manager ownership is substantial, with Boyer, McCarragher, and Segalas investing more than $1 million in the strategy.

Parent | Above Average A judicious approach to manager selection and product development underlies Harbor Capital Advisors' Above Average Parent rating.

The firm, which manages roughly $50 billion held almost exclusively in actively managed mutual funds, is an independent subsidiary of Orix Corporation Europe N.V., itself a subsidiary of Japanese financial-services firm Orix, which bought Harbor's previous parent Robeco in 2013. Today Robeco, Harbor, and other asset managers operate autonomously under Orix, which takes a hands-off approach toward its subsidiaries.

Harbor is a high-quality manager-of-managers with consistently applied standards and a solid track record of selecting and retaining skilled subadvisors. That includes large-growth equity manager Jennison Associates, which runs a $37 billion fund that is by far the firm's largest. Harbor looks for managers that will maintain a well-defined process through market cycles and focuses on their potential over the long haul--indeed, its subadvisor relationships often stretch over a decade. But such longevity isn't a given. Harbor may break ties with firms exhibiting instability of their personnel or investment style.

Rapidly growing demand for low-cost investment options, such as index funds and exchange-traded funds, has challenged the firm in recent years. Many of its funds' fees have remained relatively stagnant as peers' have declined.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's second-costliest quintile. That's poor, but based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we still think this share class will be able to overcome its high fees and deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Silver.

Performance The fund has posted good, albeit volatile, results over the long haul. Over the past 15 years--a period that fully overlaps the firm tenures of most members of the growth-equity team--its institutional shares' 13.0% annualized gain through August 2020 beat the Russell 1000 Growth Index and large-growth Morningstar Category by 0.7 percentage points and 2.9 percentage points, respectively. The fund's excess returns have been consistent: Over the 145 monthly rolling three-year periods on the managers' watch, it outperformed its peers' average 98% of the time. But the fund also consistently courts volatility, which dulls its performance edge when measured on a risk-adjusted basis.

Several of its most volatile holdings have delivered its juiciest profits, particularly in 2020 for the year to date through August. For example, longtime holding and top active weight Tesla TSLA--whose stock price in recent years has been among the index's most erratic, as measured by standard deviation--climbed fivefold. That eye-popping return heavily contributed to the fund's 45.1% cumulative gain versus the Russell 1000 Growth Index's 30.5%.

Much of the rest of the portfolio has also been well-positioned during the year. Most holdings within the IT services, software, and entertainment industries notched gains of over 50%; a handful of them doubled in value.

Portfolio As of July 2020, the strategy's 55-stock portfolio was dominated by rapidly growing industry behemoths. In aggregate, the portfolio's average estimated five-year earnings-growth rate ranked in the top decile of the large-growth category. More than two thirds of its assets were consumed by mega-caps.

That's not to say that the team thinks most highly of the index's heftiest firms. Though Amazon, Apple AAPL, and Microsoft MSFT were the July portfolio's three largest positions, the latter two were also its most significant stock-level underweights. In recent years, the trio's rapid market-cap growth thrust their combined share of the index to nearly 30%. The portfolio was less top-heavy with a 20% share.

Management is willing to pay a premium for companies it thinks have competitive advantages and long growth trajectories. In July, the portfolio's average price/forward-earnings ratio of 47.1 put it at a premium of 45% to the index's. High-multiple stocks carry high risks of disappointment if their earnings-growth expectations don't materialize.

The strategy plays to the team's stock-picking strengths by overweighting the consumer discretionary and communication-services sectors, which recently amounted to 39% of assets combined versus the index's 27% share. Another 43% of assets were in technology, also one of the team's fortes.