A Prudent Investor

IBM was up 3 1/4 points last week, earning Harvard about $3.25 million. Coca-Cola gained a point, adding roughly $100,000 to Harvard's portfolio value. Kodak's gain of 2 7/8 offset the near-$700,000 loss caused by Xerox's 2 1/2-point decline. And AT&T's additional 1 3/4 points netted Harvard about $1.5 million.

The day-to-day and week-to-week price fluctuations for stocks that Harvard owns translate into very large gains and losses--often hundreds of thousands and even millions of dollars. But for the people who manage Harvard's $1.7-billion endowment, such ups and downs elicit only the slightest arch of an eyebrow during a perusal of the Sunday stock tables. What matters to them is the long-run.

Walter M. Cabot '55, president of Harvard Management Company, which has been overseeing the University's endowment for seven years, constantly emphasizes his organization's primary task in managing Harvard's money: striking a balance between producing income for the present and the future. So far, HMC has been doing that fairly well, producing a hefty yearly income from investments--slightly more than $100 million in fiscal 1980--while at the same time maintaining steady growth for the endowment. "Although good shorter-term performance is heartwarming, the real measure of success can only be taken over a long-term period of time." HMC said in its annual report for 1980. Between 1974 and now, the endowment has increased by about $400 million.

Money earned on University investments represents one of the main sources of Harvard's income. Revenue also comes from tuition and other fees paid by students, the government, gifts and miscellaneous sources. Most of those sources are hard-pressed to keep up with the massive yearly cost increases for running the University. Endowment income distributed among the University's dozens of budget units increased 11.3 per cent to 76.6 million in fiscal 1980 over the previous year, while University expenses rose 13 per cent, to $393,491,000.

During the last decade, money made from investments and then distributed for use by the University's programs (as opposed to being plowed back into investment funds) has increased at a compound rate of 6.9 per cent, well below the compound rate of increase in University expenses of 7.6 per cent for the same period. Over the last ten years, the share of total University income provided by the endowment declined from 20.9 per cent to 19.5 per cent. Similarly, the proportion of total income provided by gifts and government grants also declined. Only miscellaneous and student sources of income increased their portion of the budget burden during the last decade. Of all the categories, student fees is the most flexible source of income, and students have felt the crunch in the form of tuition hikes above the rate of inflation. As a result, students supplied 29.1 per cent of University income in 1980, compared with 23 per cent in 1970.

The increasing responsibility placed on students has reached the point where those who pay to attend the University as well as those paid to teach here are looking for ways to reduce the financial pressure on students. Attention quickly focuses on endowment. If it is so large, many wonder, why must students bear the brunt of inflation and why must Harvard raise $250 million in its five-year campaign? The answer harkens back to Cabot's "striking-a-balance" philosophy.

"There's certainly pressure to produce income," he acknowledges, and the latest financial report (for 1979-80) states that "if endowment income is to retain its centrally important role at the University, then it is clear that substantial additions to the endowment must be made each year from gifts and from funds generated internally." But at the same time, Cabot warns that trying to produce enough income to ease the burden on students now would come back to haunt the University in the future. "The more you ask of an investment to produce today," he explains, "the less growth you can get out of it later." So, for example, even though a bond with a five-year maturity that pays 16 per cent may look extremely tempting, a stock paying only 4 or 5 per cent but growing at a rate of 25 per cent a year would be the better long-term buy, Cabot says.

Even so, HMC recognizes the need to produce for today and therefore employs investment strategies that strike the proper balance. For the last several years, the plan has been to invest a large chunk of the portfolio in common stocks. Not just any stocks, though; the managers at HMC do careful research before making their investment decisions, often seeking the advice of Harvard experts at their disposal. In the early to mid-1970s, their research told them that world oil prices would increase substantially and that American prices would have to catch up. Translated into an investment strategy, that meant "buy petroleum stocks," which they did in a big way starting in 1974. By October 1980, Harvard had $600 million in oil and oil-related stocks, about 60 per cent of its total stock portfolio.

But any investment strategy must adapt to the times; and since January 1, Cabot says, a glut of oil on the world market caused by increased production in the Middle East as well as stepped-up conservation efforts has made oil issues less attractive, reducing their prices by an average 15 to 20 per cent from what they were eight months ago. As a result, HMC has been selling off many of its petroleum holdings, especially those in international firms.

Just as the world oil situation affects HMC's investment plans, so too does the Reagan administration's economic proposals. Cabot says that if Reagan's plans work, productivity will-increase as a result of the refurbishing of American industry. Because of that, Cabot says he remains bullish on stocks. For the near-term, however, which Cabot describes as the next 12 to 18 months, the bond market looks attractive because as Reagan's policies are implemented, interest rates should come down, increasing the value of bonds. As a result, HMC's current strategy is to recommit itself to the bond market and reduce exposure in common stocks. This strategy represents a substantial change from recent year, during which the proportion of Harvard's portfolio invested in stocks reach a high of 75 per cent from a norm during the '70s of about 60 per cent. "What we're trying to do is say where is the better value? We don't see how an economy can continue to prosper with very high interest rates," Cabot says.

Beginning in 1976, HMC entered a high-risk investment area--venture capitalism, so-called because the investor puts up capital to help found extremely speculative business ventures. Because of the risk, the potential rewards are great. Harvard originally invested $20 million, or 1 per cent of the endowment, in venture capital. Some of the companies invested in by the venture capital pool in which Harvard is participating are just beginning to go public, often at five to ten times the original cost. "We were early in the venture capital game, and those investments are going to be very fruitful for the University," Cabot assures. The program is now continuing, with plans to increase the commitment to $30 million.

HMC's investment strategies have elicited a variety of responses from financial analysts. In December 1979, a Wall Street Journal article stated that Harvard's endowment "has been conservatively run for some period of time." The writer based his conclusion on Harvard's reluctance to join the pack of universities in the early 1970s that followed the recommendation of a Ford Foundation report to begin spending capital gains as well as dividends. Harvard's treasurer at the time, Paul C. Cabot '21, Walter's uncle, refused to spend principal, sparing Harvard a cash squeeze when stocks plunged.

In March 1980, a a New York Times article said Harvard had begun to show a "growing aggressiveness" because of its decision to invest heavily in stocks. The article based a part of its argument on comparative statistics: Between mid-1974 and mid-1979, the endowment grew 10.5 per cent to 1.3 billion; while between mid-1979 and March 1980, it grew 21 per cent to 1.6 billion.

Cabot says that terms like "conservative" and "aggressive" are bandied about loosely; he seems to favor the word "prudent," explaining that because of the importance of investments earnings to the University's income, Harvard will always operate using prudent investment strategies. But Cabot is quick to recall the long-term picture: "We won't be able to accomplish for Harvard what we want to in the long term if we are conservative, I don't think we're stodgy investors. We're aggressive with some degree of prudence."