Board investment committees should respond to the current crisis by analyzing four factors that can crystallize money-management decision points.

by John S. Griswold Jr.

As seen in December 2001 issue of AGB's Trusteeship

 Even before the horrendous events of September 11, many economists thought the country was entering a mild recession. Now it is becoming clear that the recession already may be here, and the downturn may be long and painful. Under a best-case scenario, the investment atmosphere will remain uncertain. Because we’re in uncharted waters, no one knows exactly what a worst-case scenario might be.

Clearly, recent events compound the complexity of decisions facing investors, no less board investment committees. As committees reconvened at the end of the summer, Topic A without a doubt was last year's returns and their effect on asset-allocation policy. Topic B was likely the question of when the economy would bounce back and spark a recovery in equity markets.

But the terrorist attacks introduced a wild card. Suddenly, asset allocation took on greater urgency, and the question of when a recovery would occur became a more ominous question of if.

The specter of a repeat of the 1973-75 recession and bear market now hangs over Wall Street. On September 21, when the stock market reached its post-9/11 low, we heard echoes of "the death of equities" speculation common in the late 1970s. A crisis mentality prompts many among us to take a short-term view, but our job as fiduciaries is to maintain a longer perspective.

Everyone I know believes the United States and its allies ultimately will prevail in the struggle against terrorism. What no one can predict is what twists and turns the battle will take and how long it will last. Had portfolios not already lost value, quiet confidence probably would hold sway. But investment committee members become unnerved when they envision what their portfolio would look like if the next 18 months' returns were to mirror those of the past 18 months.

While a SWAT ("Special Weapons and Tactics") team may be the appropriate response to terrorist actions, boards would benefit from conducting a "SWOT" analysis, the venerable strategic planner's tool that assesses "Strengths, Weaknesses, Opportunities, and Threats." The SWOT approach can be applied to four key factors to crystallize decision points for trustees and help them think through the current conditions and those that may lie ahead. A SWOT analysis will help shed light on (1) the effect of September 11 on markets; (2) the overall economic backdrop; (3) the outlook for investment committees; and (4) what, if anything, investment committees should do.

Let's look, then, at the four components of a SWOT analysis.

The Strengths. Investors can take heart in our market's strengths more than they can in any other factor. Equity market corrections are inevitable. To some, an 18-month bear market may leave the glass half empty, but after an 18-year bull market, the glass is more than half full.

The fact is, our economy is still the strongest in the world. Despite the recent slide, we still have low unemployment. Inflation has been in check for years. Thanks to easing by the Federal Reserve Board, interest rates are approaching historically low levels. The government is acting to provide much-needed fiscal and monetary stimuli. Until needs dictated emergency spending, the government was operating in the black (and there's no reason to assume we can't return to a surplus). On issues both economic and political, the government and Americans generally are more united than at any time in recent memory.

Despite a technology sector undergoing a massive and painful retrenchment, solid companies continue to push horizons in information technology, communications, the life sciences, and medicine. Arguably, an unusual combination of events brought about the boom and bust in technology: the Telecommunications Act of 1996, which led to overbuilding in the telecom industry; Y2K, which led to a concentrated period of heavy investment in IT assets; and, of course, the dot.com phenomenon. The passage of time, if nothing else, will restore balance to the telecom and IT industries. With regard to dot.coms, speculation has been purged from the system, allowing us to focus more clearly on the key fact that more and more people are using technology every day.

In the education sector, there is widespread financial strength today, much of it stored up during the 18-year bull market. For the first time in decades, many institutions are close to financial equilibrium — that is, balancing expenses and receipts. Public institutions in particular have done a remarkable job of fund-raising; in fact, they represent the fastest growing segment of the endowment market.

Finally, boards in general and investment committees specifically offer more talent and sophistication than ever before. This bodes well for informed decision making within the framework of a long-term perspective.

The Weaknesses. We could rightly be accused of burying our heads in the sand if we didn't acknowledge that the economy is laced with weaknesses. The events of September 11 have seriously eroded the public's confidence, which quickly resulted in a dismal September for retailers. Nearly all experts agree that holiday shoppers this year will not be going about their business with the free-spending ways familiar in recent years.

In addition, because the economy had grown progressively weaker over recent quarters, we've most likely already entered a recession that may last until the Fed's interest-rate cuts work their magic. Consumer spending makes up two-thirds of our economy, and a fearful consumer is less likely to spend. Productivity, a pillar of our economic strength in recent years, no longer shows impressive gains. What's more, public and private investment in security precautions (in transportation, for example) will serve as a tariff on our way of life; that is, increased spending but without much return aside from allaying our fears.

Perhaps the greatest weakness will be felt in our vast service economy. The domino effect stemming from September 11 quickly became apparent: First to fall were the industries built around airlines and then, in rapid order, hotels, resorts, restaurants, rental cars, entertainment, and all the industries that support them. These sectors may take a long time to recover fully because they depend on healthy consumer confidence.

The Opportunities. A little less exuberance, a bit more sophistication, a tad less overconfidence — that's not all bad. As a country, we may find our social values in better balance. Our nation has the opportunity to reorder its priorities, to take fewer of our many blessings for granted and — ironically — to become "the kinder, gentler nation" the elder President Bush once envisioned. At the same time, events have made us painfully aware that we no longer can afford to live in a "fool's paradise." Individually and collectively, we will need to be tougher, smarter, and more vigilant.

Turning from values to valuations, the excesses of recent years have largely been purged from the markets and replaced by more rational, reasonable return expectations. One can argue whether the Standard & Poor's 500 is now "X percent" undervalued or that on a price-earnings basis valuations are still above historical norms. That's not the point. Long-term investors never should chase short-term returns. Today's equity markets offer excellent opportunities for the thoughtful, long-term investor who seeks average annual inflation-adjusted returns from 7 percent to 10 percent.

Another opportunity lies in the skill sets of today's investment managers. We have plenty of smart, experienced investment managers to call on. And we (and they) have more tools than ever before. Whereas the opportunity set was once limited to domestic stocks and bonds, modern institutional investors typically include in their portfolios allocations to hedge funds, absolute-return strategies, real estate, venture capital, private equity, and oil and gas, not to mention a plethora of domestic and international equity strategies.

The Threats. In the grim area of threats, a tour of the horizon can actually start with some good news: Many economists expect a "U-shaped" recovery. What's more, they say, the country should bottom out in the "U" in late 2001 or early 2002. September 11 created a "V" at the bottom of the "U." Because of 9/11, that bottoming-out process probably will take longer, but the implication remains that we are at or near the bottom and should be turning up. That's where the caveat enters, in the form of fallout from another major terrorist strike. If such an event occurs, then the "V" becomes an "L," and we are in for a long recession.

Although no one wants war of any kind at any time, observers must be realistic enough to acknowledge that ramping up for a "wartime economy" could lift our present economic prospects. In our current condition, however, that isn't likely. The number of companies that stand to benefit from a protracted set of limited actions against terrorists is relatively small.

If anything, we are at risk of an overreaction by corporate leaders and the public. On the corporate side, we see lowered revenue expectations, widespread layoffs, and reduced capital spending. Vacant malls and cancelled vacations speak to the public's reaction. Such dramatic pullbacks are symptomatic of what we hope will occur — that is, a quick resolution to the situation, after which we can resume life as usual. In reality, our nation is being asked to do something that doesn't come naturally to us: Be patient.

Of course, there is always the alluring possibility that things will go better than we expect. We score victories over terrorists, capital investment resumes, corporate earnings rise, the stock market rallies, consumers spend at a healthy clip, and — with interest rates so low — all of these pluses combine, frustratingly, to ignite inflation. Yes, some asset classes — energy and real estate, for instance — will fare well in that environment, but most will not.

Finally, the outlook is unsettling in the realm of education finance. Several states already are running budget deficits, and more are certain to follow. Support for public higher education almost certainly will be reduced in these states for the first time in a decade. Private institutions will see their base of donors erode if the market enters a prolonged bear market, creating a "double whammy" on top of a decline in endowment market values.

Final Watchwords. Your board's investment committee surely will benefit from performing its own SWOT analysis. I can't tell you what particular strengths, weaknesses, opportunities, or threats will emerge, but the discussion will help trustees create a long-term view of events and force into relief the priority decisions your institution most needs to address. What I do recommend is that committees stay the course. Make changes where change is needed, but make your decisions in light of expectations over the next two to three years, not the next two to three months. It's always a good time to consider rebalancing, and now is no exception.

Among the asset classes to consider is real estate; in today's climate it offers attractive benefits as a diversifier, a source of current income, and an inflation hedge. Take a good look, as well, at alternative assets, including hedge funds, absolute-return strategies, venture capital, private equity, and international private capital.

Recently, the Commonfund Institute surveyed college and university endowments in anticipation of its next full "Commonfund Benchmarks Study," to be released this winter. Our "Interim Report" of results shows that 56 percent of respondents said they had changed their asset allocations in the past 12 months, with 40 percent reporting increases in hedge-fund allocations.

The report also uncovered something that, while not surprising, is a bit scary: 74 percent of respondents reported flat or negative returns for the fiscal year ending June 30, 2001. If your endowment is down and the decline is in the double-digits, you're going to have to be cautious. Even with a smoothing formula in place, your annual spending level is likely to be affected, and that may affect your operating budget.

In a nutshell, my advice to investment committees is to be cautiously optimistic, plan your endowment like a business plan, use SWOT analysis as a strategic-planning tool, make tactical decisions that support your strategic views, and diversify your investments.

John S. Griswold Jr. is senior vice president for marketing services and external relations of Commonfund Group in Wilton, Conn. He also directs the Commonfund Institute's educational and professional development activities.

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