portfolio management 101

Portfolio Simulation Discussion

David Matheson, President and

CEO

(c) 2000-2013 SmartOrg, Inc.1


David Matheson

Dr. David Matheson has helped senior management of firms in the United States and Europe improve their results from portfolio

management, product development, innovation, R&D, capital

investment and strategy, and is an expert on measuring value and

managing uncertainty.

His practical experience covers a wide variety of industries, including

printing, software development, biotechnology, telecommunications,

chemicals, pharmaceuticals, medical devices, manufacturing, electric

power and entertainment.

He is co-author of the best selling book, The Smart Organization:

Creating Value through Strategic R&D (Harvard Business School Press)

and has authored numerous articles on innovation, portfolio

management and decision making.

In addition to SmartOrg, his executive roles include: currently member

of the board at Photozini, Inc. and prior to founding SmartOrg in 2000, a

principal at Strategic Decisions Group.

His Ph.D. is from Stanford University, where he currently teaches on

Strategic Portfolio Management and other topics at the Stanford

Center for Professional Development

SmartOrg software and services helps companies find the most profitable projects


Life science Aerospace Technology Other

http://www.bayer.com/

http://www.lilly.com/index.html

http://www.ineco.es/ApliServlet?accion=verPagina&idNavegacion=100

http://www.alcatel-lucent.com/wps/portal/!ut/p/kcxml/04_Sj9SPykssy0xPLMnMz0vM0Y_QjzKLd4w3cjUDSUGYpvqRKGIG8Y4IkSB9b31fj_zcVP0A_YLc0IhyR0dFAJgg_-M!/delta/base64xml/L3dJdyEvd0ZNQUFzQUMvNElVRS82X0FfMkU2

http://www.cisco.com/en/US/hmpgs/index.html

http://www.andersenwindows.com/

Software and services to help you build your capability.

Portfolio Navigator Software Services


Evaluate and track

sources of value,

risk and upside.

Focus stakeholders

on critical issues.

Aggregate and

compare projects

and portfolios.

Jim Matheson, Ph.D. Chairman

Nadine Oeser,European Consultant

Greg Lorch,Consultant

Somik Raha, Ph.D.Consultant

Grant Steinfeld,Software

Peter McNamee, Ph.D. Solutions & Software

• Training & Coaching

• Management Consulting

• Pilots & Implementation

Projects

• Customization

We are just launching a new product, Rangal


A portfolio is a related set of assets that compete for resources and deliver value for an organization.


Portfolio

Asset 5

€ $ ¥

Asset 4

€ $ ¥

Asset 3

€ $ ¥

Asset 2

€ $ ¥

Asset 1

€ $ ¥

Value

Delivered

Interactions among the assets increase the complexity of portfolio

decision-making. Examples:

• Synergy, cannibalization, and halo effects among assets

• Common variables that affect multiple assets (e.g., oil price)

• Contribution to the same organizational objectives

• Competition for multiple types of limited resources

Limited

Resources

What is your most important portfolio business challenge?

Too many projects for our

resources

Cutting costs without cutting the

future

Delivering growth

Getting more for less faster

Other

0 5 10 15 20 25 30 35 40 45

Here are survey results on challenges felt by participants in a previous course:

“Improve Results”

“Relieve Pain”

What frustrates you most about your portfolio process?

0 5 10 15 20 25 30 35

Most of the items below

Decisions cycle, get made

late or ineffectively

Politics dominate decisions

No consistent & transparent

way to measure value

Unable to address risk &

uncertainty systematically

Other

Percent


SPD-Framework v15—8 © 2009 by Stanford Strategic Decision and Risk Management. All rights reserved.

Strategic Decision and Risk Management

A Professional Certificate Program

A person who undertakes to

carry a cat home by the tail

learns ten times as much as a

person who simply watches.

Mark Twain


We will focus on a portfolio of projects (or assets or opportunities), each having two kinds of uncertainty:

• Achieving Project Success (Overcoming all hurdles)

– In R&D or development projects this means creating a commercially viable result and passing all of the legal, regulatory and sometimes public acceptance barriers that allow a attempt at commercialization

- This could mean creating a new drug, finding an oil or mineral deposit, creating new software, developing an idea for a movie into an actual ―green light‖ project, etc.

– In more general circumstances it means doing whatever it takes to get a shot at producing profits

- For example, acquiring the right kind of firm or capability, arranging a consortium, getting agreement on a international standard or regulation, lining up a joint venture, etc.

• The Value of Commercial Success (Extracting the Value)

– Most often characterized as an uncertain net present value, which depends on uncertainties such as market demand, competitive response, production costs, etc.


We will characterize a project with two uncertainties: success and value.

(c) 2000-2013 SmartOrg, Inc.

Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if

SuccessfulProject Score

(Points)

Success of

Project

.16

11

Key for Dice Simulation


Success of Project Value of Project

White:

1 = success

2,3,4 = failure

Black:

1 = failure

2,3,4 = success

Roll only if you have achieved

technical success.

Red:

1–6 = payoff in points

Yellow:

1–20 = payoff in points

12

These dice give us four types of projects.


White Elephant Oyster

Bread and Butter Pearl

Ha

rd(low

)

Ea

sy

(hig

h)

Value if successful

(Why do it?)

Dif

fic

ult

y

(Ho

w h

ard

is

it?

)Innovation Screen

Pro

ba

bili

ty o

f S

ucce

ss

Net Present Value Given Success(low)

Incremental(high)

Game Changing

Instructions for Portfolio Simulation


• Each team gets a tray with 10 potential projects.— It will cost $5 per team to play (funding five projects).

• Analyze your portfolio.

• Select the five projects you want to fund.

• Simulate the results of each project (as instructed). Receive

point payoff based on the commercial success of your

successful projects.

• The teams that score ten points or more will each win $10;

those that score less than ten points receive nothing.

• Whichever team achieves the greatest commercial success

will receive an added 20 point market share bonus and $20.

14

People tried a variety of strategies


1 Pearl4 B&B0 Oyster





0 Pearl

Report on Analysis of Portfolio Strategy


• A table showing the mean value of each type of project

• A graph showing the risk and return of pursuing different strategies

• Analysis of the critical trade-offs implicit in choosing different strategies

16

What is this project worth?


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if


(Points)

Success of

Project

.16

17

What evaluation method is most common in your organization?

Make assumptions and put into a financial model to

calculate a figure of merit based on:

1. A high case to show what is possible.

2. A low case so you can exceed expectations.

3. A most likely case.


Value based on a business case—a high number:


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if


(Points)Success of

Project

.16

A big lie you tell to get

funding. The value goes

down as the truth

becomes revealed.

19

Value based on a business case—a low number:


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if


(Points)Success of

Project

.16

You may be able to

exceed expectations with

this number. Works best

when project is already

approved. Or used by

opponents to kill a

project.

20

Value based on a business case—most likely case:


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if


(Points)Success of

Project

.16

The most likely case is

that the project doesn’t

work. This looks like

planning for failure!

Unworkable as an

evaluation.

Not clear what ―most

likely‖ means here.

Perhaps a 3 or 4?

21

The expected value* approach combines multiple scenarios:


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Value if


(Points)Success of

Project

.16

Value given success = 3.5 =

=.16 * 6 + .16 * 5 + … + .16 * 1

*Also called probability weighted average or risk-adjusted value.

3.5Project Value = 0.875 =

= .25 * 3.5 + .75 * 0

0.875Note that what the

project is worth is in this

case a value that can

never actually occur!

22

All the projects are valuable.



Ha

rd(low

)

Ea

sy

(hig

h)

Value if successful

(Why do it?)

Dif

fic

ult

y

(Ho

w h

ard

is

it?

)Innovation Screen

Pro

ba

bili

ty o

f S

ucce

ss


Incremental(high)

Game Changing

Value =

2.625

Value =

0.875

Value =

2.625

Value =

7.875


A major challenge in portfolio management:

Saying “no” to a good idea…

In order to fund a better one…

How do you make a “no” stick?

• Power

• Pursuasion


http://images.google.com/imgres?imgurl=http://www.pachd.com/free-images/household-images/pennies-01.jpg&imgrefurl=http://www.pachd.com/free-images/household-images.html&usg=__q0kR7vIljAG-dPl8o0JAXuXW-GE=&h=768&w=1024&sz=169&hl=en&start=1&sig2=G7aziAsK0vJfMh_UT-_MjQ&um=1&tbnid=ChIzlKS0aEz0fM:&tbnh=113&tbnw=150&prev=/images?q=pennies&hl=en&rls=com.microsoft:en-us&sa=N&um=1&ei=_epYS_CDGpTEM_CEgN0E

http://www.homeenergyaffordabilitygap.com/Images/HowToUse_Images/dollars pic2.jpg

The gold standard of persuasion:

The political loser comes to the same

conclusion himself.

This decision is

bad for me but I

have to agree it is

the right priority.


http://mindmillion.com/MONEY/gold-treasure-wealth.htm

The silver standard of persuasion:

The political loser accepts that the process was

fair and accurate.

This decision is bad

for me and I think

it’s the wrong

choice, but at least

they heard the full

story and made a

tough call.


The budget constraint requires you to forego valuable projects.

The CFO Chart

0

4

8

12

16

20

24

28

32

36

40

0 2 4 6 8

Cumulative Investment

Cu

mu

lati

ve

Va

lue

10

Budget Limit

Pearl

White Elephant


The main challenge is to balance bread and butter projects and oyster projects.



Ha

rd(low

)

Ea

sy

(hig

h)

Value if successful

(Why do it?)

Dif

fic

ult

y

(Ho

w h

ard

is

it?

)Innovation Screen

Pro

ba

bili

ty o

f S

ucce

ss


Incremental(high)

Game Changing

Value =

2.625

Value =

0.875

Value =

2.625

Value =

7.875


Is this merely a risk / return tradeoff?

GREED

vs


The Oyster Strategy is more uncertain than the Bread & Butter strategy.


Question Metric

Which is

better?

Expected Value

Downside

risk?

Chance of getting

less than 10 points

Upside

potential?

Chance of getting

more than 25 points

Bread & Butter

18

15%

5%

Oyster

18

30%

20%

Bread & Butter strategy = 1 Pearl, 4 Bread & Butters

Oyster strategy = 1 Pearl, 4 Oysters

What does it take to win?


Choosing the oyster strategy gives you a greater chance of winning the market share bonus.

0 1 2 3 4 5

10

15

20

Oyster Strategy

5 4 3 2 1 0Bread and Butter Strategy

Pro

bab

ilit

y o

f W

inn

ing

(%

)

Key

I Choose the

Bread and

Butter Strategy

I Choose the

Oyster Strategy

What Others Play


People tried a variety of strategies







0 Pearl

Results for the unfunded portfolio.


Avg=

11.3

Unfunded

Avg Succ. =

2.1 Unfunded

Projects

Key:

Some rejected projects would have succeeded.

I’d sure like to kill this project!

But what if I were to

succeed?


The embarrassment factor.

Some of your rejected projects would have succeeded.


Comparison of funded and unfunded portfolio scores.


Avg=

11.3Avg=

18.6

Unfunded

Avg Succ. =

2.1

Funded Avg

Succ. = 2.8

Unfunded

Projects

Funded

Projects

Key:


Histogram of scores by strategy


The riskier strategies are more likely to win competitively.

Good portfolio decisions create value.


Is there any way to capture some of the value of the unfunded portfolio?

# Succ. Points # Succ. Points

Overall 2.1 10.4 2.8 18.5

Safe (B&B) 1.3 12.1 3.9 20.4

Hopeful 1.4 8.4 3.2 16.0

Balance 2.2 10.2 2.8 19.1

Chicken 2.6 10.4 2.1 19.1

Go for it (Oyster) 3.8 12.4 1.2 15.1

Other 1.8 11.8 2.9 19.9

UNFUNDED FUNDED

Our metric for project value starts small and increases as a project progresses through the pipeline.


Roll a 6

Roll a 5

Roll a 4

Roll a 3

Roll a 2

Roll a 1

.16

.16

.16

.16

.16

.25

.75

Success

(Roll a 1)

Failure

(Roll a 2, 3, or 4)

6

5

4

3

2

1

0

Commercial

Phase

Business

Impact

(Points)

Technical

Phase

.163.5

0.875

Project

Value

entering

technical

phase

Project

Value

entering

commercia

l phase

41

A portfolio has “option value” if we can postpone committing until we know more about each project.


Choose

Projects

Technical

Development

Market

Value

Success

Failure

Choose

Projects

Technical

Development

Market

Value

Success

Failure

Choose

ProjectsTechnical

Development

Market

Value

Success

Failure

Choose

Projects

Technical

Development

Market

Value

Success

Failure

Technical Success Information

Complete InformationCommercial Contribution Information

Choose First - No Information

What are your best five projects

given complete information?

The value of the portfolio increases as more information is available before project decisions are made.


What is it worth paying to keep

projects “alive”?:

Value with option (select after

technical development) = 27.8

Value without option (select now) =

18.0

Option Value = 9.2

It is beneficial to have more

projects in the pipeline than you

could ever afford to

commercialize!0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 10 20 30 40 50 60 70

Portfolio Value

Cu

mu

lati

ve P

rob

ab

ilit

y

None

Market

Technical

Full

18.0

22.6

27.8

28.6

Illustrated for the Oyster strategy

Impact of improved information.


Avg=

11.3 Avg=

18.6Avg=

25.4

Unfunded

Avg Succ. =

2.1

Funded Avg

Succ. = 2.8

Selected

Avg Succ. =

5.0

Unfunded

Projects

Funded

Projects

Selected

Projects

Key:

Learning about the most decisive uncertainty creates the most value.


Expected

Value Probability Result Decision EV Result

NO INFORMATION

2.625 2.625

TECHNICAL INFORMATION

4.594 0.25 Success Stay 10.5

0.75 Fail Switch 2.625

COMMERCIAL INFORMATION

3.250 0.05 20 Stay 5

0.05 19 Stay 4.75

0.05 18 Stay 4.5

0.05 17 Stay 4.25

0.05 16 Stay 4

0.05 15 Stay 3.75

0.05 14 Stay 3.5

0.05 13 Stay 3.25

0.05 12 Stay 3

0.05 11 Stay 2.75

0.05 10 Switch 2.625

0.05 9 Switch 2.625

0.05 8 Switch 2.625

0.05 7 Switch 2.625

0.05 6 Switch 2.625

0.05 5 Switch 2.625

0.05 4 Switch 2.625

0.05 3 Switch 2.625

0.05 2 Switch 2.625

0.05 1 Switch 2.625

Expected

Value Probability Result Decision EV Result

ALL INFORMATION

4.622 0.0125 20 Stay 20

0.0125 19 Stay 19

0.0125 18 Stay 18

0.0125 17 Stay 17

0.0125 16 Stay 16

0.0125 15 Stay 15

0.0125 14 Stay 14

0.0125 13 Stay 13

0.0125 12 Stay 12

0.0125 11 Stay 11

0.0125 10 Stay 10

0.0125 9 Stay 9

0.0125 8 Stay 8

0.0125 7 Stay 7

0.0125 6 Stay 6

0.0125 5 Stay 5

0.0125 4 Stay 4

0.0125 3 Stay 3

0.0125 2 Switch 2.625

0.0125 1 Switch 2.625

0.75 0 Switch 2.625

Value of Information Calculation for Oyster Project

The greatest opportunity for capturing option value comes from the oyster projects.

0 1.97(25%)

0.63(50%)

2.0(22.5%)

0 0.66(75%)

0.56(50%)

0.94(50%)

Oys

ter

Pro

jec

tB

rea

d &

Bu

tte

r P

roje

ct

Value of information based on opportunity cost in portfolio of 2.625

No Information Technical

Success

Commercial

Contribution

Technical &

Commercial

Greater uncertainty leads to greater option value!


Capturing this option value requires an efficient pipeline and an ability to make great strategic decisions over time.


Intake - Ideation

$ $ $

Fuzzy Front End

Market & Technical Evaluation

Whole-Product

Development

Scale

Up

Commercialization

Product Development

& Trial

1000 serious

ideas

100 developed

and tried

10 taken to

scale

3 commercialized

1 great success

47

Poor decision making results in poor pipelines and significant loss of value.


Fuzzy Front End

Commercialization

$

The Bucket:

too expensive

Fuzzy Front End

Commercialization

$

The Straw:

not enough innovation

―Strategic‖

decisions

made too

early and too

broadly.

No

decisions--

everything

is funded.

Summary results table


# Succ. Points # Succ. Points # Succ. Points

Overall 2.1 10.4 2.8 18.5 5.0 23.6

Safe (B&B) 1.3 12.1 3.9 20.4 3.0 23.2

Hopeful 1.4 8.4 3.2 16.0 5.0 19.9

Balance 2.2 10.2 2.8 19.1 5.0 24.3

Chicken 2.6 10.4 2.1 19.1 5.0 28.1

Go for it (Oyster) 3.8 12.4 1.2 15.1 5.0 22.1

Other 1.8 11.8 2.9 19.9 4.0 19.8

UNFUNDED FUNDED SELECTED

A strategic perspective on portfolio management:


• You cannot pick winning projects–but you can pick a portfolio with good prospects.

— Uncertainty about which projects will be the winners is not the same as portfolio risk.

— Some rejected projects will succeed.

— Good decisions add value

• If you are going to take long shots–take lots of them.— To beat the competition you have to take long shots–conservative

portfolios are unlikely to win.

— Many organizations implicitly encourage conservative portfolio strategy, by rewarding project success.

• Great value is available from capturing the option value of projects through an efficient pipeline.

— Identify your risks and work on the hard ones first = “fail fast”

— Greater uncertainty leads to greater option value!

50

And our book award goes to the highest scoring person present.


Award: based on funded points, then successes, then best 5 points

Name Points

Sailor Moon 43

Adrian 40

Skyler Dougherty 33

Kaia Simmons 32

Sharon Zhang 27

Petar B. Manchev 27

Kirsten 26

Stephen 25

portfolio management 101

Education

portfolio asset

smartorg software

strategic portfolio

founding smartorg

portfolio process

software development

value deliveredinteractions

measuring value