portfolio management 101
TRANSCRIPT
Portfolio Simulation Discussion
David Matheson, President and
CEO
(c) 2000-2013 SmartOrg, Inc.1
(c) 2000-2013 SmartOrg, Inc.2
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
(c) 2000-2013 SmartOrg, Inc.3
Life science Aerospace Technology Other
Software and services to help you build your capability.
Portfolio Navigator Software Services
(c) 2000-2013 SmartOrg, Inc.4
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
(c) 2000-2013 SmartOrg, Inc.5
A portfolio is a related set of assets that compete for resources and deliver value for an organization.
(c) 2000-2013 SmartOrg, Inc.6
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
(c) 2000-2013 SmartOrg, Inc.7
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
(c) 2000-2013 SmartOrg, Inc.9
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.
(c) 2000-2013 SmartOrg, Inc.10
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
(c) 2000-2013 SmartOrg, Inc.
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.
(c) 2000-2013 SmartOrg, Inc.6
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
(c) 2000-2013 SmartOrg, Inc.
• 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
(c) 2000-2013 SmartOrg, Inc.15
1 Pearl4 B&B0 Oyster
1 Pearl2 B&B2 Oyster
1 Pearl3 B&B1 Oyster
1 Pearl1 B&B3 Oyster
1 Pearl0 B&B4 Oyster
0 Pearl
Report on Analysis of Portfolio Strategy
(c) 2000-2013 SmartOrg, Inc.
• 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?
(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
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.
(c) 2000-2013 SmartOrg, Inc.18
Value based on a business case—a high number:
(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
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:
(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
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:
(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
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:
(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
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.
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
Value =
2.625
Value =
0.875
Value =
2.625
Value =
7.875
(c) 2000-2013 SmartOrg, Inc.23
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
(c) 2000-2013 SmartOrg, Inc.24
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.
(c) 2000-2013 SmartOrg, Inc.25
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.
(c) 2000-2013 SmartOrg, Inc.26
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
(c) 2000-2013 SmartOrg, Inc.27
The main challenge is to balance bread and butter projects and oyster 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
Value =
2.625
Value =
0.875
Value =
2.625
Value =
7.875
(c) 2000-2013 SmartOrg, Inc.28
Is this merely a risk / return tradeoff?
GREED
vs
(c) 2000-2013 SmartOrg, Inc.29
The Oyster Strategy is more uncertain than the Bread & Butter strategy.
(c) 2000-2013 SmartOrg, Inc.30
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?
(c) 2000-2013 SmartOrg, Inc.31
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
(c) 2000-2013 SmartOrg, Inc.32
People tried a variety of strategies
(c) 2000-2013 SmartOrg, Inc.33
1 Pearl4 B&B0 Oyster
1 Pearl2 B&B2 Oyster
1 Pearl3 B&B1 Oyster
1 Pearl1 B&B3 Oyster
1 Pearl0 B&B4 Oyster
0 Pearl
Results for the unfunded portfolio.
(c) 2000-2013 SmartOrg, Inc.34
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?
(c) 2000-2013 SmartOrg, Inc.35
The embarrassment factor.
Some of your rejected projects would have succeeded.
(c) 2000-2013 SmartOrg, Inc.36
Comparison of funded and unfunded portfolio scores.
(c) 2000-2013 SmartOrg, Inc.37
Avg=
11.3Avg=
18.6
Unfunded
Avg Succ. =
2.1
Funded Avg
Succ. = 2.8
Unfunded
Projects
Funded
Projects
Key:
(c) 2000-2013 SmartOrg, Inc.38
Histogram of scores by strategy
(c) 2000-2013 SmartOrg, Inc.39
The riskier strategies are more likely to win competitively.
Good portfolio decisions create value.
(c) 2000-2013 SmartOrg, Inc.40
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.
(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
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.
(c) 2000-2013 SmartOrg, Inc.42
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.
(c) 2000-2013 SmartOrg, Inc.43
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.
(c) 2000-2013 SmartOrg, Inc.44
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.
(c) 2000-2013 SmartOrg, Inc.45
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!
(c) 2000-2013 SmartOrg, Inc.46
Capturing this option value requires an efficient pipeline and an ability to make great strategic decisions over time.
(c) 2000-2013 SmartOrg, Inc.
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.
(c) 2000-2013 SmartOrg, Inc.48
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
(c) 2000-2013 SmartOrg, Inc.49
# 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:
(c) 2000-2013 SmartOrg, Inc.
• 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.
(c) 2000-2013 SmartOrg, Inc.51
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