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Portfolio management 101

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Portfolio Management 101: This presentation was part of a Stanford class where students learned the basics of Portfolio Management.

Portfolio Management 101: This presentation was part of a Stanford class where students learned the basics of Portfolio Management.

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  • 1. Portfolio Simulation Discussion David Matheson, President and CEO 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 2 (c) 2000-2013 SmartOrg, Inc.
  • 3. SmartOrg software and services helps companies find the most profitable projects Life science 3 (c) 2000-2013 SmartOrg, Inc. Aerospace Technology Other
  • 4. Software and services to help you build your capability. Portfolio Navigator Software Evaluate and track sources of value, risk and upside. Services • Training & Coaching • Management Consulting • Pilots & Implementation Projects • Customization Focus stakeholders on critical issues. Aggregate and compare projects and portfolios. Peter McNamee, Ph.D. Solutions & Software Nadine Oeser, European Consultant 4 (c) 2000-2013 SmartOrg, Inc. Somik Raha, Ph.D. Consultant Grant Steinfeld, Software Jim Matheson, Ph.D. Chairman Greg Lorch, Consultant
  • 5. We are just launching a new product, Rangal 5 (c) 2000-2013 SmartOrg, Inc.
  • 6. A portfolio is a related set of assets that compete for resources and deliver value for an organization. Portfolio Limited Resources 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 6 (c) 2000-2013 SmartOrg, Inc.
  • 7. Here are survey results on challenges felt by participants in a previous course: What is your most important portfolio business challenge? 0 5 10 15 20 25 30 35 40 45 Too many projects for our resources Cutting costs without cutting the future What frustrates you most about your portfolio process? Percent 0 5 10 Most of the items below Delivering growth Decisions cycle, get made late or ineffectively Getting more for less faster Politics dominate decisions No consistent & transparent way to measure value Other “Improve Results” Unable to address risk & uncertainty systematically Other “Relieve Pain” 7 (c) 2000-2013 SmartOrg, Inc. 15 20 25 30 35
  • 8. Strategic Decision and Risk Management A Professional Certificate Program SPD-Framework v15—8 © 2009 by Stanford Strategic Decision and Risk Management. All rights reserved.
  • 9. 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 9 (c) 2000-2013 SmartOrg, Inc.
  • 10. 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. 10 (c) 2000-2013 SmartOrg, Inc.
  • 11. We will characterize a project with two uncertainties: success and value. Success of Project Value if Successful Roll a 6 .16 Success (Roll a 1) .25 .16 .16 .16 .16 .16 .75 11 Failure (Roll a 2, 3, or 4) (c) 2000-2013 SmartOrg, Inc. Roll a 5 Roll a 4 Roll a 3 Roll a 2 Roll a 1 Project Score (Points) 6 5 4 3 2 1 0
  • 12. Key for Dice Simulation Success of Project Value of Project Roll only if you have achieved technical success. White: 1 = success 2,3,4 = failure Black: 1 = failure 2,3,4 = success 12 Red: 1–6 = payoff in points Yellow: 1–20 = payoff in points (c) 2000-2013 SmartOrg, Inc.
  • 13. Probability of Success (high) Innovation Screen Bread and Butter White Elephant (low) Hard Difficulty (How hard is it?) Easy These dice give us four types of projects. (low) Incremental 6 (c) 2000-2013 SmartOrg, Inc. Net Present Value Given Success Value if successful (Why do it?) Pearl Oyster (high) Game Changing
  • 14. Instructions for Portfolio Simulation • Each team gets a tray with 10 potential 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 — It will cost $5 per team to play (funding five projects). (c) 2000-2013 SmartOrg, Inc.
  • 15. People tried a variety of strategies 1 Pearl 2 B&B 2 Oyster 1 Pearl 4 B&B 0 Oyster 15 (c) 2000-2013 SmartOrg, Inc. 1 Pearl 3 B&B 1 Oyster 1 Pearl 1 B&B 3 Oyster 1 Pearl 0 B&B 4 Oyster 0 Pearl
  • 16. Report on Analysis of Portfolio Strategy • • A graph showing the risk and return of pursuing different strategies • 16 A table showing the mean value of each type of project Analysis of the critical trade-offs implicit in choosing different strategies (c) 2000-2013 SmartOrg, Inc.
  • 17. What is this project worth? Success of Project Value if Successful Roll a 6 .16 Success (Roll a 1) .25 .16 .16 .16 .16 .16 .75 17 Failure (Roll a 2, 3, or 4) (c) 2000-2013 SmartOrg, Inc. Roll a 5 Roll a 4 Roll a 3 Roll a 2 Roll a 1 Project Score (Points) 6 5 4 3 2 1 0
  • 18. 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. 18 (c) 2000-2013 SmartOrg, Inc.
  • 19. Value based on a business case—a high number: Success of Project Value if Successful Project Score (Points) Roll a 6 .16 Success (Roll a 1) .25 .16 .16 .16 .16 .16 .75 19 Failure (Roll a 2, 3, or 4) (c) 2000-2013 SmartOrg, Inc. 6 Roll a 5 5 Roll a 4 4 Roll a 3 3 Roll a 2 2 Roll a 1 1 0 A big lie you tell to get funding. The value goes down as the truth becomes revealed.
  • 20. Value based on a business case—a low number: Success of Project Value if Successful Project Score (Points) Roll a 6 .16 Success (Roll a 1) .25 .16 .16 .16 .16 .16 .75 20 Failure (Roll a 2, 3, or 4) (c) 2000-2013 SmartOrg, Inc. 6 Roll a 5 5 Roll a 4 4 Roll a 3 3 Roll a 2 2 Roll a 1 1 0 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.
  • 21. Value based on a business case—most likely case: Success of Project Value if Successful Project Score (Points) Roll a 6 .16 Success (Roll a 1) .25 .16 .16 .16 .16 .16 .75 21 Failure (Roll a 2, 3, or 4) (c) 2000-2013 SmartOrg, Inc. 6 Roll a 5 5 Roll a 4 4 Roll a 3 3 Roll a 2 2 Roll a 1 1 0 Not clear what ―most likely‖ means here. Perhaps a 3 or 4? The most likely case is that the project doesn’t work. This looks like planning for failure! Unworkable as an evaluation.
  • 22. The expected value* approach combines multiple scenarios: Success of Project Value given success = 3.5 = =.16 * 6 + .16 * 5 + … + .16 * 1 Project Value = 0.875 = = .25 * 3.5 + .75 * 0 Success 3.5 (Roll a 1) .25 Value if Successful Roll a 6 .16 .16 .16 .16 .16 0.875 .16 .75 6 Roll a 5 5 Roll a 4 4 Roll a 3 3 Roll a 2 2 Roll a 1 1 Failure (Roll a 2, 3, or 4) *Also called probability weighted average or risk-adjusted value. 22 (c) 2000-2013 SmartOrg, Inc. Project Score (Points) 0 Note that what the project is worth is in this case a value that can never actually occur!
  • 23. Probability of Success (high) Innovation Screen Value = 2.625 Value = 0.875 Pearl Value = 2.625 White Elephant (low) Incremental 23 Value = 7.875 Bread and Butter (low) Hard Difficulty (How hard is it?) Easy All the projects are valuable. (c) 2000-2013 SmartOrg, Inc. Net Present Value Given Success Value if successful (Why do it?) Oyster (high) Game Changing
  • 24. 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 24 (c) 2000-2013 SmartOrg, Inc.
  • 25. 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. 25 (c) 2000-2013 SmartOrg, Inc.
  • 26. 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. 26 (c) 2000-2013 SmartOrg, Inc.
  • 27. The budget constraint requires you to forego valuable projects. The CFO Chart 40 36 White Elephant 32 Cumulative Value 28 24 20 16 Budget Limit 12 Pearl 8 4 0 0 2 4 6 Cumulative Investment 27 (c) 2000-2013 SmartOrg, Inc. 8 10
  • 28. Probability of Success (high) Innovation Screen Value = 2.625 Value = 0.875 Pearl Value = 2.625 White Elephant (low) Incremental 28 Value = 7.875 Bread and Butter (low) Hard Difficulty (How hard is it?) Easy The main challenge is to balance bread and butter projects and oyster projects. (c) 2000-2013 SmartOrg, Inc. Net Present Value Given Success Value if successful (Why do it?) Oyster (high) Game Changing
  • 29. Is this merely a risk / return tradeoff? vs GREED 29 (c) 2000-2013 SmartOrg, Inc.
  • 30. 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% Bread & Butter strategy = 1 Pearl, 4 Bread & Butters 30 (c) 2000-2013 SmartOrg, Inc. Oyster 18 30% 20% Oyster strategy = 1 Pearl, 4 Oysters
  • 31. What does it take to win? 31 (c) 2000-2013 SmartOrg, Inc.
  • 32. Choosing the oyster strategy gives you a greater chance of winning the market share bonus. Probability of Winning (%) 20 Key 15 I Choose the Bread and Butter Strategy I Choose the Oyster Strategy 10 Oyster Strategy 0 1 2 3 4 5 Bread and Butter Strategy 5 4 3 2 1 0 What Others Play 32 (c) 2000-2013 SmartOrg, Inc.
  • 33. People tried a variety of strategies 1 Pearl 2 B&B 2 Oyster 1 Pearl 4 B&B 0 Oyster 33 (c) 2000-2013 SmartOrg, Inc. 1 Pearl 3 B&B 1 Oyster 1 Pearl 1 B&B 3 Oyster 1 Pearl 0 B&B 4 Oyster 0 Pearl
  • 34. Results for the unfunded portfolio. Unfunded Avg Succ. = 2.1 Avg= 11.3 34 (c) 2000-2013 SmartOrg, Inc. Key: Unfunded Projects
  • 35. Some rejected projects would have succeeded. I’d sure like to kill this project! 35 (c) 2000-2013 SmartOrg, Inc. But what if I were to succeed?
  • 36. The embarrassment factor. Some of your rejected projects would have succeeded. 36 (c) 2000-2013 SmartOrg, Inc.
  • 37. Comparison of funded and unfunded portfolio scores. Key: Avg= 11.3 37 (c) 2000-2013 SmartOrg, Inc. Unfunded Avg Succ. = 2.1 Avg= 18.6 Unfunded Projects Funded Projects Funded Avg Succ. = 2.8
  • 38. Histogram of scores by strategy 38 (c) 2000-2013 SmartOrg, Inc.
  • 39. The riskier strategies are more likely to win competitively. 39 (c) 2000-2013 SmartOrg, Inc.
  • 40. Good portfolio decisions create value. UNFUNDED FUNDED # Succ. Points # Succ. Points 2.1 10.4 2.8 18.5 Overall Safe (B&B) Hopeful Balance Chicken Go for it (Oyster) Other 1.3 1.4 2.2 2.6 3.8 1.8 12.1 8.4 10.2 10.4 12.4 11.8 Is there any way to capture some of the value of the unfunded portfolio? 40 (c) 2000-2013 SmartOrg, Inc. 3.9 3.2 2.8 2.1 1.2 2.9 20.4 16.0 19.1 19.1 15.1 19.9
  • 41. Our metric for project value starts small and increases as a project progresses through the pipeline. Technical Phase Commercial Phase Project Value entering commercia l phase Project Value entering technical phase Success (Roll a 1) .25 Roll a 6 .16 .16 3.5 .16 .16 .16 0.875 .16 Roll a 5 Roll a 4 Roll a 3 Roll a 2 Roll a 1 Business Impact (Points) 6 5 4 3 2 1 .75 Failure (Roll a 2, 3, or 4) 41 (c) 2000-2013 SmartOrg, Inc. 0
  • 42. A portfolio has “option value” if we can postpone committing until we know more about each project. Choose First - No Information Choose Projects Technical Development Market Value Technical Success Information Technical Development Success Failure Commercial Contribution Information Market Value Market Value Success Failure Choose Projects Choose Projects Technical Development Complete Information Technical Market Development Value Success Success Failure Choose Projects Failure What are your best five projects given complete information? 42 (c) 2000-2013 SmartOrg, Inc.
  • 43. The value of the portfolio increases as more information is available before project decisions are made. Illustrated for the Oyster strategy Cumulative Probability 100% 90% What is it worth paying to keep projects “alive”?: 80% Value with option (select after technical development) = 27.8 70% 60% Value without option (select now) = 18.0 50% None Market Technical Full 40% 30% 20% 18.0 Option Value 22.6 27.8 It is beneficial to have more projects in the pipeline than you could ever afford to commercialize! 28.6 10% 0% 0 10 20 30 40 Portfolio Value 43 (c) 2000-2013 SmartOrg, Inc. 50 = 9.2 60 70
  • 44. Impact of improved information. Unfunded Avg Succ. = 2.1 Key: Unfunded Projects Avg= 11.3 44 Funded Avg Succ. = 2.8 Avg= 18.6 (c) 2000-2013 SmartOrg, Inc. Avg= 25.4 Selected Avg Succ. = 5.0 Funded Projects Selected Projects
  • 45. Learning about the most decisive uncertainty creates the most value. Expected Value Value of Information Calculation for Oyster Project Probability Result Decision NO INFORMATION 2.625 EV Result 2.625 TECHNICAL INFORMATION 4.594 0.25 Success 0.75 Fail 10.5 2.625 COMMERCIAL INFORMATION 3.250 0.05 20 0.05 19 0.05 18 0.05 17 0.05 16 0.05 15 0.05 14 0.05 13 0.05 12 0.05 11 0.05 10 0.05 9 0.05 8 0.05 7 0.05 6 0.05 5 0.05 4 0.05 3 0.05 2 0.05 1 45 Stay Switch Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Switch Switch Switch Switch Switch Switch Switch Switch Switch Switch 5 4.75 4.5 4.25 4 3.75 3.5 3.25 3 2.75 2.625 2.625 2.625 2.625 2.625 2.625 2.625 2.625 2.625 2.625 (c) 2000-2013 SmartOrg, Inc. Expected Value Probability Result ALL INFORMATION 4.622 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.0125 0.75 Decision 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Stay Switch Switch Switch EV Result 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2.625 2.625 2.625
  • 46. The greatest opportunity for capturing option value comes from the oyster projects. Value of information based on opportunity cost in portfolio of 2.625 Bread & Butter Project Oyster Project No Information Technical Success Commercial Contribution Technical & Commercial 0 1.97 0.63 0 0.66 0.56 0.94 (25%) (75%) (50%) (50%) 2.0 (22.5%) (50%) Greater uncertainty leads to greater option value! 46 (c) 2000-2013 SmartOrg, Inc.
  • 47. Capturing this option value requires an efficient pipeline and an ability to make great strategic decisions over time. Intake - Ideation Fuzzy Front End 1000 serious ideas Market & Technical Evaluation 100 developed and tried Product Development & Trial Whole-Product Development 10 taken to scale Scale Up 3 commercialized Commercialization 1 great success 47 (c) 2000-2013 SmartOrg, Inc. $$$
  • 48. Poor decision making results in poor pipelines and significant loss of value. Fuzzy Front End Fuzzy Front End ―Strategic‖ decisions made too early and too broadly. No decisions-everything is funded. Commercialization Commercialization $ The Straw: not enough innovation 48 (c) 2000-2013 SmartOrg, Inc. $ The Bucket: too expensive
  • 49. Summary results table Overall UNFUNDED FUNDED SELECTED # Succ. Points # Succ. Points # Succ. Points 2.1 10.4 2.8 18.5 5.0 23.6 Safe (B&B) Hopeful Balance Chicken Go for it (Oyster) Other 49 (c) 2000-2013 SmartOrg, Inc. 1.3 1.4 2.2 2.6 3.8 1.8 12.1 8.4 10.2 10.4 12.4 11.8 3.9 3.2 2.8 2.1 1.2 2.9 20.4 16.0 19.1 19.1 15.1 19.9 3.0 5.0 5.0 5.0 5.0 4.0 23.2 19.9 24.3 28.1 22.1 19.8
  • 50. 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 (c) 2000-2013 SmartOrg, Inc.
  • 51. And our book award goes to the highest scoring person present. Name Points Sailor Moon 43 Adrian 40 Skyler Dougherty 33 Kaia Simmons 32 Sharon Zhang 27 Petar B. Manchev 27 Kirsten 26 Stephen 25 Award: based on funded points, then successes, then best 5 points 51 (c) 2000-2013 SmartOrg, Inc.