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

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.