Portfolio Management Principles (Four-Region Framework)

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Most business strategies involve a series of investments over time. R&D programs and market-entry strategies, for example, are usually run in stages; initial investments are limited commitments that include the option to fully commit later on, and later investments are contingent on the performance of earlier ones. The key to creating value for customers is to make the right decisions--to exercise the investment (ramp up), abandon it, or maintain your options--at the right time.
Source: "Road Maps Through Uncertainty" by Hugh Courtney | Optimize, March 2002
| visit original source   Subject: Strategy/Frameworks

Most business strategies involve a series of investments over time. R&D programs and market-entry strategies, for example, are usually run in stages; initial investments are limited commitments that include the option to fully commit later on, and later investments are contingent on the performance of earlier ones. The key to creating value for customers is to make the right decisions–to exercise the investment (ramp up), abandon it, or maintain your options–at the right time.

When you’re facing high uncertainty, four factors are particularly relevant:

  1. The expected net present value of a full commitment strategy (the expected value of exercising the option)
  2. The degree of uncertainty over this NPV estimate
  3. The threat of competitive preemption and loss of opportunity involved with not exercising the option
  4. Other direct costs involved in maintaining the option, such as ongoing operating losses

The accompanying chart presents a framework for updating your strategy portfolio over time based on these four factors. The framework is divided into four “regions,” each with a different prescription for exercising, abandoning, or maintaining an option.

  • In region 1, the expected NPV of an immediate full commitment is greater than zero, and there’s very low uncertainty. The option is in the money, and the low uncertainty suggests that little will be gained by waiting; postponing the investment isn’t likely to generate any new information that will increase the odds of your making the right choice. In this case, exercise the option and make a full-commitment investment today.
  • In region 2, the expected NPV of an immediate full-commitment investment is also greater than zero, but there’s high uncertainty concerning this NPV estimate, and large losses are recognized as possible.
  • In this region, think like a New York Yankees general manager conducting contract negotiations with a star free agent. If negotiation costs are high, and the expected NPV is greater than zero, the manager should commit quickly with a big offer to lock the player in. But if costs are insignificant and no other team is bidding for the guy, it makes sense to keep negotiations open, do a little more research on his abilities and personality, and then make a final decision. Exercise an investment option in this region only if there’s a high probability of competitive preemption or if it’s very costly to maintain the option. Otherwise, maintain the option and postpone a decision.

  • In region 3, the expected NPV of an immediate full commitment is negative, but also very uncertain–implying that there could be significant profits. Here, it’s usually worthwhile to maintain the option and postpone the decision. Pharmaceutical companies maintain R&D investments in gene therapy despite negative expected NPVs because the extreme uncertainty also implies potentially huge profits. They’d abandon those investments only if they were burning cash at an unsustainable rate.
  • In region 4, the NPV of an immediate full-commitment investment is less than zero, and the uncertainty over this estimate is quite low. Odds are it will never make sense to exercise this option. Cut your losses and abandon it.

To get the most out of this framework, track the expected NPVs and degrees of uncertainty of potential investments. Opportunities may change regions over time as new information becomes available and uncertainties are resolved.

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