A Pragmatic Approach to Portfolio Analysis

Robert D. Solimeno PhD

Immersitech LLC, 1776 Mentor Avenue, Suite 330, Cincinnati, Ohio 45212

Abstract Managers needing to allocate resources (both human and nancial) must decide in some fashion how the allocation takes place to maximize the value of their project portfolio. A dierent wayby application of a spreadsheet scoring model followed by Principal Components Analysis (PCA) produces a map of all projects and scoring parameters together in a single plot. This map is a useful aid to guide the critical decision making in allocating scarce resources.

Key words: portfolio analysis, project management, business strategy, maximizing portfolio value

Introduction

Many businesses in the manufacturing sector have an abundance of project work: to improve operations, to address quality issues, to develop new and innovative products, etc. These same businesses have a talented sta that these days is typically lean in number. This leads one to the conclusion that there is an even more acute need for an objective decision making process by which business managers decide on where to put their limited resources. This article presents another look at how to guide those decisions in a pragmatic way as a proxy for a more rigorous analytic method. The approach presented uses a multi-faceted scoring model followed by principal components analysis of the scoring results. The result is a map of all projects to guide the business stakeholders in deciding which projects should get the limited resources.

Background

The governing strategic approach with this model is that the value of the portfolio is maximized. The rst step in doing such a portfolio analysis is to list all projects in a portfolio and then to score each of them using a scoring model as has been described in Cooper, Edgett, and Kleinschmidt[1]. The scoring model is comprised of 19 questions in ve categories: (1) (2) (3) (4) (5) likelihood of commercial success, likelihood of technical success, business leverage, nancial reward, and strategic leverage.

Most often there will be many more projects than project scores. The project scores are easily compiled into a data matrix (spreadsheet) of 19 columns (the scores) by n rows (the projects). The traditional approach as explained in detail by Cooper, et al.[1] is to simply add the scores within each category to yield factor scores, and then to add the ve factor scores together in a weighted fashion to generate an overall project score. While simple and straight-forward, this approach homogenizes the information from this array of categories. Major concerns expressed by managers as described by Cooper, et al.[1] that use this technique are that: (1) Precision is imaginary project scores are necessarily compared and a threshold established for funding. When the overall averaged project scores are very close, one has to draw a line among a cluster of projects. Small dierences can be meaningless. The measured scores are not precise and are like uy cotton balls. To measure one with a micrometer can be misleading. (2) High scores across the board The Halo Eect a project scoring high on one criterion often score high on many criteria. As a result some rms have, over time, reduced the number of criteria signicantly to avoid the eect. Nevertheless, not all rms using the scoring model share this view and the various categories are thought to capture dierent facets of project value. (3) No assurance of eciency with purely nancial-based models (NPV or ECV methods) the parameter to be maximized is divided by the constraining resource to maximize the value of the portfolio. The scoring model as described fails to do this. 2

Growth Opportunity

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Market Attractiveness

Fig. 1. Scatter plot of Market Attractiveness versus Growth Opportunity for nine ctitious projects.

Simple Graphical Analysis

A graphical approach to data analysis of the raw scores has the potential to overcome the imaginary precision issue. Visualizing data by constructing simple scatter plots is an easily accomplished step toward identifying potential patterns. Any pair of scoring parameters may be arranged on an x-y scatter plot. As an example nine ctitious projects were scored for all 19 parameters and Figure 1 displays a plot of two of those parameterscomparing Market Attractiveness versus Growth Opportunity. Scatter plots like this can be constructed for any pairwise combination of the 19 parameters in the scoring model. Plotting all combinations of 19 x 19 parameters generates a matrix of 361 plots! Attempting to evaluate what all of the plots mean individually, and then as a whole is a most daunting exercise. Interpretation is so cumbersome at this level of granularity that the big picture is lost. Fortunately, there is a better way to analyze large data sets such as this . . . and even much larger ones. 3

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Track.Record Mfg.Capability 4 Growth.Opportunity 3 Competitive.Intensity Technical.Gap Equipment.Resources Technology.Skill.Base

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Fig. 2. Principal Component bi-plot of PC1 versus PC2 with overlaid loading vectors (numerals in the plot correspond to the project name listing, and parameter names appear at the maximum end of the loading vector)

A Pragmatic Approach

The improved analysis presented here retains the original 19 dimensions of the raw data in the scoring model without the homogenization induced by summing or averaging the individual scores. The scoring data are analyzed by a method known as Principal Components Analysis (PCA), rst described by Pearson[2]. A more modern textbook by Jollie [3] is a comprehensive text on the subject. The analysis, which may be accomplished with many modern statistical software packages, ultimately produces a two-dimensional plot of the data and the corresponding dimensions. The R environment for statistical computing [4] was used in preparation of this work. The plot is a map that managers can use to debate the relative merits of like and dissimilar projects. The ultimate desired outcome is that the map guides the key stakeholders in making as informed a decision as possible with the available information. The project map of nine ctitious projects is shown in Figures 2 and 3. 4

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Fig. 3. Magnication of Figure 2

Interpretation of Results

The PCA bi-plot packs a terric amount of information into a concise and seemingly simple plot. Interpretation may seem daunting at rst, but once the analyst recognizes a few features of the plot the real value of the method emerges. At rst glance one can see in Figure 2 a cluster of arrows and text superimposed upon a scatter plot of numbers from 1 to 9 (referring to the nine projects in the current portfolio under study) and their juxtaposition on the plot depicts how each of them relate to the others with respect to all 19 scoring parameters. Figure 2 quite literally represents a map of the project portfolio. Upon this map are superimposed each of the 19 parameters (the arrows) with which all nine projects were evaluated. The names of each parameter are shown adjacent to the respective loading vector. The rst principal component, PC1, is the major driver of the plot since it represents the greatest proportion of variance of any of the principal components. So directionally it makes sense to pay most attention to the x-axis corresponding to PC1 where we see a number of loading vectors pointing to the left. A clearer view of this is evident in 5

Figure 3 where projects 5, 7, and 8 appear in the upper end (high scores) of the distribution for most of the scoring parameters (e.g. Business Fit, Synergy, Market Attractiveness, Business Impact, etc pointing in generally similar directions). Those projects have a lot in common similar high scores for those parameters! Projects positioned opposite of any given arrow score low for that parameter. The general rule to follow is that projects clustered in proximity to each other have similar characteristics. Proximity of any project point, or cluster of projects, near a vector arrow indicate high values and opposite the arrow head are low values. Thus in contrast to projects 5, 7, and 8 projects 4, 3, 2, and 9 in the upper right quadrant of Figures 2 and 3 have similarities with each other but dier signicantly from the rst cluster. Projects 6 and 1 appear to be clear outliers from the others. Now that projects in the portfolio can be readily grouped in clusters, the picture of the portfolio as a whole becomes much clearer with respect to all metrics applied. Business managers can now debate which projects should be funded and logical decisions can be made about where resources will be put. Business strategy is not implemented until money is committed to specic projects. This analytical approach provides a most pragmatic, objective, and ecient data reduction to provide business managers a clear view of project opportunities for decision making.

Conclusion

The pragmatic approach of applying Principal Components Analysis to a portfolio of projects that have been scored among many criteria provides a useful visual map of how these projects are interrelated. This method also addresses at least one major concern expressed by managers using the scoring model: imaginary precision. The PCA analysis avoids the imaginary precision issue by graphically presenting the juxtaposition of all projects relative to each other and their raw scores. Management debate is still necessary to decide where to place resources, but project similarities and dierences are clearly related by position on the map. That debate is both stimulated and facilitated by employing this analysis and is perhaps one of the most valuable outcomes of this method of analysis.

References

[1] Robert Gravlin Cooper, Scott J. Edgett, and Elko J. Kleinschmidt. Portfolio management for new products. Perseus Publishing, 2001.

[2] Karl Pearson. On lines and planes of closest t to a system of points in space. Philisophical Magazine, 2:55772, 1901. [3] I.T. Jollie. Principal component analysis. Springer series in statistics. Springer, 2002. [4] The R Foundation. http://www.r-project.org/.