If you’ve ever listened to Warren Buffett talk about investing, you’ve heard him mention the idea of a company’s moat. The moat is a simple way of describing a company’s competitive advantage. A strong competitive advantage, or a wide moat, gives a company sustainability, which, as investors, we’re highly interested in.

In this article, we review a popular tool for evaluating competitive advantage, called SWOT analysis. SWOT analysis should be done on every company we’re thinking of making an investment in.

SWOT stands for:

Analyzing these four factors will help you make better investment decisions. It’s a brainstorming exercise, so take your time. A good SWOT analysis takes effort, but the more you put into SWOT analysis the better you will understand the company. Let’s look at each factor in turn.

Strengths

First, we look at the company’s strengths. What does the company do well? What makes it better than others? What does the company have, or do, that sets it apart from its competition?

These are important questions, and should include aspects of the company that made you consider it for investment in the first place. Look at branding, image, pricing power, size, market share, financial position (balance sheet strength), etc.

Here are some strengths to look for:

• The size of the company relative to others in the industry

• Balance Sheet strength

• Cash flows

• Perception of the company’s products

• Perception of the company’s brand(s)

• What advantages the company has over its competitors

• In general, what does the company do well?

Weaknesses

Now that you’ve determined how wonderful the company is, it’s time to look for the weaknesses. The same questions should be asked when looking for weaknesses. What does the company do poorly, or not so well? What are other companies doing better? What is keeping the company from greater success.

It’s important that you don’t gloss over this section. SWOT analysis is a brainstorming effort, so don’t discount anything that comes to mind. If you perceive a weakness, list it. The weakness you fail to list today could be why your investment turns out poorly next year.

Some weaknesses to look for:

• Deteriorating balance sheet

• Poor perception of company’s brand(s) and/or products

• Advantages other company’s have?

• Lack of management or other employee talent

• In general, what does the company do poorly?

Opportunities

We shift our focus to external factors when we look at opportunities. Here we try to identify areas of business we think the company is looking to enter, or should be looking to enter. We also look for opportunities to gain market share from competitors, or grow the company’s market to new customers.

But there are more than just external opportunities. There are opportunities within a company that should be considered. Can the company combine product lines to increase sales? Maybe the company has duplicate costs that can be streamlined. Companies can always find ways to do things better.

Some opportunities to look for:

• New markets for products

• Financial or legal trouble for competitors

• New technologies the company could adopt

• Changes in regulatory / tax burdens

• Strategic investments

• Internal efficiencies

Threats

Finally, we need to consider threats to the company. Again, threats can be internal as well as external. In fact, I’ve found that internal threats usually come first, which opens the door to external threats. Therefore, it’s important to do a good threat analysis.

Internal threats aren’t usually classified as such, which I think is a mistake. Any internal problem is a threat to the company’s well-being and should be evaluated alongside the external threats. For example, a company that relies on developing innovative products, such as Microsoft or Intel, faces the threat of losing engineering talent every day. This is an internal threat that could easily pave the way for external threats.

Some possible threats are:

• Internal obstacles the company is facing.

• Financial constraints on the company.

• Cash flow problems.

• The relative position of the company’s largest competitors.

• Technological advances in the industry (if the company isn’t keeping pace).

• New technologies that threaten to displace the company’s products.

SWOT analysis is a brainstorming activity, and you should learn from it. Focus on the weaknesses and the threats when doing SWOT, because that’s what will turn around and bite you after you make your investment. I’m not saying you should look only for the negatives, and ignore the company’s potential. But you should analyze the risks with as much, or more, scrutiny then the opportunities. Opportunities don’t always show up, but somehow risks always do.

About The Author

Chris Mallon is the editor and publisher of the Undervalued Weekly, a financial analysis newsletter. Chris holds a Master of Science in Finance and is the leading analyst for the Dynamic Investors partnership. He is available at chrismallon@dynamicinvestors.net or the through the website at www.dynamicinvestors.net/index7.html.

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