SWOT analysis can be a useful tool in evaluating and monitoring equity investments. Standing for "strengths, weaknesses, opportunities and threats," SWOT analysis was reportedly developed by Albert Humphrey in the 1960s and has become a staple concept in business management and investment evaluation. (To understand the qualities that make for a great company, investors must dig deep into "soft" metrics. Check out Qualitative Analysis: What Makes A Company Great?)

TUTORIAL: Behavioral Finance

Most commonly used as a business planning tool, SWOT analysis can be used to evaluate products, divisions, companies and entire markets. It can also be used as an investment tool; giving an investor a handy snapshot of the potential advantages or disadvantages of a company's current positioning.

The Components of SWOT
Although the concepts that make up a SWOT analysis seem straightforward, diligence and attention to detail are important. More than is generally the case with company and stock evaluation methods, SWOT analysis is a great example where the quality of results will never be better than the quality of the inputs.

It is also worth noting that, broadly speaking, strengths and weaknesses should reflect "what is" today, while opportunities and threats are more about what could happen in the future.

Strengths are characteristics that give the subject a meaningful advantage or form the basis of above-average performance potential. In many cases, a subject's strengths will be the basis of its competitive advantage. Not only do strengths consider what a company does well, but why or how it does it well.

In the case of a mining company, for instance, a valuable mineral asset in a politically stable country may be listed as a strength, while a major consumer company may have some of its greatest strengths in the value of its brands. It is important to note that above-average revenue growth or superior margins are not in and of themselves strengths – it is the popularity of the products or the relative efficiency of its manufacturing process that represent the real strengths.

In a SWOT analysis, weaknesses are vulnerabilities to the company's competitive position and/or opportunity to earn positive economic returns. Common weaknesses could include a unionized labor force, products that are essentially regarded as commodities, or the requirement to comply with expensive or elaborate regulatory regimes to sell its goods/services.

Weaknesses can also refer to how the company is integrated and affected by economic conditions. An economic environment heavily burdened with competition, for example, would be considered a potential weakness of the firm.

Opportunities represent scenarios or options where the company can meaningfully improve itself. The introduction of a significant product can be an opportunity, as well as a restructuring or acquisition. It is important to note, though, that "better margins" or "better sales" are not in themselves opportunities; generally more specificity is in order (the details of how the company will improve those margins or sales).

Another type of opportunity presents itself from an untapped customer demographic. For example, if an independent pizza restaurant on the west side of the side introduces a delivery service, it has the opportunity to expand its customer base beyond only those living in the neighborhood.

The threats portion of a SWOT analysis should answer the question "what could change for the worse?" with a particular company. Like opportunities, threats may be prospective or even theoretical, but they should offer more specificity than "something might go wrong." Increased government regulation, a failure to secure approval/acceptance for a major new product, or the introduction of a rival product/service would all represent meaningful threats to a company's competitive standing and economic returns.

There are key limitations that users of SWOT analysis should understand. To start, it totally ignores valuation and other significant fundamental metrics like return on capital, margins, cost of capital and so on. Although there is no rule out there that an investor cannot opt to include fundamental details as strengths or weaknesses in evaluating a stock's prospects as an investment, these analyses work best when the user explores why and how company earns a certain return on capital.

SWOT analysis also does not tend to offer much scope or scale to the size or significance of various opportunities and threats. It stands to reason that the creator of a SWOT analysis would not bother with non-material opportunities or threats, but it is nevertheless important to try to quantify the impact of these items on a company's returns.

The largest limitation of SWOT analysis is that it is subjective and self-directed. The entire process relies solely on the creator's knowledge and judgment, and there is an inherent potential for bias. In the case of a biotech, for instance, a bull may well see an experimental therapy as a major opportunity while a bear will see a weakness or threat in the vast amounts of money that are to spent developing a doomed therapy. Likewise, an optimist may well see an emerging brand as a major asset (a strength), while the bear sees little value in a brand and major threats from competition from more established brands/companies.

On balance, SWOT analysis is best used by investors as a way of crystallizing and quantifying the thought process that goes into an investment decision. The entire process can, and should, make an investor think more deeply about the weaknesses of and threats to a company, while also helping to tease out what is really important and distinctive about one company versus its rivals.

SWOT analysis also works best when it is done consistently. By using it on a regular basis and keeping track of the information, SWOT analysis can allow for better comparisons across industry participants and more frequent use can also help limit some of the dangers of bias and selective (or incomplete) analysis.

Investors can look at SWOT analysis as a good screening tool for potentially interesting ideas that merit further research. Likewise, investors may find that SWOT analysis provides a useful means of tracking current holdings and comparing the development and evolution of those companies to the original purchase theses. (These five qualitative measures allow investors to draw conclusions about a corporation that are not apparent on the balance sheet. Check out Using Porter's 5 Forces To Analyze Stocks.)

A SWOT analysis will not tell an investor what price is fair for a stock, or if a stock is presently undervalued. What SWOT analysis does do, however, is force some discipline and systematic thinking into the investment evaluation process. A careful and thoughtful analysis should bring into focus the balance of a company's advantages and vulnerabilities, and also give the investor a benchmark to evaluate the company in future years. (Knowing what the company's financial statements mean will help you to anaylze your investments. To learn more, visit Breaking Down The Balance Sheet.)

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