Change from outside, capability from inside
External environments constantly change, creating new opportunities and new challenges. Companies positioned to seize an opportunity prosper while others miss out; companies with strong fundamentals survive a threat while vulnerable ones perish. The Covid-19 pandemic locked down many businesses: a major threat under which weak balance sheets were extremely vulnerable and strong ones survived. Reading these factors lets an analyst judge both growth potential and risk tolerance.
SWOT, one of the popular frameworks for business fundamentals, stands for strengths, weaknesses, opportunities and threats. Strengths and weaknesses are internal to the company; opportunities and threats emanate from external conditions.
The first approach identifies strengths and weaknesses first, then asks which opportunities they can exploit and which threats the company is vulnerable to. The second identifies opportunities and threats first, then asks which strengths will exploit the opportunities and which weaknesses expose the company to the threats. The first suits a company deciding its strategy. For an external observer such as an equity analyst the second is more suitable, and in the economy-industry-company framework, where external conditions are studied before the company, it is also the logical order.
Strengths and weaknesses
| Strengths (internal capabilities to exploit opportunities and withstand threats) | Weaknesses (internal issues that create vulnerability or block opportunities) | |
|---|---|---|
| Finances | Strong financial position | Weak financial position |
| Costs and margins | Low cost or high margins | High fixed cost; low margins that can easily turn negative in a slowdown |
| Customers | Low customer concentration | Higher customer concentration |
| Assets and backing | Highly valuable intellectual property; support from a parent company or government | Significant legal cases that distract focus or can cause losses |
| Capability | Strong execution capability and track record | Lack of experience in executing a strategy or operating in an environment |
Focus on strengths and weaknesses that relate to the opportunities and threats. Lack of experience in self-driving cars is a weakness for an Indian auto maker only if catalysts are about to fuel that market; otherwise it is a weakness of no immediate relevance. A sequential decline in revenue or profit is not a weakness unless it makes the company lose a new opportunity, become ineligible for a loan, or creates some other vulnerability.
No company discloses its clout in government or the strength of its lobby, and a company hiding financial trouble through creative accounting is hard for outsiders to catch. SWOT is a good framework, but the analyst should stay aware of these blind spots.
Opportunities
Opportunities come from the external environment in countless forms; the syllabus gives an indicative list.
Threats
Threats are risks from the external environment, and the analyst must keep them apart from internal risks: high customer concentration is a risk, but being internal it is a weakness, not a threat. What creates an opportunity for one industry can threaten another.
Include opportunities and threats that have a reasonable probability of occurring. A Black Swan event like the Covid-19 crisis is always possible, but listing every conceivable threat produces a list too long to be useful.
A company depends on one customer for 40% of revenue (weakness), owns patents its rivals lack (strength), faces a proposed ban on its packaging material (threat), and could enter a neighbouring country whose capital controls were just lifted (opportunity). The first two are inside the company; the last two arrived from outside.
- External change creates opportunities and threats; well-positioned companies prosper and strong fundamentals survive (Covid-19 lockdowns punished weak balance sheets). Strengths and weaknesses are internal; opportunities and threats come from outside.
- Two approaches: strengths and weaknesses first, then opportunities and threats (suits a company setting strategy); or opportunities and threats first, then the strengths that exploit them and the weaknesses that expose the company (suits an external equity analyst and fits the economy-industry-company order).
- Strengths: strong finances, valuable intellectual property, low customer concentration, low cost or high margins, parent or government support, execution track record. Weaknesses: weak finances, high fixed cost, thin margins that can turn negative, high customer concentration, significant legal cases, lack of experience. Focus only on those relevant to the opportunities and threats; outsiders cannot see everything (lobbying clout, creative accounting).
- Opportunities: inflection events (new battery technology, production moving out of China after Covid), new business from technology or regulation (Companies Act 2013 consulting, Y2K for Indian IT, ESG compliance), geographic expansion, consolidation in adverse conditions (Jet Airways' April 2019 suspension, cheap shares and low rates in recessions). Threats: recession, regulatory headwinds (single-use plastics ban), technological disruption (AI versus BPO), deregulation removing entry barriers (RBI's on-tap bank licences). Include only threats with reasonable probability; a Black Swan like Covid-19 exists but listing everything is useless.