A big part of investing in the financial markets is navigating the business cycle. This is not only practical, but essential for successful portfolio building. A brief crash course on industry classifications and sectoral breakdowns is a good way to get started.
Businesses that operate in the financial markets are classified along several strata, including industry and sector. These classifications help investors to infer broader trends about the market and overall economy. Knowing your consumer staples from your financials is a good way to diversify your portfolio and hedge against risks associated with the ups and downs of the business cycle. Knowledge of these systems is also important when comparing companies that produce similar products or services and when evaluating the end markets they serve.
That being said, sorting stocks into separate industries and sectors isn’t as clear-cut as it sounds. In the following, we discuss three broad approaches for evaluating stocks on the basis of their industry or sectoral makeup.
Main Classification Systems
When it comes to evaluating equities, financial markets rely on three main classification schemas: the Global Industry Classification Standard (GICS), the Industrial Classification Benchmark (ICB) and the Thomson Reuters Business Classification (TRBC). Beyond these specific methods, experts group companies using one of two approaches: the production-oriented approach and market-oriented approach.
As the names imply, the production-oriented approach groups companies based on similar products and services, whereas the market-oriented approach classifies businesses based on the end-market they serve.
The Global Industry Classification System is a market-based schema that consists of more than 43,000 businesses compiled into 11 sectors, 24 industry groups, 69 industries and 158 sub-industries. The 11 first tier sectors include the following:
- Information Technology
- Consumer Discretionary
- Consumer Staples
- Real Estate
- Communications Services
The S&P 500 Index currently employs this industry classification. Under this system, each company is assigned a GIC classification code at the sub-industry level.
The Industrial Classification Benchmark tracks more than 70,000 companies in over 70 countries, making it one of the most comprehensive schemas available. Under the ICB system, businesses are grouped into 10 industries, 19 supersectors, 41 sectors and 114 sub-sectors. The 10 main industries include:
- Oil and Gas
- Consumer Services
- Basic Materials
- Consumer Goods
Each company in the ICB database is assigned a sub-sector level that most closely aligns with its business.
The ICB model retains many of the same features as GICS. As such, Apple is still listed under technology and Johnson & Johnson under healthcare. However, Procter & Gamble would go under consumer goods.
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Developed in 2004, the Thomson Reuters Business Classification index tracks more than 70,000 companies in over 130 nations along several criteria. These includes 10 economic sectors, 28 business sectors, 56 industry groups, 136 industries and 837 activities. Such comprehensive groupings allow investors to zero in on specific business activities.
The 10 main economic sectors tracked by the index include:
- Basic Materials
- Consumer Services
- Cyclical Consumer
- Non-Cyclical Consumer
Under this system, each company is assigned to an activity. The other levels of the classification system are assigned on the basis of a company’s primary activity. If a company has multiple business segments, the one with the largest revenue is considered the primary activity.
With respect to the companies discussed previously, Apple and Johnson & Johnson would retain their broad economic sector classification in technology and healthcare, respectively. Procter & Gamble, on the other hand, would fit under non-cyclical consumer.
The Bottom Line
With knowledge of industries and sectors in hand, you are now better prepared to compare stocks on the basis of their product or end market. You’ll be glad that you have this information once demonstrable changes to the business cycle occur.
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