While the most important factors of an equity investment are the underlying fundamentals of the business, sector and industry classification are also important considerations.
For example, a given stock might be classified into the industrials sector, but this classification might not capture the totality of that company’s exposures and, likewise, all of the benefits and risks. As a result, an investor that is investing in a security partly because of its classification might be disadvantaged.
This is particularly important for investors who are considering a sector rotation strategy. With this strategy, an investor will typically buy companies in specific sectors based on an understanding of where the economy is in the business cycle, and which business sectors are poised to benefit from the expected future path of the economy.
The use of classification systems in sector rotation
There are 3 primary systems that investors use to sort companies into sectors: the Global Industry Classification Standard (GICS), the Industrial Classification Benchmark (ICB), and the Thomson Reuters Business Classification (TRBC).
One primary problem that these different classification methods may face is this: What if a company serves many markets or produces many things? In this scenario, classifying a company into a sector or industry can be complex. Further, it can be difficult to find an individual company where the primary drivers of value are identical to the whole industry. Consequently, classification systems can be imperfect with real potential consequences for the investor.
The case of General Electric
An excellent case in point for the limits of classification systems is one of the oldest and largest companies still operating, General Electric. General Electric is widely considered to be an “industrial” company because of its widely known industrial and manufacturing business segments. General Electric manufactures a wide range of products, ranging from toaster ovens to aviation equipment. However, GE also derives a large percentage of its revenues from its financial businesses.
This raises the complicated question as to how the company should be classified. An investor who wants to gain exposure to the industrials sector would certainly be able to do so by investing in General Electric. Yet the same investor would also gain significant exposure to the financial sector with GE.
Should GE be reclassified?
It might be intuitive to suggest that, since GE’s financing operations are so large, it makes sense to consider the company as a financial. However, it's important to consider the division in the context of the company as a whole. Even though the financial business contributes a large amount of the company's revenues, it's just one part of a larger company that operates in many segments.
So, even though GE does have a large exposure to the general trends that affect the financial industry through GE Capital, it has been determined by the various classifications systems consider the company an industrial stock.
This serves to illustrate a fundamental point that investors need to keep in mind if they use sector investing frameworks. Even though classification systems can be helpful in reaching an investment decision, they have their limitations. Investors should consider that they may have difficulty applying a wide-reaching framework without doing a little bit of additional homework.
Are these difficulties universal?
GE is just one example of many that illustrate the complexities that can arise with sector and industry classifications. Of course, it’s possible for a company to have a number of business lines and still be relatively easy to classify. Oracle, for example, has a wide range of businesses under its umbrella—manufacturing everything from servers to the Java programming language—but can still be understood as a company in the technology sector. There may be some cases where its solutions are used in other industries, but it principally provides technology solutions. Investors should always conduct careful research into any company they invest in to determine what exposures they may be gaining.
The limitations of the classification systems can also affect an investor’s ability to diversify appropriately. To reduce risk, investors can choose certain companies because they expect those securities to have low correlations to other portfolio holdings and perform independently in response to changes in the business cycle. Because a classification system may not adequately explain how a company generates its revenues, it could cause investors to unwittingly reduce overall portfolio diversification by choosing assets that are highly correlated to other portfolio holdings.
For example, an investor may purchase GE stock to gain the densification benefits of a company in the industrial sector, without realizing that they may also be getting exposure to the financial sector. For a portfolio with a significant allocation to financial stocks, the addition of GE stock may or may not provide additional diversification benefits and might actually increase overall portfolio risk. By not providing enough information on how a company could react to the business cycle, the limitations of various classification systems may affect investment performance and overall portfolio risk exposure.
Conclusion
When pursuing any sector rotation strategy, it is important that investors understand the limitations of the various sector classification systems, especially how they relate to the classification of conglomerates like GE. The reality that a classification system may not adequately represent a company’s business and the potential impact of the business cycle on its earnings can have implications for portfolio performance and diversification. For this reason, it's important that you not rely solely on the classification systems. By doing your own analysis and by understanding how a company generates its revenues, you're more likely to circumvent the limitations of sector classification and to select companies that fit your intended investment and risk strategies.