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.
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?
It is possible for a company to have a number of business lines and still be relatively easy to classify. Some companies may have a wide range of businesses under their umbrella but can still be understood as belonging in a particular sector. 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.
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. 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.