Effective portfolio designs begin with an understanding of the organizing structure used to classify and evaluate the thousands of publicly held companies offering investment opportunities. Various classification systems exist, but all are based on aggregating businesses into similar groups in order to compare and analyze their performance. How well the different systems keep up with the times and emerging (or declining) industries also varies; most are reviewed and/or modified periodically. In the investment world, a globally consistent and easily understood industry analysis framework is essential.
The terminology of industries and sectors is essentially a commonsense reflection of how people tend to talk about the economy and the business world. Companies are assigned to an industry based on the similarity of their primary line of business. Related industries are aggregated into a few major sectors. In short, it’s a matter of scope. Sectors pertain to big, generic categories of the economy and are generally limited to a dozen or so, depending on the classification system used. Industries and subindustries are increasingly specific and contain progressively fewer members.
For example, the Health Care sector includes such industries as Equipment and Supplies, Care Providers & Services, and Pharmaceuticals. Each of these industries can be further broken down into subindustries, depending on the degree of granularity desired.
Industries and sectors are terms used by economists to define and analyze a given economy — world, national, regional, or local — and by financial analysts to break down the stock or equity market. This is what we are concerned with. This is important to investors because sectors and industries form the framework for investment research, portfolio management, and asset allocation.
Frequently asked questions
How is a company assigned to a specific sector and industry category? Why is a company typically assigned to only one category, even if it is diversified across several different categories?
A company is assigned to a specific industry based on its main line of business, as measured primarily by revenues. For those companies that are engaged in more than one substantially different business activity, the company is classified where the majority of revenues and profits are derived or, if there is no majority, the industry that best reflects the company’s principal business.
Are the sector definitions used in government statistics comparable to the definitions applied to stock and bonds?
Government analyses and the equity markets use different, although often similar systems. The North American Industry Classification System (NAICS) became the basis for most government economic reports after 1997. It was developed to reflect changes in the economy, particularly the growth of service-based businesses. NAICS has generally replaced the familiar Standard Industrial Classification (SIC) System, although a few government agencies, including the Securities and Exchange Commission, may still use SIC codes. NAICS is used in Canada and Mexico as well as in the United States.
By comparison, the Global Industry Classification System, or GICS, was designed by MSCI Barra and Standard & Poor’s to provide a consistent taxonomy for use by the worldwide financial community. Introduced in 1999, it has received substantial acceptance.
In addition, there are other, less widely used classification systems, such as the FTSE Industry Classification Benchmark (ICB) and the Thomson Reuters Business Classification (TRBC), which are the basis of various indexes and market analyses.
How many industries and sectors are there?
This varies with the specific classification system. Do food and beverages constitute one industry or two? Do alcohol and orange juice belong in the same industry? If one is tracking overall economic activity, broader segmentation may serve the purpose; if one is considering investing in the rapidly growing niche market of craft beers, for instance, more specific classifications are necessary in order to isolate this segment from a broader beverage market with a number of mature segments.
Why are sectors important in global equity investing?
Traditionally, investors have structured global equity portfolios based on regional factors. For example, a typical investment strategy would seek increased diversification or outperformance relative to a benchmark by under- or over-weighting specific regions or countries. As global correlations have increased, however, a number of sectors have exhibited unique patterns regardless of the countries in which they are domiciled.
Over time, as the global economy has strengthened, differences among countries and regions have become far less pronounced. Many sectors now exhibit patterns based on the nature of the business, regardless of geographic region.
The energy sector is a classic example, as global oil and gas prices tend to drive the performance of energy companies across the world in a tight and coordinated trend. In a similar manner, large health care companies are impacted by news affecting their businesses in different regions.
To an investor this means that the benefits of portfolio diversification generated through traditional geographically based asset allocation strategies have diminished, while investment strategies based on economic sectors may continue to provide significant diversification benefits within the global equity markets.