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How well do you know stock industries and sectors?

16 September 2016 in Investing Insights

 

Key Takeaways

  • The U.S. economy is comprised of roughly a dozen sectors, which contain thousands of industries.
  • Sector and industry classification benefits economists, financial analysts and investors in many ways such as analyzing businesses and economies, and effectively managing diversified portfolios.
  • The GICS industry classification system was established in 1999 and remains quite popular today.

Have you ever been confused about when to use the term industry versus sector? If so you’re not alone. These two terms are often used interchangeably, but there actually is a small difference in meaning between them, hence the confusion.

Sector and industry both describe a group of companies that share a similar business type or operate in the same economic segment. However, the term sector is typically intended to describe a large segment of the economy whereas the term industry often refers to a small and specific group of businesses.

In other words, sectors are broad and industries are narrow. Thus, every sector is comprised of multiple industries. The U.S. economy today has about a dozen different sectors, such as the financial sector and the basic materials sector, which contain thousands of industries.[1]

 

Why is sector and industry classification important?

Economists utilize sectors and industries to define and analyze economies at a local, regional, national and global level. Additionally, financial analysts and investors use sectors and industries as a framework for research, performance analysis, portfolio management and asset allocation.

As we recently discussed, metrics such as the P/E ratio can vary significantly from one industry to another. A benefit of classification is it makes it easier to analyze and compare similar companies and metrics when making trading decisions. Comparing apples to oranges rarely benefits investors, but comparing apples to apples can be quite insightful.

Historically, many global equity portfolios were structured based on regional factors. But due to the strengthening of the global economy over time, the differences between regions and countries have largely faded and are much less prominent today. On the plus side, many patterns within sectors have emerged regardless of where businesses are located. Thus, investment strategies based on sectors have become more popular as a result and can help investors stay diversified.[2]

 

How are companies divided up into sectors?

There are two main methodologies used to classify companies into sectors. The first is known as a production-oriented approach. This method is based on a company’s manufacturing process and the products it creates. In other words it focuses on how a company operates and what it produces.

The second method for classifying companies into sectors is market-oriented and is focused on a company’s target consumer audience. This method isn’t concerned with how companies make their products or what they’re producing. It’s centered on which market segment the company is trying to reach instead.[3]

 

Which classification schemas are used to organize industries?

Just like there is more than one recipe to make apple pie, there is more than one way to classify industries within a sector. The governments in the U.S., Canada and Mexico typically use the North American Industry Classification System (NAICS) to analyze growth and changes in the economy. It was adopted in 1997 to improve comparability in business statistics amongst the North American countries.[4]

When it comes to the stock market, however, one of the most popular classification schemas is the Global Industry Classification Standard (GICS). The GICS system was established in 1999 by Standard & Poor’s and Morgan Stanley Capital International (MSCI). All of the MSCI indexes use GICS today as well as many portfolio managers.[5]

GICS uses revenue as a major factor in determining a company’s principal business activity along with earnings and market perception. Here’s a look at how it is structured.

msci-GICS-en

GICS is a four-tiered, hierarchical industry classification system. Revenues are a key factor in determining a company’s principal business activity. Source: MSCI

In addition to GICS, there are two other industry classification systems you may come across: Industrial Classification Benchmark (ICB) and Thompson Reuters Business Classification (TRBC). They are similar to GICS but are lesser known and have their own distinct groupings.

 

Are companies ever assigned to more than one industry?

One way businesses grow is by expanding their range of products and services. Sometimes this involves acquiring other companies or building out new departments and teams. Alphabet [GOOGL] and GE [GE] are examples of two conglomerates that operate in many different lines of business.

Even though there are multiple methods of industry classification, companies are typically assigned to just one industry – based on its primary line of business – even if they operate across multiple categories. The largest revenue stream often determines the classification. If a majority isn’t present, the industry that best represents the company’s principal line of business is usually selected.

Thus, it’s good practice when researching a company to familiarize yourself with its entire scope of business operations. Looking at the industry classification alone may not reveal every niche a company is exposed to.

 

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[1] Langager, Chad, “What is the difference between an industry and a sector?” Investopedia, September, 2016.

[2] DST Systems, Inc., “What are sectors and industries? A guide to frequently asked questions,” Fidelity, September 2016.

[3] MarketSnacks, “What you should know about sectors and industries,” Fidelity, September 2016.

[4] NAICS, “Introduction to NAICS,” U.S. Census Bureau, September 7, 2015.

[5] MSCI, “GICS,” MSCI Inc., September 2016.

  1. Rob
    7 Oct at 9:57 am

    I’ve heard of the GICS system before but wasn’t familiar with the others. We really don’t need more than one system I suppose, but there’s always more than one way to categorize companies. Reminds me of how there are multiple ways to calculate credit scores.

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