Industry classification attempts to place companies into groups on the basis of commonalities. There are three major approaches to industry classification.
Products and/or Services Supplied
The most widely used industry classification method is the grouping of companies offering similar products and/or services. A company’s classification is usually based on its principal business activity or the source from which the company derives a majority of its revenues or earnings. Sectors are used to describe a group of related industries.
Companies are sometimes grouped as cyclical or non-cyclical (defensive), depending on the company’s relative sensitivity to the business cycle. A cyclical company is one whose profits are strongly correlated with the strength of the overall economy and generally experiences above-average profit variability. Examples would include automotive, construction, heavy equipment, and airline industries.
A non-cyclical company is one whose performance is largely independent of the business cycle, such as a public utility company.
Statistical approaches group companies based on the correlations of past securities’ returns, often forming non-intuitive groups of companies through cluster analysis.
Current Industry Classification Systems
Commercial Industry Classification Systems
- Global Industry Classification Standard: developed by Standard & Poor’s and MSCI Barra. Each company is assigned to a sub-industry according to its principal business activity. Comprised of 154 sub-industries, 68 industries, 24 industry groups, and 10 sectors.
- Russel Global Sectors: based on the products or services a company produces. Comprised of 141 industries, 32 subsectors, and 9 sectors.
- Industry Classification Benchmark: jointly developed by Dow Jones and FTSE. Companies are categorized based on their primary source of revenue. Comprised of 114 subsectors, 41 sectors, 19 supersectors, and 10 industries.
Description of Representative Sectors
- Basic materials and processing: building materials, chemicals, paper and forest products, containers and packaging, and metal, mineral, and mining companies
- Consumer discretionary: cyclical consumer-related products or services
- Consumer staples: non-cyclical consumer-related products or services
- Energy: the exploration, production, or refining of natural resources
- Financial services: banking, finance, insurance, real estate, asset management, and/or brokerage services
- Healthcare: medical products or supplies
- Industrial/producer durables: capital goods manufacturers and providers of commercial services
- Technology: manufacturers or retailers of computers, software, semiconductors, and communications equipment
- Telecommunications: communication services, sometimes grouped in with utilities
- Utilities: electric, gas, water
Governmental Industry Classification Systems
- International Standard Industrial Classification of All Economic Activities (ISIC): adopted by the United Nations in 1948. Classifications based on the principal type of economic activity the entity performs. Comprised of more than 400 classes, 233 groups, 88 divisions, 21 sections, 11 categories.
- Statistical Classification of Economic Activities in the European Community: the classification of economic activities that correspond to ISIC at the European level. Classified based on the principal type of economic activity.
- Australian and New Zealand Standard Industrial Classification (ANZSIC): jointly developed by the Australian Bureau of Statistics and Statistics New Zealand.
- North American Industry Classification System (NAICS): jointly developed by the United States, Canada, and Mexico. NAICS distinguishes between an establishment (a single physical location where business is conducted) and an enterprise (more than location performing economic activities).
Drof, a fictional company that manufactures and sells cars, and Snov, a fictional company that owns grocery stores across the United States, are grouped together using one classification approach. Drof’s earnings are closely tied to the strength of the economy, while Snov’s earnings are much less dependent on the business cycle. Despite the differences, the daily stock price movements of Drof and Snov over the last ten years have been strongly correlated. What classification approach is the most likely to group these two companies together?
A. Products and/or services supplied
B. Business-cycle sensitivities
C. Statistical similarities
The correct answer is C.
The companies have few similarities in terms of products supplied or business-cycle sensitivities, but their statistical similarities would be likely to include them in the same group.
Reading 40 LOS 40b:
Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system