There are many different classification systems that analysts, journalists, investors, and other market participants use to navigate, aggregate, and benchmark companies.
For instance, an investor interested in comparing a company’s price-earnings ratio to its industry peers require a way to quickly find the most similar companies. Mutual funds and exchange-traded funds (ETFs) tracking a specific industry similarly require a list of companies to build a portfolio.
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Classification systems provide a standardized way to accomplish these goals and countless others. Since there are many different ways to classify companies, there are several different classification standards that have been developed over the years.
Let’s take a look how classification systems are developed and some of the most popular ones in use today.
Classification Systems 101
The most popular classification systems were created by market data providers and rating agencies. After all, these businesses require classification systems to power their internal index creation, benchmarking, and other mission-critical tasks.
They use one of two approaches to break down sectors:
- Production-based approaches focus on the processes that a company uses to manufacture its products. For example, Rolex and Lululemon may very different target markets and products, but they are both produced in a manner that’s consistent with a “consumer goods” classification.
- Market-based approaches are focused on the markets that a company services rather than its products. For example, Google and Microsoft have completely different products, but they may both fall under “information technology” due to their similar target markets – corporations using technology for business.
These classification systems may appear very similar on the surface, but there are important differences as you drill down. For example, Fidelity points out that airlines are classified as a Transportation subsector by GICS, grouped into the Travel & Leisure supersector by ICB, and split into Consumer Travel versus Airport Services by the TRBC.
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Industry Classification Benchmark (ICB)
The ICB was created by Dow Jones and FTSE in 2005 to segregate markets into sectors within the economy.
The classification includes ten industries partitioned into 19 supersectors, 41 sectors, and 114 subsectors. Companies are classified based on their source of revenue.
The first tier sectors include:
- Oil and Gas
- Consumer Services
- Basic Materials
- Telecommunications
- Industrials
- Utilities
- Consumer Goods
- Financials
- Healthcare
- Technology
The ICB is used by the NASDAQ, NYSE, and several other markets around the world.
Global Industry Classification Standard (GICS)
The GICS was created by the MSCI and Standard and Poor’s (S&P) in 1999 to categorize all major public companies.
The classification includes 11 sectors, 24 industry groups, 68 industries, and 157 subindustries. Companies are classified based on their primary business activity.
The firsttier sectors include:
- Energy
- Healthcare
- Materials
- Financial
- Industrials
- Information Technology
- Consumer Discretionary
- Consumer Staples
- Real Estate
- Communications Services
- Utilities
The GICS is used as a basis for S&P and MSCI market indexes, including the benchmark S&P 500 index.
Learn about recent changes to the GICS structure here.
Thomson Reuters Business Classification (TRBC)
The TRBC was created by Thomson Reuters to classify over 70,000 public companies across 130 countries.
The classification includes 10 economic sectors, 28 business sectors, 54 industry groups, 143 industries, and 837 activities. Companies are classified based on their primary business activity that provides the largest revenue contribution.
The first tier sectors include:
- Basic Materials
- Consumer Services
- Cyclical Consumer
- Non-Cyclical Consumer
- Energy
- Technology
- Financials
- Telecommunications
- Healthcare
- Utilities
The TRBC is used as a basis for Thomson Reuters indexes.
Implications For Investors
Classification systems are used for many different purposes, and selecting a classification system has many implications.
For example, here are some common use cases and implications to consider:
- Investors might use classification systems when comparing a company’s price-earnings ratio to its peers. Depending on the classification system, the peer group’s earnings multiple can be very different.
- Journalists might use classification systems to identify companies affected by an industry trend. In this case, the classification system that they use will influence their ability to identify the appropriate companies.
- Hedge funds might use classification systems to benchmark their performance. In some cases, they may choose a more favorable classification system, which makes it important for investors in the hedge fund to dig deeper when analyzing alpha.
The Bottom Line
Classification systems are extremely important for analysts, investors, journalists, and other market participants looking to break down companies into various sectors.
Investors should understand these different classification systems, especially when investing in index funds that use them to build their underlying portfolios.
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