The key to sector investing and diversifying an equity portfolio is in understanding how sectors are defined and how they are made up. There are two competing systems for classifying stocks into sectors and industries: the Global Industry Classification Standard (GICS) and the Industrial Classification Benchmark (ICB). Both were designed to provide an accurate and standardized industry definition for the global investment community. Each classification scheme establishes an industry and sector framework for investment research, portfolio management and asset allocation. Their international scope allows for meaningful comparisons between sectors and industries worldwide. In practice, most of the same sector and industry designations exist in both standards and most of the major companies globally will be classified under both systems. (For background reading, see The Industry Handbook.)

Description of the GICS
The Global Industry Classification Standard was developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor's (S&P) in 1999. According to GICS, it is applied to more than 35,000 companies globally and covers approximately 95% of the world's equity market capitalization in more than 90 markets as of 2008.

In classifying companies into industries, there are two approaches: the production-oriented approach and the market-oriented approach. A production-oriented approach classified according to what the company produces. For example, a company producing a good might be classified differently than a company that offers a service, even if both are sold in the same marketplace. Of course, many companies offer both goods and services, so the line between goods and services has become blurred

The GICS takes a market-orientation approach. For example, the distinction between consumer goods and services has been replaced by the more market oriented sectors of "consumer discretionary" and "consumer staples", which contain both goods and services industries. Consumer staples companies include companies that provide consumer products and services that are considered necessities and thus would not be impacted severely in an economic slowdown. This includes industries like food producers and food retail stores. (For related reading, see Using Consumer Spending As A Market Indicator.)

Consumer staples are considered a non-cyclical sector. Consumer discretionary companies produce goods and services that are not considered necessities, and thus tend to be impacted by economic slowdown. This includes industries like automobile manufacturers, restaurants and hotels. The consumer discretionary sector is considered to be a cyclical sector. (For related reading, see Cyclical Vs. Non Cyclical Stocks and The Ups And Downs Of Investing In Cyclical Stocks.)

The GICS classification system consists of four levels or hierarchy. In 2008, there were 10 sectors, 24 industry group, 67 industries and 147 sub-industries. (Note: These numbers are subject to change.) The 10 sectors are:

  1. Energy
  2. Materials
  3. Industrials
  4. Consumer Discretionary
  5. Consumer Staples
  6. Healthcare
  7. Financials
  8. Information Technology
  9. Telecommunication Services
  10. Utilities

A company is assigned GIC classification codes at the sub-industry levels by Standard & Poor's and MSCI according to their definition of the company's principal business. The most important factor in determining the principal business activity is a company's main source of revenue. Other factors, such as earnings analysis and market perception also aid in providing the proper classification. Companies are reviewed annually and whenever there is a major corporate event that changes a company's primary line of business to ensure the proper code.

Description of the ICB

The Industrial Classification Benchmark (ICB) was developed jointly by Dow Jones Indexes and the FTSE Group in 2006. According to ICB, this scheme classifies more than 60,000 companies in more than 70 countries. The ICB standard has been adopted by stock exchanges globally.

The ICB has been devised from Dow Jones Indexes and FTSE Group's proprietary industry classification systems, and uses a balanced, four-tier structure with industry, supersector, sector and subsector levels. In 2008, the ICB used a system of 10 industries partitioned into 19 supersectors, which were further divided into 41 sectors, which then contain 114 subsectors.(Note: These numbers are subject to change.) The 10 industries are:

  1. Oil and Gas
  2. Basic Materials
  3. Industrials
  4. Consumer Goods
  5. Healthcare
  6. Consumer Services
  7. Telecommunications
  8. Utilities
  9. Financials
  10. Technology

The ICB allocates each company to the subsector that most closely describes the nature of its business. A company will be assigned a classification code jointly by FTSE and Dow Jones Indexes. When a company conducts two or more types of business that differ substantially from, FTSE and Dow Jones Indexes it will determine the sector to which the company should belong based on its audited accounts and director's report. FTSE and Dow Jones Indexes have the discretion to classify companies on the basis of either the immediate or the end use of the product, or the industrial process used.

How to Use Sector Information
Just as all stocks tend to move based on the underlying factors that drive the overall market, stocks in a similar industry tend to move based on underlying factors that impact the industry. For example when oil prices are rising, oil stocks tend to follow suit. Similarly, the subprime mortgage market crisis of 2007-2008 impacted most financial stocks. One of the most basic methods for understanding the risk of an investment portfolio is to determine its sector breakdown. Is the portfolio spread across different industrial sectors or is it concentrated in just a few? This provides a good indication of how an investment portfolio will respond to macroeconomic factors or industry trends.

Of course, understanding sector composition is crucial for a sector rotation strategy. A rotation strategy is very similar in approach to tactical asset allocation, but rather than asset classes, the investor will allocate his funds to different sectors depending on his short-term view. The investor will overweight the sectors that he or she believes will outperform and underweight those expected to underperform. Sector information is very important not only for the underlying research that drives the sector rotation strategy, but also in its implementation. (To learn more, read Sector Rotation: The Essentials and ETFs Smooth The Road For Sector Rotation Strategies.)

Companies in the same or similar industries are analyzed in a similar fashion. Understanding the industry is very helpful when valuing companies because different industries might have more useful valuation metrics than others. In some industries, cash flow or EBITDA might be more relevant than earnings in stock valuation. As such, comparing companies from the same industry is easier - it is not a coincidence that equity research analysts generally cover companies that are in the same industry.

Comparisons Between ICB and GICS Systems
The ICB and GICS systems are more similar than they are different. Each has a four-layer hierarchical structure and a comparable number of subcategories within those structures.

The largest difference between the two is how consumer businesses are classified at the sector level. With the ICB, companies doing business with consumers are divided into providers of goods and providers of services; with the GICS, companies are classified by cyclical/non-cyclical distinctions, or between discretionary spending and the staples of everyday life.

With the exceptions of the consumer sectors, the other eight industries of the ICB correspond closely to the eight sectors of the GICS. At the lower levels, there are more differences, but their impact will not be significant to the highest levels. For example, in the ICB, coal companies are found in "basic materials", but under the GICS these companies are classified in "energy".

Whether one of the systems is superior is a matter of preference and end use. In many cases, the end user does not have a choice; all the indexes that are associated with MSCI and Standard & Poor's use the GICS, while those associated with Dow Jones Indexes and FTSE Group (FTSE) use the ICB.

For investors using sector exchange-traded funds (ETFs), it is important that they are all part of the same family and use the same underlying classification scheme.

The Global Industry Classification Standard (GICS) and the Industrial Classification Benchmark are two competing schemes for classifying stocks into sectors and industries worldwide. Differences between the two are minor and they each have an industry and sector framework for investment research, portfolio management and asset allocation.

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