Industry Classification Systems

It has been said that 60% of the stocks movement can be contributed to the overall market (up during bull markets and down during bear markets), and that 30% is due to how well a group of related stocks (by industry for example) is doing, and the last 10% or so is due to the company itself.

While some will argue about the percentages, almost everyone agrees with the basic premise.

This has been observed since the early days and one of the reasons why Charles Dow created the Dow Jones Industrial Index (and DJ Transportation Index).

The goal of Industry classification systems is to organize companies into industrial groupings based on similar production processes, similar products, or similar behavior in financial markets.

There are basically 5 major competing systems:
Morningstar Industrial Classification System (Old - Hemscott)
Morningstar Industrial Classification System (MICS, new 4 level)
Global Industry Classification Systems (GICS)
Industry Classification Benchmark (ICB)
Thomson Reuters Business Classification (TRBC)

Why bother with all of this? Well there are a number of reasons why.

One reason that comes to mind can be illustrated via two competing sayings -

"Don't put all of your eggs in the same basket" - Many strongly believe that in order to survive the ups and downs of the market you need to spread out your portfolio amongst different asset classes and within stocks (equities) different industries.

The reverse of the above is "Put all of your eggs into one basket - but watch them like a hawk". Okay that may not be the exact phrase but it's close enough. If you look at stocks that have had 1000% + gains, they have a lot of common traits. It is these types of stocks that some folks advocate that you invest in (versus buying a utility company for it's dividend).

Industry classification systems can help identify one or more aspects of those types of stocks.

Another reason to understand what industry a stock belongs to is to help determine when to invest ie market timing using the economic cycle.

This graphic from www.ritholtz.com shows the relationship of the ecomomic cycle and that of the stock market. It also shows which sectors of the market do better during certain phases.

Over a series of posts I will go into greater detail of various classification systems and present my opinions as to the advantages and disadvantages of them.

Next post --> Morningstar Industrial Classification System (Old - Hemscott)

Trade well,
Monk