Industries

What Are Industries?

An industry represents a distinct group of businesses or organizations that are involved in similar economic activities or produce closely related goods and services. Categorizing businesses into industries is a fundamental aspect of economic analysis and portfolio theory. It allows for the systematic study of markets, performance comparison, and the identification of market trends. Understanding industries is crucial for investors, policymakers, and businesses alike, as it provides a framework for comprehending the structure and dynamics of the economy.

History and Origin

The concept of classifying businesses into industries emerged formally to standardize the collection and analysis of economic data. In the United States, one of the earliest widespread systems was the Standard Industrial Classification (SIC) system, established in 1937 by the U.S. government. Its primary purpose was to provide a uniform method for government agencies to classify establishments for statistical purposes, facilitating comparisons across various economic data sets.²¹ The SIC system was last revised in 1987.²⁰

In response to a changing global economy and the need for greater comparability with international classification systems, the SIC system was replaced in 1997 by the North American Industry Classification System (NAICS).¹⁸, ¹⁹ NAICS was developed jointly by the statistical agencies of the United States, Canada, and Mexico to enable a high level of comparability in business statistics across North America.¹⁷

Beyond government statistical purposes, market-based industry classification systems were developed for financial professionals. The Global Industry Classification Standard (GICS) was jointly developed in 1999 by S&P Dow Jones Indices and MSCI.¹⁴, ¹⁵, ¹⁶ GICS was designed to provide a comprehensive, consistent, and global standard for categorizing companies into sectors and industries, enhancing investment research and asset allocation processes worldwide.¹², ¹³

Key Takeaways

• Industries group businesses with similar activities or products.
• Classification systems like NAICS and GICS organize industries for analysis and reporting.
• Understanding industry classifications aids in investment analysis, market share assessment, and economic forecasting.
• Industries are dynamic, evolving with changes in technology and the global economy.
• They are critical for portfolio diversification and competitive analysis.

Formula and Calculation

Industries themselves do not have a direct formula for calculation, but their size and contribution to the economy are often measured using economic indicators. For instance, an industry's contribution to the overall Gross Domestic Product (GDP) can be calculated as:

Where:

• Industry Value Added: The amount of value that an industry adds to the economy. This is often reported by statistical agencies like the U.S. Bureau of Economic Analysis (BEA).¹⁰, ¹¹
• Gross Output: The total sales or receipts of an industry.⁹
• Intermediate Consumption: The value of goods and services used as inputs in the production process by the industry.

This calculation helps in understanding the direct impact of an industry on economic growth.

Interpreting Industries

Interpreting industries involves analyzing their characteristics, performance, and trends to make informed decisions. An industry can be assessed by its size (e.g., total revenue, number of employees), growth rate, profitability, and competitive landscape. For example, a rapidly growing industry might indicate strong consumer demand or technological advancements, making it attractive for investment strategy. Conversely, a declining industry may signal obsolescence or oversupply.

Analysts often look at how an industry performs relative to broader economic indicators or other industries. This involves examining financial metrics, regulatory environments, and the overall business cycle to gauge an industry's health and future prospects. Investors use industry classifications to identify potential investment opportunities, assess risks, and construct diversified portfolios.

Hypothetical Example

Consider an investor, Sarah, who wants to diversify her portfolio beyond the technology sector. She decides to explore the "Renewable Energy Equipment Manufacturing" industry. Using a classification system like GICS, she identifies companies primarily engaged in producing solar panels, wind turbines, and related components.

Sarah then researches several companies within this specific industry. She analyzes their revenue growth, profit margins, and debt levels. She might compare these metrics to the broader "Utilities" sector or even to other industries within the "Energy" sector to understand relative performance. If she finds that the Renewable Energy Equipment Manufacturing industry is experiencing significant tailwinds due to government incentives and increasing global demand, she might decide to allocate a portion of her portfolio to an exchange-traded fund (ETF) that specifically tracks this industry, thereby gaining exposure to its growth potential.

Practical Applications

Industries serve as a fundamental organizational structure in various financial and economic contexts:

• Investment Analysis: Investors and financial analysts use industry classifications to group companies for comparison, conduct peer analysis, and identify investment opportunities. For example, understanding the "Pharmaceuticals" industry allows for a focused analysis of drug development pipelines, regulatory hurdles, and market dynamics.
• Portfolio Diversification: By investing across different industries, investors can reduce specific risks associated with any single industry. This is a core principle of modern portfolio theory.
• Economic Reporting and Policy: Government agencies like the U.S. Bureau of Economic Analysis (BEA) use industry data to track economic performance, measure GDP contributions, and inform policy decisions.⁷, ⁸ The Federal Reserve also analyzes industry-specific data to gauge economic health and inform monetary policy.⁵, ⁶
• Market Research and Business Strategy: Businesses utilize industry classifications for market segmentation, identifying competitors, assessing market size, and developing strategic plans. This helps them understand their competitive landscape and potential for growth.
• Regulatory Frameworks: Regulations often target specific industries due to their unique characteristics or potential societal impact. For example, the "Banking" industry faces distinct regulatory requirements compared to the "Retail Trade" industry.

Limitations and Criticisms

Despite their utility, industry classification systems have limitations. One challenge is the increasing convergence of business activities, making it difficult to assign a single, definitive industry code to companies engaged in diverse operations. For example, a company that produces both software and hardware might span the "Information Technology" and "Electronics Manufacturing" industries. This can lead to misclassification, which can affect the accuracy of financial research and benchmarking.⁴

Furthermore, the static nature of some classification systems can struggle to keep pace with rapid technological advancements and the emergence of entirely new business models. While systems like GICS and NAICS undergo periodic revisions to address these changes, they may still lag behind the dynamic evolution of the global economy.², ³ Changes in classification can also significantly impact how economic data, such as employment composition, is measured and interpreted over time, even without underlying changes in economic activity.¹ Another critique involves the potential for subjective judgment in assigning classifications, particularly for multifaceted businesses, which can introduce inconsistencies.

Industries vs. Sectors

While often used interchangeably in casual conversation, "industries" and "sectors" represent different levels of granularity in economic and financial classification.

The term Sectors serves as an overarching category under which various industries are nested. For instance, the "Financials" sector might include industries like "Banks," "Diversified Financial Services," and "Insurance." This hierarchical structure allows for analysis at different levels of aggregation, catering to various analytical needs from broad macroeconomic views to granular company-specific insights.

FAQs

Q1: Why is industry classification important for investors?

Industry classification is crucial for investors because it allows them to compare companies producing similar goods or services, identify market trends, and manage portfolio risk through portfolio diversification. It helps in making informed decisions about where to allocate capital.

Q2: What are some common industry classification systems?

Two widely used industry classification systems are the North American Industry Classification System (NAICS), used primarily by government agencies for statistical purposes, and the Global Industry Classification Standard (GICS), widely used by financial professionals for investment analysis.

Q3: How do new industries emerge?

New industries often emerge due to technological innovation, shifts in consumer preferences, or changes in regulatory environments. For example, the advent of the internet led to the creation of industries like e-commerce and social media, which did not exist in older classification systems.

Q4: Can a company belong to more than one industry?

While most classification systems aim to assign a company to a single primary industry based on its dominant revenue source or business activity, many large, diversified companies operate across multiple business lines that could theoretically fit into different industries. For classification purposes, however, a single primary classification is typically assigned.

Q5: How often are industry classifications updated?

Industry classification systems like GICS and NAICS are periodically reviewed and updated to reflect changes in the global economy, the emergence of new industries, and the evolution of existing ones. These updates ensure the systems remain relevant and accurate for economic analysis and statistical reporting.