Industry classification

What Is Industry Classification?

Industry classification is a system used to categorize businesses into distinct groups based on their primary economic activities, products, or services. This organizational framework is fundamental to both financial analysis and economic statistics, providing a standardized way to understand and compare companies and sectors. By grouping similar entities, industry classification helps investors, analysts, and policymakers gain insights into market trends, allocate resources, and assess financial performance. The concept underpins much of modern portfolio management and investment research, enabling a structured approach to viewing the vast global economy.

History and Origin

The need for a standardized approach to categorize economic activities emerged in the early 20th century, particularly as economies grew more complex. In the United States, the initial effort materialized in the late 1930s with the development of the Standard Industrial Classification (SIC) system. The U.S. government, through agencies like the U.S. Bureau of the Budget (now the Office of Management and Budget) and the U.S. Bureau of the Census, created SIC codes to standardize the reporting of economic data across various government departments. This system classified businesses by a four-digit code, with revisions occurring periodically to reflect changes in the economy¹⁷,,¹⁶.

However, by the late 20th century, the SIC system faced increasing criticism due to its inability to adequately capture the evolving service economy and globalized markets. In response, a collaborative effort involving the United States, Canada, and Mexico led to the creation of the North American Industry Classification System (NAICS) in 1997. NAICS was designed to offer enhanced coverage, particularly for the service sector, and to provide greater comparability of business statistics across the three North American countries. It superseded the SIC system as the primary standard for federal statistical agencies in the U.S.¹⁵,¹⁴.

Simultaneously, for the financial community, the Global Industry Classification Standard (GICS) was developed in 1999 by MSCI and S&P Dow Jones Indices. This system was specifically designed to provide a comprehensive, consistent, and globally applicable framework for classifying companies traded on public equity markets. Its purpose was to enhance asset allocation and investment analysis, addressing the limitations of existing classifications for equity investment purposes¹³,¹²,¹¹.

Key Takeaways

• Industry classification categorizes businesses based on their primary economic activities, facilitating organized analysis of markets and economies.
• Major systems include the North American Industry Classification System (NAICS) for government and statistical use, and the Global Industry Classification Standard (GICS) for financial markets.
• These systems are hierarchical, moving from broad market sectors down to detailed sub-industries.
• Industry classification helps in risk management, market analysis, and identifying investment opportunities.
• Despite their utility, these classifications face challenges in capturing rapidly evolving business models and diversified companies.

Formula and Calculation

Industry classification itself does not involve a specific formula or mathematical calculation in the way a financial metric might. Instead, it is a qualitative assignment process. Companies are assigned an industry classification based on their principal business activity. For systems like GICS, this determination primarily considers the majority of a company's revenues. Other factors like earnings and market perception can also be taken into account during the annual review process to ensure the classification accurately reflects the company's core business¹⁰,⁹.

Interpreting Industry Classification

Interpreting industry classification involves understanding the hierarchical structure and the nuances of how companies are grouped. Both NAICS and GICS employ a multi-level hierarchy, moving from broad categories to more specific ones. For instance, GICS begins with 11 sectors, further dividing them into 25 industry groups, 74 industries, and 163 sub-industries,⁸. A company is typically assigned to the lowest level (sub-industry) that most accurately describes its primary revenue-generating activity⁷.

For example, a company might be classified under the "Information Technology" sector, then the "Software & Services" industry group, the "IT Services" industry, and finally the "IT Consulting & Other Services" sub-industry. This granular approach allows for precise market analysis and peer comparisons within specific niches, providing context for evaluating a company's performance relative to its true peers.

Hypothetical Example

Imagine an investor, Sarah, is analyzing a new company, "Quantum Innovations Inc.," which develops advanced artificial intelligence software for various industries. Sarah wants to understand where Quantum Innovations Inc. fits within the broader economy and how it compares to its peers.

She looks up its industry classification. Under the Global Industry Classification Standard (GICS), Quantum Innovations Inc. would likely be categorized as follows:

• Sector: Information Technology
• Industry Group: Software & Services
• Industry: Software
• Sub-Industry: Application Software

This classification immediately tells Sarah that Quantum Innovations Inc. is primarily a technology company focused on software, specifically applications. This helps her compare its growth prospects, valuation multiples, and competitive landscape against other companies in the Application Software sub-industry, rather than broadly against all technology firms or even just IT services companies. This focused view is crucial for detailed investment analysis.

Practical Applications

Industry classification systems are integral to numerous aspects of investing, economic analysis, and government operations.

• Investment Analysis and Portfolio Construction: Financial professionals use industry classification to identify investment opportunities, construct diversified investment portfolios, and implement sector-based strategies. By understanding sector exposure, investors can manage portfolio diversification and align investments with specific economic themes or growth trends.
• Economic Data Collection and Reporting: Government agencies rely on systems like NAICS to collect, analyze, and publish statistical economic data. This data informs policymakers, helps track economic performance, and supports national accounting. For instance, the U.S. Census Bureau uses NAICS to publish statistics for the U.S. business economy⁶,⁵.
• Regulatory Compliance: Some regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), continue to use older classification systems like SIC codes for certain filings and disclosures, even as NAICS has become the standard for statistical agencies. This ensures historical consistency in regulatory reporting. The SEC maintains a public list of SIC codes for reference. [https://www.sec.gov/info/edgar/siccodes.htm]
• Market Benchmarking and Indexing: Major equity indices, like those from S&P Dow Jones Indices and MSCI, are often constructed and analyzed using GICS, allowing for consistent benchmarking of equity markets and performance attribution across different sectors and industries.
• Business Planning and Competitive Analysis: Businesses use industry codes to identify competitors, conduct market research, and understand their position within a specific industry landscape. This can inform strategic decisions and business development efforts.

Limitations and Criticisms

Despite their widespread use and utility, industry classification systems face several limitations, particularly in today's rapidly evolving global economy.

One significant challenge is the increasing blur between traditional industry lines. Companies, especially those in technology, often diversify their operations across multiple distinct areas, making it difficult to assign a single primary industry classification. For example, a company that started as a software provider might now have significant revenue from cloud services, hardware, and even financial technology. Assigning it to just one sub-industry might not fully capture its diverse revenue streams or its competitive set⁴.

Another criticism revolves around the hierarchical structure itself. While providing granularity, this structure often allocates a company to only one sub-industry, potentially mislabeling it if a smaller, rapidly growing division is driving future value or if its products serve multiple traditional industries. This can lead to a company trading with market capitalization and valuation multiples more aligned with a "new economy" sector, even if its official classification places it in a more traditional "old-line" industry. The dynamic nature of modern industries, especially with technological innovations, means that classification systems must constantly evolve to remain relevant. [https://www.worldquant.com/insights/modern-challenges-in-company-classification/]

Furthermore, the annual review processes, while necessary for updating classifications, can lead to reclassifications that impact passive investment vehicles and cause shifts in index composition, which in turn can affect trading volumes and stock prices.

Industry Classification vs. NAICS Code

While related, "industry classification" is a broad concept, whereas a "NAICS Code" is a specific manifestation of an industry classification system.

Industry Classification refers to the general principle and methodology of grouping businesses based on their economic activities. It encompasses various systems, both public and private, used for different purposes (e.g., GICS for financial markets, SIC historically for government). The term highlights the overarching idea of organizing the economy into coherent segments.

A NAICS Code, or North American Industry Classification System Code, is a specific standardized numerical code assigned to business establishments in the United States, Canada, and Mexico. Developed jointly by these three countries, its primary purpose is to facilitate the collection, analysis, and publication of economic data by federal statistical agencies,³. It's a production-oriented system, meaning it groups establishments based on the similarity of their production processes². While NAICS codes are a form of industry classification, they are specifically designed for statistical and governmental uses, not necessarily for investment analysis or portfolio benchmarking in the same way GICS is.

FAQs

What is the primary purpose of industry classification?

The primary purpose is to standardize the grouping of businesses by their economic activities to facilitate data analysis, economic reporting, investment research, and competitive benchmarking.

Who uses industry classification systems?

Various entities use them, including government statistical agencies (e.g., U.S. Census Bureau), financial professionals (e.g., portfolio managers, analysts), market index providers (e.g., MSCI, S&P Dow Jones Indices), and businesses themselves for strategic planning and market research.

How often are industry classifications updated?

Major industry classification systems like GICS and NAICS undergo periodic reviews and updates. GICS is reviewed annually, while NAICS is typically updated every five years to reflect changes in the economy and emerging industries¹,.

Can a company belong to more than one industry classification?

Typically, under systems like GICS and NAICS, a company is assigned a single primary industry classification based on its main revenue-generating activity. However, in reality, many companies operate across multiple lines of business, which can make a single classification challenging and sometimes limit the system's ability to fully capture their diverse operations.