What it means
There are thousands of listed companies, and comparing them is hard unless they are grouped sensibly. A bank should be compared with other banks, and an airline with other airlines.
A classification system gives everyone the same labels, so that sector reports, indices and funds are built on the same foundation. The ICB uses four levels, running from broad to narrow.
The top level has a small number of industries, such as financials or health care, and these are split into supersectors, then sectors, then subsectors. A company is placed in the subsector that best describes where most of its revenue comes from.
Classification matters for investment work. A fund manager who wants to avoid putting too much money in one industry can check the weight of each sector in a portfolio.
An analyst valuing a company picks peers from the same subsector and compares their valuation ratios, such as the price to earnings ratio. The ICB is one of several systems.
Another widely used scheme is the Global Industry Classification Standard (GICS), developed by MSCI and S&P Dow Jones Indices, and the two differ in how they group some businesses. When using sector data, it is important to know which system produced it.
Classification is a judgement, and companies can be hard to place. A firm that makes software and also sells hardware might be put in either group, depending on which brings in more revenue.
Companies can also move between categories as their business changes. Data users should also check how often the classification is reviewed.
Index providers update company placements periodically, so a share that moved sector may suddenly be added to or removed from sector funds, which can affect its price.
In practice
Real-world examples.
Example
A fund manager reviews her portfolio and finds that 40% of the money is in a single sector according to the classification. She sells part of the holding and buys shares in other sectors. Her fund is now more evenly spread. She repeats the check every quarter.
Example
An analyst values a regional supermarket chain. She selects peers from the same subsector and compares price to earnings ratios and profit margins. The comparison shows that the chain trades at a discount to its peers. She recommends the shares to her clients.
Example
A company's board notes that its business has shifted from selling equipment to selling subscriptions. The finance director asks the index provider whether the company might be reclassified. A new classification could change which funds and indices hold the shares. The director prepares a briefing for investors.
Formula
Calculation
Sector weight = Total market value of companies in the sector / Total market value of all companies in the index x 100
Suppose an index contains companies with a combined market value of $2,000,000,000, and the companies classified in technology have a combined value of $500,000,000. The technology sector weight is 500,000,000 / 2,000,000,000 x 100 = 25%.
If health care companies are worth $300,000,000, their weight is 300,000,000 / 2,000,000,000 x 100 = 15%. An investor holding the index would therefore have 25% of the money in technology and 15% in health care.Case study
Seen in the real world.
Summit Retail Group is a fictional company that started as a chain of physical bookshops and gradually moved to online sales and digital subscriptions. Five years ago, 85% of its revenue came from shops, and now only 30% does.
The investor relations team found that the company was still classified with traditional retailers, so analysts compared it with companies that grow slowly and carry large property costs. They prepared a presentation showing revenue by source and asked the classification provider to review its position.
In this illustrative case, the provider reclassified the company in an online retail subsector after reviewing the accounts. The change attracted a different group of investors, and the share price began to be compared with faster-growing peers. Management had to explain the new comparison to long-standing shareholders.
Watch out
Common mistakes.
- Comparing companies from different subsectors as if they were peers, which can give misleading valuation conclusions.
- Assuming all classification systems use the same categories, when ICB and GICS group some businesses differently.
- Forgetting that a company can be reclassified as its revenue mix changes.
Questions
People also ask.
Who maintains the ICB?
FTSE Russell maintains it and applies it across the indices it produces.
How is a company placed in a category?
It is based on the source of most of its revenue, supported by company reports.
Why does classification matter to investors?
It determines which peer group a company is compared with and which sector funds may hold it.
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