Approaches to Classifying Companies
Industries can be classified on some common traits and similar characteristics.
They include:
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Product or service classification
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Cyclical and non-cyclical classification
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Statistical similarities
Product or Service Classification
Companies can be classified on the basis of common services and products. For example, the mobile manufacturers industry would include Samsung, Apple, LG, and Nokia.
Companies can be segregated on the basis of a sector too. By sector we mean a group of related industries. The mobile sector would thus include mobile service providers, mobile accessories, mobile applications, etc.
Companies are classified on the basis of their primary business activity, which is also their primary source of revenue. If these companies have other revenue streams from a related business the revenues and profits are booked under a different segment in their financial statements.
Cyclical and Non-cyclical Classification
Companies can be classified based on whether they are sensitive to business cycles or are immune to it. Some sectors are sensitive to business cycles with aggregate demand and profits being low during recession and high during business cycle peaks. Examples include the travel industry and the automobile industry. Non-cyclical industries on the other hand are 'recession-proof' and aggregate demand stays stable irrespective of the economy's ups and downs. Notable examples are healthcare, education, food and beverage and utilities.
Statistical Similarities
Companies can be grouped based on the correlation of past securities returns. The cluster analysis methodology is used in which the historical stock returns are used to divide companies into groups. Correlation within the groups is high but between is low. The limitation of such a grouping is that it may be a disparate group of companies who may not follow similar patterns of returns in the future. The classification itself may add a company to the group by chance where the correlation is not strong and in some cases exclude a company where there might be significant correlation.