The Importance of Proper Classifications

July 2021

Phil Ruthven, AM

A lot of executives and directors still describe companies in market terms, rather than industry terms. This practice is one of the dangerous distortions to have emerged from the market-oriented focus of the post-Industrial age.

Nobody denies that knowing one’s market is a condition of survival, but this knowledge can never define an individual company’s intellectual property (IP), uniqueness, or raison d’être. In short: a company can never ‘own’ a market; the customers own it.

Yes, there are times when some companies are in a sellers’ market – an especially relevant observation when it comes to commodities, agriculture or minerals, or even dwellings – but a company can’t own a sellers’ market.

What makes a company successful is its own IP (not somebody else’s) and its specialty in its own industry, which gives it an advantage over fellow players. Therefore, it is important for a company to determine its own industry segment (major, niche, ultra-niche, etc.), and to ensure its product offering has an advantage within its segment (in terms of unique special properties, or USP). Specialisation by demography, psychographics, geography and other factors is always secondary.

For example, it is common today to describe some manufacturers or wholesalers as a fast-moving consumer goods (FMCG) business. However, in doing so, these companies are defining their business based on the market served, which must always be a secondary factor.

In short: if you are not unique in your own industry via your products and systems/technology, you cannot win by just being friendly to, or part of, a market. In other words, what are you bringing to the table?  That’s why industry definitions of what you do (and, hopefully, do better than your competitors) come first, and are all that you can truly ever own. Although one’s market is terribly important, it must never be allowed to define what you do, or why you are good at it.

Examples of the confusion

Stock exchanges are a prime example of how company definitions can go awry. Unlike industry classification systems, where government bodies allocated hundreds of millions of dollars to their research and implementation, stock exchange descriptions are arbitrary and unofficial, using a mixture of industry definitions, market definitions and technology definitions to categorise listed companies.

Tesla is an interesting case in point. Elon Musk might be said to be in the ‘technology’ business. Indeed, he might even believe it, especially as he is in batteries (for motor vehicles, electricity grids and households), space satellite launching and exploration (SpaceX), and electric vehicle manufacturing (Tesla). (And now, he is considering cryptocurrency and restaurants.) However, when pushed to a preference, Musk seems to believe he is in the battery business; the rest is saleable, shareable, whatever. He also wants to save the planet from its inhabitants in the energy equation issue.

However, his business empire is currently a classic conglomerate – much more than a technology company (whatever that means) – and he is easily bored. Ten years or more from now, this will prove a dangerous cocktail: Musk will have different competitors in each ‘technology’ business, and without any common customers. Who, then, could run such a giant conglomerate after Musk?

Our statistics show fewer than three of the 100 most profitable and successful companies are ever conglomerates. Like so many conglomerates, Tesla is likely to be extremely successful for a long time into the future. But there aren’t that many Musks in the world. Of course, this issue is as much about the Institute’s first rule of business success (Focus on one business at a time) as it is about defining one’s business.

Classification systems

When defining industries, and the companies in them, it useful to start with the world’s only official and logical system: the Standard Industrial Classification (SIC) system.

In the early 1900s, each branch of a United States government agency would conduct business analysis using its own methods and metrics, unknown – and, thus, meaningless – to other branches.

In the 1930s, the US Government needed standardised and meaningful ways in which to measure, analyse and share data across its various agencies. Industrial classification originated in a recommendation at a 1934 Interdepartmental Conference; the Technical Committee worked first on manufacturing industries; and, in June 1938, the Interagency Committee accepted a list of industries. Thus, the Standard Industrial Classification system was born.

Government agencies use the SIC system to classify industry areas, where SIC codes – four-digit numerical representations of major businesses and industries – are assigned based on common characteristics shared in a business’s products, services, production and delivery system.

The SIC system is also used by agencies in other countries – for example, Australia and New Zealand share a common SIC system; being ANZSIC. In the United States, the SIC code has been replaced by the North American Industry Classification System (NAICS code), which was released in 1997. Some US government departments and agencies, such as the US Securities and Exchange Commission (SEC), use SIC codes, but not the share market.

Part of the logic of the SIC system’s coding is based on the evolution of new products and industries through the ages of progress. Such evolution is seen in Australia over the past several centuries via the following exhibit.

In short, industries began with primary industries of hunting and trapping, then agriculture and mining; then secondary industries (the Industrial Age) and tertiary industries (commerce); then quaternary and quinary industries (our current age, spanning from c.1965 to c.2050). The first chart shows the relative importance of these industry divisions in our economy; while the second chart offers a stark and confusing contrast by way of the mixed-bag and arbitrary stock market system.

The previous chart also highlights the huge distortion in our stock market, where mining and finance account for 58% of the market capitalisation compared with less than 20% of the nation’s wealth creation (GDP). This is concerning, considering much of the Finance industry is now matured or maturing (as will be the case with the Mining industry before the end of this decade).

This one of the reasons, but not the most important one, for their being only around one in 10 of our listed companies achieving world best practice profitability (22% ROSF) compared with four in 10 in the United States. But these other reasons for success are not the subject of this particular Insight

In a final observation on classification systems for industries and the companies in them, including listed companies, we provide the hierarchy that exists in an SIC system; in this case, our own ANZSIC.

The Institute has coded its databases at the Divisions level in the pyramid above, as well as the ASX code. However, in our in-depth Strategic Diagnostic Rating (SDR) reports on individual stocks, we code the stocks down to the four-digit ANZSIC Class level, where we integrate our sister company IBISWorld’s global industry database information and forecasts into our unique reports.

 

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