Equity Segmentation

Published at 1719806705.525151

Equities play a significant role in global investments and are essential components of investment portfolios. Reasons for investment in equities include the opportunities to benefit from growth and earnings, as well as ownership stakes in diverse business entities across different sizes, economic activities, and regions. Publicly traded equities in the stock market offer higher liquidity, facilitating low-cost transactions compared to other asset classes.

Equities provide certain benefits to an investment portfolio for an organization or an individual. These benefits include capital appreciation, diversification with other asset classes, and the potential to act as a hedge against inflation. In addition, specific investment considerations help segment an equity portfolio.

Benefits of Equities

Capital appreciation. Portfolios consist of shares in publicly traded companies. As these companies grow and expand their operations, their profits increase. When investors own a stake in a successful company, they benefit from its financial success. Also stock prices are influenced by market demand and market sentiment. Positive news about a company or a strong overall economy can attract more investors, leading to higher stock prices. Conversely, negative news can cause price declines. Understanding market dynamics is essential for capital appreciation. Historically, equities have delivered some of the highest long-term returns among various asset classes worldwide.

Dividend income. Every year some companies distribute dividends to their shareholders. These dividends represent a portion of their annual profits. Owning dividend-paying stocks can provide a reliable source of income. Some companies choose to distribute cash flows as dividends instead of reinvesting them in projects, particularly when suitable investment opportunities are scarce. However, while large corporations often increase their dividend payments over time, there are no guarantees that these payments will continue to grow or even be maintained.

Diversification. Equities tend to behave differently from other asset classes, such as bonds or real estate. When bonds face challenges for example, an equity portfolio may thrive. By investing in stocks, capital is allocated to different sectors and companies. While equities often exhibit high correlation in returns, combining them with other assets creates a risk-adjusted portfolio. Although diversification doesn’t guarantee against losses, it enhances the likelihood of preserving capital.

Hedge against inflation. Some companies or sectors with inelastic demand from their goods and services can raise sale prices in line with inflation, such as sectors in raw materials, energy, industrial metals. As a result, their revenues and earnings may also increase. Holding these equities allows investors to participate in this growth, preserving purchasing power. Also equities tend to grow in value over a long period of time. Diversifying a stock portfolio helps safeguard against the erosion of purchasing power caused by inflation. Empirical studies show a positive correlation between real equity returns and inflation, though this relationship depends on the assessed time period. Notably, equity prices often serve as a leading indicator of the business cycle, while inflation is typically a lagging indicator.

Segmentation of Equities

In the realm of publicly traded equities, there are multiple methods for building equity portfolios, mutual funds, or open-ended funds. An important task for portfolio managers is to segment equities or sectors according to similar characteristics. This segmentation enables better evaluation and construction of equity portfolios, as well as targeted capital allocation based on the portfolio or fund’s objectives. The following are the most commonly used approaches to segmentation.

Segmentation by investment size and style. The most popular approach is to consider  market capitalization (size) and investment style of stocks. For size, an equity is often categorized by large-cap, mid-cap, and small-cap. For style, it can be growth, value, or a core, which maintains a neutral stance, not favoring either growth or value. The following tables highlight key characteristics of size and style segmentation.

 

Portfolio managers enhance client investment strategies by categorizing equities according to size and style. This approach enables better decision-making and portfolio construction by considering the risk-return tradeoff across different segments. Additionally this segmentation facilitates diversification across economic sectors and industries, reducing concentration risks associated with investing in various sizes and styles.

Through this segmentation, managers can analyze how company characteristics change over time (e.g. moving from small-cap to mid-cap, or from growth to value stocks). They can then adjust capital allocation based on changing market conditions, client preferences, and comparative benchmarks. For example, a small investment firm may specialize in mid-cap and small-cap companies, seeking to outperform a benchmark index or comparable peer group of mutual funds. However, the key disadvantage of this approach is that the categories may be defined differently across investment firms.

Segmentation by economic activities. Equities can be grouped into sectors and industries based on their economic activities. Some examples include technology, healthcare, and finance sectors.

There are two main approaches in this segmentation: the market-oriented approach and the production-oriented approach. In the first approach, companies are categorized based on the markets they serve, consumer usage of their products, cash flow generation. This sheds light on consumer behavior, market dynamics, and revenue streams, helping investors in understanding growth opportunities. On the other hand, the production-oriented approach groups companies by the products they manufacture and necessary production inputs. For example, companies producing automobiles and companies producing semiconductors belong to two different segments. This approach has an advantage of comparing similarities in production methods and the firm cost structures. It’s also useful for assessing supply chain risks.

There are 4 main global classification systems. The global industry classification standard (GICS) uses a market-oriented approach, while the Industry Classification Benchmark (ICB), the Thompson Reuters Business Classification (TRBC), and the Russell Global Sectors Classification (RGS) use a production-oriented approach. Each classification system drills down to 3-4 levels as in the table below.

Overall, economic activity segmentation provides considerable advantages. First, by investing across different sectors, investors diversify their portfolios and spread the respective risks. Second, investors can choose to focus on specific industries they forecast will outperform due to trends or growth prospects. Third, sector rotation allows portfolio adjustments based on economic cycles (e.g. defensive sectors during economic downturns and recessions). However, this segmentation requires accurate market timing, which can be difficult at certain market conditions. Another limitation is that this can lead to sector bubbles as investors chase hot sectors and inadvertently lead them to inflated valuations (e.g. dot-com bubble during the late 1990s).

Segmentation by geography. Geographic segmentation is of consideration for global, international investment funds such as iShares MSCI Frontier and Select EM ETF. It involves dividing stocks based on the regions or countries the funds operate. The following table illustrates 3 different types of geo markets.

Geographic segmentation offers significant benefits in emerging and frontier markets due to their rapid economic growth and demographic trends. It also opens access to specific sectors across different regions, enhancing portfolio diversification. However, key limitations include higher volatility in emerging and frontier markets. These markets often have limited liquidity as well, making it challenging to buy or sell large positions without impacting prices. Currency risk from exchange rate fluctuations can impact returns for international investments for performance evaluation purposes.

Each segmentation approach has its own benefits and risks, from exploiting opportunities in different markets to managing volatility and liquidity. Applying the appropriate segmentation approach will help optimize investment performance and build a sustainable portfolio.