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The Hidden Nasty In The FTSE 100

Investors putting money into FTSE 100 tracker funds such as the iShares FTSE 100 (LSE: ISF) often believe they are getting a balanced, diversified range of investments — but are they?

FTSE100Looked at as a whole, the FTSE 100 (FTSEINDICES: ^FTSE) seems reasonably good value, with a P/E of 13.8 and a yield of 3.5%.

What may not be obvious is that the FTSE’s valuation is dominated by just two sectors: natural resources and finance.

The four largest firms in the FTSE 100 — Royal Dutch Shell, HSBC Holdings, BHP Billiton and BP account for almost 25% of the FTSE’s total market capitalisation of £2.2 trillion. Shell alone accounts for 14% of the index!

It’s no coincidence that these four firms are almost amongst the cheapest in the index, and offer some of the highest yields:

Company 2014
forecast P/E
forecast yield
Royal Dutch Shell 12.0 4.3%
HSBC Holdings 11.1 5.2%
BHP Billiton 12.2 3.8%
BP 10.3 4.8%

Source: Consensus forecasts/Reuters

There are others, too — Rio Tinto, Standard Chartered, Barclays and Glencore Xstrata — that are cheaper than average, and command sizeable market caps that skew the FTSE towards the banking and natural resources sectors.

Look at it this way —  if FTSE 100 minnow Travis Perkins (market cap £4.4bn) rose by 20%, the FTSE 100 would rise by just 0.04%. If Shell rose by just 2%, the index would rise by 0.3%.

What about the rest?

If eight of the biggest companies in the index have a below-average valuation, many of the rest must have above-average valuations — and so it seems.

Here’s a snapshot of the six biggest companies in the index, excluding the natural resources and banking sectors:

Company 2014
forecast P/E
forecast yield
GlaxoSmithKline 15.5 4.9%
Unilever 20.3 3.5%
British American Tobacco 16.0 4.3%
Vodafone 16.4 5.3%
SABMiller 22.2 2.0%
Diageo 19.0 2.7%

Source: Consensus forecasts/Reuters

These numbers suggest that valuations are more buoyant in sectors other than commodities and finance. There are exceptions, of course — supermarkets are cheap — but many of the FTSE’s mid-sized members — such as cement giant CRH and cater Compass — do seem quite expensive, in my view.

Isn’t this normal?

To some extent, this is normal. Company valuations tend to peak at different points in the economic cycle — I expect to see banking valuations rise, over the next few years, for example.

However, I don’t expect natural resource giants such as Shell and BHP Billiton to climb to premium P/E ratings, as their businesses are increasingly focused around shareholder returns and efficiency, rather than outright growth.

The good news is that you can improve the diversity of your portfolio, without sacrificing your FTSE tracker holdings. 

Investing in a handful of carefully-selected growth opportunities, such as the British high-tech engineering firm selected as "The Motley Fool's Top Growth Stock For 2014", can give you a decent chance of beating the index.

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Roland owns shares in Royal Dutch Shell, HSBC Holdings, Rio Tinto, Standard Chartered, Barclays, GlaxoSmithKline, Unilever and Vodafone, but not in any of the other companies or funds mentioned in this article.
The Motley Fool owns shares in , Standard Chartered and Unilever, and has recommended GlaxoSmithKline