Top buys for a blue-chip starter portfolio

Every quarter I take a look at the top FTSE 100 companies in each of the index’s 10 industries to see how they shape up as a potential ‘starter portfolio’. The table below shows the 10 heavyweights and their valuations based on forecast 12-month price-to-earnings (P/E) ratios and dividend yields.

Before looking at which individual companies might be particularly good buys today, let’s get a feel for the overall value. The table below shows average P/Es and yields for the group for the last four quarters and four years.

My rule of thumb for the group is that an average P/E below 10 is bargain territory, 10-14 is good value and above 14 starts to move towards expensive.

As you can see, the group P/E is currently towards the expensive end of my valuation spectrum. I’d previously excluded Vodafone from the average, as its P/E had been atypically high (30-40) due to a lull in earnings following the 2014 sale of its stake in Verizon Wireless. However, its P/E has now come down to under 30, so I’m including it in the average from here.

Although Vodafone’s P/E remains relatively high at 29, earnings are set to increase rapidly after three years of huge investment. For this calendar year a 30% leap is forecast, so the P/E of less than 30 represents good value for the growth on offer.

In addition, Vodafone’s 6.2% dividend yield is highly attractive. The payout may not be covered by accounting earnings for a while but it is set to be covered by free cash flow, which is the lifeblood of dividends. This adds to my conviction that Vodafone is an attractive investment at this juncture.

Also attractive

Companies in the technology sector tend to trade on higher-than-average P/Es and lower-than-average dividend yields, so I don’t think investors should be put off by accountancy software giant Sage’s P/E of 20 and yield of 2.5%.

Sage is working hard to attract new customers and to enhance its relationships with its existing customers and there’s good earnings momentum in the business. Earnings increased 9% (ahead of expectations) in the company’s last financial year and growth is forecast to accelerate to 15% for the current year to 30 September.

Sage announced last month that it’s evaluating potential strategic options for its North American payments business, including a sale. The shares have risen somewhat since, but are still 13% below last year’s high and look attractive to my eye at this level.

Finally, National Grid also has corporate activity in the offing (a partial sale of its UK gas distribution business) and its shares are also at a good discount to last year’s high, being 16% lower. In fact, the last time National Grid’s P/E was below the current 14.7 in my quarterly reviews was as long ago as July 2015.

The P/E and dividend yield of 4.8% are attractive compared not only with the company’s own recent history but also with utility stocks generally. As such, I also rate these shares as a ‘buy’ today.