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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.

Company Industry Recent share price (p) P/E Yield (%)
BAE Systems Industrials 592 13.9 3.7
British American Tobacco Consumer Goods 4,622 16.3 3.9
GlaxoSmithKline Health Care 1,562 14.1 5.2
HSBC Holdings Financials 657 13.0 6.0
National Grid (LSE: NG) Utilities 952 14.7 4.8
Rio Tinto Basic Materials 3,159 11.7 4.4
Royal Dutch Shell Oil & Gas 2,354 15.7 6.3
Sage (LSE: SGE) Technology 655 20.0 2.5
Tesco Consumer Services 207 21.7 1.0
Vodafone (LSE: VOD) Telecommunications 200 29.0 6.2

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.

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  P/E Yield (%)
January 2017 17.0 4.4
October 2016 17.3 4.0
July 2016 17.2 4.4
April 2016 16.4 5.0
January 2016 13.7 6.0
January 2015 13.5 4.8
January 2014 12.7 4.5
January 2013 11.7 4.6

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.

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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended HSBC Holdings, Rio Tinto, Royal Dutch Shell B, and Sage Group. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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