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My top FTSE 100 buys for an instant starter portfolio

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Screen of price moves in the FTSE 100
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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 industry heavyweights and their valuations based on forecast 12-month price-to-earnings (P/E) ratios and dividend yields.

Company Industry Share price (p) P/E Yield (%)
BAE Systems Industrials 482 10.6 4.9
British American Tobacco Consumer Goods 3,181 10.0 6.6
GlaxoSmithKline Health Care 1,598 14.4 5.0
HSBC Financials 623 11.3 6.3
National Grid Utilities 851 14.6 5.7
Rio Tinto Basic Materials 4,469 10.8 5.6
Royal Dutch Shell Oil & Gas 2,428 11.3 5.9
Sage Technology 701 22.5 2.5
Tesco Consumer Services 232 13.6 3.2
Vodafone (LSE: VOD) Telecommunications 140 14.1 9.1

Before looking at individual companies, let’s get a feel for overall value. The table below shows average P/Es and yields for the group as a whole for the last four quarters and six years.

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  P/E Yield (%)
April 2019 13.3 5.5
January 2019 12.3 5.9
October 2018 13.3 5.3
July 2018 14.7 4.8
April 2018 14.2 5.0
April 2017 16.8 4.6
April 2016 16.4 5.0
April 2015 14.9 4.8
April 2014 12.8 4.6
April 2013 12.4 4.4

My rule of thumb 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, although the group’s P/E has increased since last quarter, it remains in my ‘good value’ territory at 13.3.

With the exception of Sage, I’d be happy to buy this diverse group of industry heavyweights today, and tuck them away in a Stocks and Shares ISA as a starter portfolio of core long-term holdings.

I’m erring on the side of caution in seeing Sage — with its P/E of 22.5 and 2.5% dividend yield — as one to avoid at this stage. However, many of my Foolish colleagues are positive on the stock, and I’d certainly encourage you to read the bull case.

Eye-catchers

Turning to stocks at the lower P/E and higher dividend yield end of the valuation spectrum, British American Tobacco in one that catches the eye. It has the lowest P/E of all at 10, and the second highest yield at 6.6%. I’ve covered this stock recently in an in-depth article, explaining why I believe it has the potential to deliver strong capital gains and a reliable flow of dividends.

Another stock that stands out in the table today is Vodafone. While its P/E of 14.1 is a little above average, its dividend yield of 9.1% is the highest by a considerable margin.

Lessons from Shell and Rio Tinto

Vodafone’s yield has risen to 9.1%, because its share price has declined 40% over the last 15 months. When a yield gets this high, it generally means the market sees the dividend as unsustainable. In stock market parlance, the market is “pricing-in a cut.”

The market often — but not always — gets it right. For example, back in my January 2016 review, I highlighted the value in Shell and Rio Tinto, which were both yielding 9.1% at the time. Shell went on to maintain its dividend, while Rio rebased its payout.

Nevertheless, the shares of both companies have risen strongly since. Shell, of course, has delivered a terrific level of dividend income on top, but Rio has also produced a decent income return from its rebased level.

We now have a similar situation with Vodafone. It’s touch-and-go whether its cash flows and balance sheet will be strong enough for it to maintain its dividend through a year or two of elevated capital commitments. Either way, though, I believe its current valuation is so depressed that investors will be handsomely rewarded in the end, just as those of Shell and Rio have been.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended HSBC Holdings, Sage Group, and Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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