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LONDON -- Here at The Motley Fool, we've long extolled the virtues of low-cost index trackers as a one-stop shop for equity investment. Tracker funds simply replicate an index, such as the FTSE 100 (INDEX: ^FTSE ) or FTSE All-Share.
However, index tracking isn't everyone's cup of tea. Some people prefer to invest directly in the shares of individual companies.
Shares vs. trackers
One reason some investors prefer shares is because of the industry imbalances within the FTSE indices. Some industries are more heavily represented than others.
At the broadest level, there are 10 industry sectors in the official classification. The table below shows the proportion of these industries within the FTSE 100 (and, thus, a FTSE 100 tracker).
|Oil & Gas||20|
As you can see, the imbalances are quite substantial. Oil & gas, for example, represents one tenth of the 10 industries, but makes up a fifth of the index. At the other end of the scale, technology also represents one tenth of the industries, but makes up just one hundredth of the index.
Oil & gas, financials, consumer goods, and basic materials (mainly mining) and are all "overweight," while the other six sectors are all "underweight."
Investors in trackers have to live with the sector skews of the index. But investors in individual companies are free to choose the industries they invest in and the weight they give them.
Some investors argue that, because we can't know how the different sectors will perform in the future, "equal weighting" between industries is the most logical approach.
A starter portfolio
Every quarter I take a look at the largest FTSE 100 companies in each of the 10 industries to see how they shape up as a potential "starter" portfolio.
The table below shows the 10 industry heavyweights and their current valuations based on forecast 12-month price-to-earnings ratios and dividend yields.
Share price (p)
|Royal Dutch Shell||Oil & Gas||2,198||7.8||5.2|
|BHP Billiton||Basic Materials||1,925||10.3||3.9|
|British American Tobacco (LSE: BATS.L )||Consumer Goods||3,180||14.3||4.6|
|Vodafone (LSE: VOD.L )||Telecommunications||176||10.8||7.4|
|Rolls-Royce (LSE: RR.L )||Industrials||843||13.5||2.5|
Excluding tech share ARM, the companies have an average P/E ratio of 11.1 (10.7 last quarter) and an average yield of 5% (5% last quarter).
So, the group of nine is rated a bit more highly today on P/E than it was three months ago, but still offers the same yield. My rule of thumb for this group is that an average P/E below 10 is firmly in "good value" territory, while a P/E above 14 starts to move towards expensive.
Despite the rise in the rating since last quarter, the group remains near the value end of the spectrum. As such, I think the market continues to offer a good opportunity for long-term investors to buy a blue-chip bedrock of industry heavyweights for a U.K. equity portfolio.
Let's have a quick look at the three companies whose P/Es are lower today than three months ago.
Rolls-Royce's shares have had a storming 12 months, having traded at less than 600 pence a year ago. They reached a high of close to 900 pence, but have now come off the boil somewhat and the P/E has dropped from 14.2 to 13.5. The dip has left the shares still on quite a high rating, and the dividend yield of 2.5% ranks lower than all bar ARM's. However, analysts are forecasting mid-teens earnings growth, so the P/E of 13.5 isn't altogether unattractive.
British American Tobacco is another company whose shares have been much in demand over the past year. These shares have also come off their highs. The current P/E of 14.3 is down from 14.6 last quarter. That remains a high rating -- higher than Rolls-Royce's -- particularly as analysts are forecasting only mid-single-digit earnings growth for the tobacco firm. On the plus side, BAT offers a considerably better dividend yield than Rolls-Royce.
However, for investors who are particularly interested in dividend income, Vodafone continues to have the standout yield (7.4%), and the mobile giant's P/E of 10.8 is fractionally lower than three months ago. Investors can expect an almost guaranteed yield of 5.7% from Vodafone, with the 7.4% yield being a reflection of analysts' expectations that the company will also pay a special dividend.
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