A Blue Chip Starter Portfolio

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 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 indexes. 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).

As you can see, the imbalances are quite substantial. Financials, for example, represent one-tenth of the 10 industries, but make 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.

Financials, Oil and Gas, Consumer Goods, and Basic Materials (mainly mining) 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.

Excluding tech share ARM, the companies have an average P/E of 11.4 compared with 11.1 last quarter. The average yield has come down to 4.9% from 5%.

So, the group of nine is rated a bit more highly today than it was three months ago. 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 toward expensive.

The modest rise in the rating since last quarter means the group remains nearer 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.

There are three companies in the table whose P/Es are lower today than three months ago, so let's have a quick look at them.

British American Tobacco is on a P/E of 13.9, which is down from 14.3 last quarter and 14.6 the quarter before. When investors become increasingly comfortable with riskier shares, as they have over the past six months, ultra-defensive companies, such as British American Tobacco, often get neglected. The current forecast P/E is below that of the Footsie average, while the dividend yield of 4.7% is higher.

GlaxoSmithKline's P/E of 11.4 is down from 11.7 last quarter, while the dividend yield has risen to 5.8% from 5.5%. Again, this is a company in a defensive sector -- big pharma -- whose rating has moderated as the market has moved for riskier shares. GlaxoSmithKline's P/E and dividend yield are even more attractive compared with the market average than British American Tobacco's.

Mobile giant Vodafone has gone from being a growthy tech stock to a more defensive, utility-like investment, as mobiles have become less of a luxury and more of a staple product. Vodafone's P/E of 9.6 is down from 10.8 last quarter. The shares have been weak of late, as many investors were surprised when the company failed to announce an expected special dividend. Nevertheless, analyst forecasts imply a forward yield of 7.3%. The low P/E and big yield -- two common metrics of "value" investors -- suggest Vodafone could be something of a bargain at the current share price.

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I can also tell you that one of the companies in the table above has been heavily backed by billionaire U.S. investing legend Warren Buffett. The Motley Fool special report "The One U.K. Share Warren Buffett Loves" gives you the full story on Buffett's investment. Again, you can download your report for free: simply click here.

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