A Blue-Chip Starter Portfolio

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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. Here's a look at the proportion of these industries within the FTSE 100 (and, thus, a FTSE 100 tracker).

Industry

Proportion (%)

Oil and Gas19
Financials17
Consumer Goods16
Basic Materials11
Health Care9
Consumer Services8
Telecommunications7
Industrials7
Utilities5
Technology1

The imbalances are quite substantial. Oil and Gas, for example, represents one-tenth of the 10 industries but makes up almost 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 and Gas, Financials, 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
From time to time, 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.

I did this at the weekend, and the following table shows the 10 industry heavyweights and their valuations based on forecasted 12-month price-to-earnings (P/E) ratios and dividend yields.

Company

Industry

Share Price (Pence)

P/E

Yield (%)

HSBCFinancials5619.05.2
Royal Dutch ShellOil & Gas2,2257.65.0
BHP Billiton (ISE: BLT.L) Basic Materials1,8067.64.3
British American TobaccoConsumer Goods3,24214.64.5
Tesco (ISE: TSCO.L) Consumer Services3108.85.0
GlaxoSmithKlineHealth Care1,44711.45.3
Vodafone (ISE: VOD.L) Telecommunications17910.97.4
Rolls-RoyceIndustrials85814.22.4
National GridUtilities67612.46.1
ARM HoldingsTechnology50632.20.9

Excluding tech share ARM, the companies have an average P/E of 10.7 and an average yield of 5.0%. The numbers were 9.8 and 5.2%, respectively, when I last carried out this exercise in October 2011.

So, the group is rated a bit more highly today than it was nine months ago. However, I think it still veers towards the value end of the spectrum, because my rule of thumb for this group of nine 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.

In other words, it seems to me that the market is still offering a good opportunity to buy a blue-chip bedrock of industry heavyweights for investors who are looking to embark on building a diversified portfolio of U.K. equities.

At the individual company level, oil major Shell and miner BHP Billiton, are both on an eye-catching low P/E of 7.6, as jittery investors worry about global -- and particularly Chinese -- demand for natural resources. My Foolish colleague Roland Head has been eyeing up the mining sector recently, while I thought Shell looked good value after its first-quarter results a couple of months ago.

Supermarkets have also been out of favor of late, none more so than Tesco after it issued a profit warning earlier this year. Despite its current low P/E of 8.8, I don't personally rate Tesco a buy, because I believe there's a good chance we could see the shares below 300 pence at some point.

However, Tesco is rated a bargain at the current level by plenty of my Foolish colleagues -- and also by 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 Tesco investment. You can download your copy right now for free.

For investors who are particularly interested in dividend income, Vodafone catches the eye on a standout yield of 7.4%. I've been singing Vodafone's praises as an income share for a number of years, while my Foolish colleague David O'Hara has recently described the company as the best large-cap income opportunity he can recall!

Finally, if you're in the market for blue-chip dividend shares, grab the opportunity to find out where dividend supremo Neil Woodford is investing today. All is revealed in this free Motley Fool report: "8 Shares Held by Britain's Super Investor." You can download your copy right now, and, as I say, it's 100% free.

Want to learn more about shares, but not sure where to start? Download our latest guide, "What Every New Investor Needs to Know" -- it's free. The Motley Fool is helping Britain invest. Better.

Further investment opportunities:

At the time this article was published G A Chester owns no shares in any of the companies mentioned in this article.The Motley Fool owns shares of Tesco. Motley Fool newsletter services have recommended buying shares of Tesco and Vodafone 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. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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