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After some prevarication, I've taken the plunge and made a new purchase for the Beginners' Portfolio -- it's not actually real money, but it's run exactly the same way. The new addition is BAE Systems (LSE: BA.L) , and here are the price details:
That brings our purchases so far to...
That's eight out of the 10 slots filled, with two more investments to make, so why BAE Systems?
Buy cheap sectors
Well, over the past year there have been, to my mind at least, a number of sectors that have been unfairly depressed, and I think that has provided a great extra boost for new investors just thinking about building their portfolios -- if you can get started during one of our worst stock market downturns, you are very lucky indeed.
A few of those sectors are already represented in the portfolio, and some are well on the road to recovery. But engineering, especially aerospace and defense, although it is moving, has looked slower to come back from the depths -- probably for good reason (if you're a short-termer, at least), as spending on the sector's products will most likely lag the general economic recovery.
And BAE's valuation just looks too low to me.
Before it recovers
Profits have been flat for a couple of years and are expected to remain so. But the share price is so low that the prospective price-to-earnings (P/E) ratio for the year ending December is only around eight, based on City forecasts. Now, the P/E can be tricky to make sense of (and as it's such a key ratio, I plan to look at the P/E ratios of all our holdings in more detail in a future article). The long-term average for the FTSE is around 14, so that seems like a reasonable rough benchmark for a company growing at average FTSE pace and with average FTSE debt (because a portion of earnings is really attributable to creditors rather than shareholders).
BAE's earnings growth for the next couple of years is likely to lag the FTSE average, so a fair valuation would be less than that. But I think eight is just too low, especially as BAE's debt is reasonably low. At the half-year stage it had net debt of £1.23 billion -- perhaps an eye-watering amount to you or me personally, but not really a big deal for a company valued at £11 billion with annual revenues of more than £16 billion.
And there's a 6% dividend forecast, too, which does not look under threat.
The EADS thing
Talking of rooms with elephants in them, I haven't mentioned the mooted BAE/EADS merger possibility yet, and that's the only thing that has stopped me buying BAE before now -- I was about to take the plunge when the news hit. But I've decided I'm not going to try to overanalyze the move, and if BAE looks cheap now, we should buy it -- and a merger might be one way to out the undervaluation that I'm convinced is there.
Besides, if a merger comes off then it will be an educational experience for us, and that is the core purpose of this portfolio.
As usual, please tell me what you think of this new investment, using the comments section below.
Finally, I reckon the core of any new investor's portfolio should be based on strong dividend-paying shares, and Neil Woodford is an acknowledged expert on the strategy. I heartily recommend the free Motley Fool report "8 Shares Held by Britain's Super Investor" for followers of our Beginners' Portfolio. Click here to get your free copy, while it's still available.
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