My top FTSE 100 buys for an instant starter portfolio

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.

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.

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.