Should I buy Direct Line shares for its 7.5% dividend yield?

Direct Line shares rose about 15% in the past year. It has a 7.5% dividend yield. Royston Roche reviews the stock to see if it’s a good fit for his portfolio.

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Direct Line Insurance (LSE: DLG) shares are up about 15% in the past year, so do I think this rise can continue? OK,  insurance businesses aren’t like fast-growing US technology stocks. But their potential stable dividend income and long-term stock appreciation is appealing. So would I buy?

Why I might consider buying Direct Line shares

Direct Line’s recent financial results have been good in a challenging period. For 2020, its gross written premium figure was down only marginally (by 0.7%) year-on-year to £3.2bn. And the combined operating ratio (COR) improved to 91% in the year 2020 from 92.2% in the previous year. This is one of the important metrics when assessing an insurance stock. The COR is the sum of claims, expenses and commission ratios. A COR of less than 100% indicates profitable underwriting. And Direct Line has hit this target in the past five years. 

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The company has also resumed its dividend, which is another reason why I like the stock. For the 2020 financial year, it paid an interim dividend of 7.4p, plus a special dividend of 14.4p to compensate for the cancelled 2019 final payout. The company is also paying the final dividend of 14.7p for 2020 today. At the current share price, the dividend yield is about 7.5%, which is very attractive. However, I understand that there’s no guarantee the company will continue to pay future dividends. 

Yet I hope it will. It has a stable balance sheet, a solvency capital ratio of 191% and has maintained a capital surplus above the regulatory capital requirement. The net cash generated from the operating activities improved to £584.7m for the year 2020 from £462.1m for 2019. I like companies with good operating cash flows as I consider them to be a safer bet during any economic downturns.

The downsides

The insurance sector is very competitive. This is one reason why I get nervous when judging insurance stocks. Online premium comparison sites have made matters worse for insurance companies’ profits. Also, businesses like Direct Line are being advised by the Financial Conduct Authority that they must not charge their existing clients more than new ones for insurance policies. This, in my opinion, could put a dent in its profits. 

And the lockdown has reduced the number of new vehicles registered. People have reduced their travel and this will have a negative impact on the motor insurance business. This impact could be seen in DLG’s most recent trading update. The motor insurance segment’s gross written premium fell by 11% year-on-year to £367.3m. 

Conclusion

Yet the company is fundamentally strong. It’s trading at a price-to-earnings ratio (P/E) of 11.5, lower than its five-year average of 12.1. So, I feel the shares are not trading at a significant enough discount to their historical average for me. I’ll keep the stock on my watch list, but I’m not a buyer today. I prefer another insurance stock, Aviva, that’s trading at a lower P/E ratio than Direct Line shares.

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Royston Roche has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Should you invest the value of your investment may rise or fall and your Capital is at Risk. Before investing your individual circumstances should be considered, so you should consider taking independent financial advice.

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