After the Direct Line share price jumped, should I buy?

The Direct Line share price shot up 18% in under a couple of months. Christopher Ruane assesses whether he ought to add it to his holdings now.

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The insurance company Direct Line (LSE: DLG) has surged on the stock market lately. The Direct Line share price moved up 18% between late November and last week. Over the past year, its performance has been more modest, losing 3%. After the latest price surge, should I still consider buying the firm for my portfolio?

Long-term loser

At first glance, it may look like I missed the chance to buy the share when it was on sale in November. Given its performance since then, there is an argument that the share was undervalued a couple of months ago.

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I think a swing among investors to more defensive shares such as the famous insurer has helped to push the price up. In the bigger picture, however, I am not sure that the recent price gain will be maintained. Over the past five years, the Direct Line share price has dropped 14%. Shareholders do benefit from a healthy yield, which currently stands at 7.4%. But the long-term price movement does not suggest that investors are optimistic about the company’s outlook. That may be explained by inconsistent business performance. Earnings per share last year were the lowest for four years. That could partly be a result of the pandemic, although arguably the lower rates of vehicle use helped insurers as there were fewer claims. Indeed, Direct Line reported lower claims frequency last year in both its motor and commercial lines.

Strengths and weaknesses

There are also risks on the road ahead. For example, recent changes in UK rules on insurance renewal pricing could hurt profit margins. Then again, they might actually result in a more transparent market with less unprofitable policies being written. That could turn out to be good for Direct Line. Car shortages are pushing up second hand prices, increasing settlement costs for the company. That too could hurt profits.

But I continue to see a number of attractive features about Direct Line. Demand for the sorts of insurance the company specialises in tends to be resilient. Car insurance, for example, is a legal requirement. The iconic brand Direct Line has built over decades helps it increase customer loyalty. That should support attractive profit margins.

Although the long-term share price decline does concern me, I reckon the yield is very attractive. Dividends are never guaranteed, but the appealing economics of the insurance industry mean I think Direct Line could continue to make handsome payouts for years to come.

My next move on the Direct Line share price

I do have doubts about the growth prospects for the company. Last year was the third consecutive year in which revenues declined. I think that may explain why the Direct Line share price has drifted downwards for years despite the occasional surge like we saw recently. But I believe growth could return in future, given the company’s strong brand.

However, I like the Direct Line business. I also appreciate the share’s passive income potential that could boost the dividends I earn from my portfolio. Purely from an income perspective, I see a case for tucking it in my portfolio and holding it for years. If I could wait to do that in another dip like we saw in November, it could boost the dividend yield I would get.

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Christopher Ruane 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.

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