Why Direct Line Insurance Group PLC Is A Bad Share For Novice Investors

The insurance business really is  mixed bag for me when I  think about investing for novices, as I suggested when I took a look at RSA Insurance Group.

On the one hand, it might be a bit cyclical but over the long term it tends to deliver the goods. But the risk can be variable, and some have a better long-term track record of dealing with earnings and dividends than others. Another problem, of course, is that the ins and outs of the business can be tricky for non-experts to understand.

So what about Direct Line Insurance Group (LSE: DLG)?

Well, I’d have a couple of big problems suggesting it for novices…

No track record

Direct Line was only floated in 2012, so we have no history to examine to check on the firm’s dividend policy or to see how it handles its business during the inevitable economic ups and downs.

Prior to flotation, Direct Line was in fact the insurance arm of Royal Bank of Scotland and, well, that firm’s recent record of financial management can only be rated, at the very least, as “could do better“.

To consider an investment in an insurance company, I’d want to see a history of aiming for strong but sustainable dividends, while recognising that they will be cyclical. And I even want to see a readiness to cut dividends before they get overstretched — yes, I want to see my short-term income reduced when that will be of longer-term benefit to the company and to my lifetime’s returns.

Overall, then, the dividend picture for me should say “sustainable over the long term”, not “as high as possible this year”.

Early dividends

Sure, we had a 3.7% yield for the tail-end of Direct Line’s first year as a public company, and for the full-year to December 2013 we’re expecting more than 6%. But that should be covered less than 1.5 times by forecast earnings, compared to 2.7 times for my favourite, Aviva, and 1.8 times for RSA.

And to me, that’s perhaps sailing a bit close to the wind in these early days as an independent company, and could be seen as a sweetener for early investors — and RBS still owns more than a quarter of the business, which it is set to unload by the end of next year.

That brings me to my next big worry, and that is my aversion to flotations. With a few exceptions (like when governments are flogging off state assets on the cheap), I think novices should steer clear of them and their aftermath.

Flotations are not bargain sales

The reason is quite simple — the people selling them off are trying to get the thickest lining they can for their own pockets, not trying to provide you with a bargain. And I really don’t like it in the short term after flotation, when the price hasn’t really had time to settle to its still-unknown long-term valuation — and having RBS’s continuing stake hanging over the price is a further concern.

In short, investments should be for the long term, and novices usually have longer timescales than wizened-old has-beens like me. But all we have to go on here is short-term indications.

Finally, I reckon looking for a track record sustainable dividends should be a key part of any novice investor's strategy. If you agree and you want to learn of a great candidate, have a read of the Motley Fool's Top Income Share report. It's a company whose services are even more essential than insurance, and it currently offers a very tasty 5.7% yield.

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> Alan does not own any shares mentioned in this article.