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Why I’d Sell Royal Bank of Scotland Group plc And Lloyds Banking Group plc But Buy Direct Line Insurance Group plc

It’s been some time since the carnage of the 2008-9 financial crisis, yet it still seems to be the case that not a day goes by without another bad news story about one of our big banks.

If they’re not getting into trouble for rigging the Libor rate, they’re mis-selling payment protection to their unsuspecting customers. But, more to the point, they are now paying the price – with interest.

So what is it with the UK’s love affair with these bad banks? Even today, they still command a place in many private investors’ portfolios, not to mention our huge holdings by proxy.

It’s hard to let go

As the heading suggests, some investors reading this article may well be long-term holders of RBS (LSE: RBS) and Lloyds (LSE: LLOY) since the financial meltdown that blighted investment returns in 2008-9.

Although a relative newcomer to stock market investing during that time, I, too, flirted with the banks. My thinking, rather naively in hindsight, was how much money I could make when they returned to their pre-crisis levels. Having realised the error of my ways, I exited some time ago, licking my wounds.

There are some schools of thought who believe that investors feel the pain of a loss on an investment twice as much as the elation of a gain. This can cause them to focus on their losing investment too much, often doubling down, a tactic that can sometimes makes fools of even the most experienced investors.

Despite all of the current negativity, I felt that it was worth revisiting these FTSE 100 constituents to see whether they make for a decent investment, or whether there is better value and income to be found in other less controversial parts of the market.

A wise-guy, huh?

Having looked elsewhere, not too far away from the banks, I stumbled upon Direct Line (LSE: DLG) after watching Harvey Keitel reprising his character Winston Wolf from ‘Pulp Fiction’ in one of the insurance groups adverts.

Sold off by RBS in October 2012 as punishment for receiving state aid, this insurer has seen its share price more than double since floating on the market, whilst throwing off dividends and special dividends to its shareholders.

The company recently announced some expectation-beating results, too, though these were flattered by an absence of extreme weather in the first half. Still, the combined operating ratio or COR (this is the sum of the loss, commission and expense ratios, and is a measure of the amount of claims costs, commission and expenses compared to net earned premium generated) was 89.4% — anything under 100 means that the business is making a profit.

Despite the rise in the share price, the shares still only trade on a forward P/E of under 13 times forecast earnings and are expected to yield over 7%.

Not all bad

Despite all of the bad news on the front page, behind the scenes, Lloyds and RBS are fixing the things that went wrong and slowly, very slowly, returning to health. Indeed, if it wasn’t for further provision for PPI and restructuring costs, both banks would now be profitable.

Lloyds has returned to the dividend list and is on a 12 month forward rolling basis is expected to yield around 4% — it has even intimated that it could pay additional special dividends, too.

Even RBS is expected to return to paying a dividend  in the next twelve months And although the forecast 1% pay-out isn’t much, it’s a move in the right direction.

In addition, the treasury seems happy to begin to reduce its stake, albeit at a loss. Whilst I’m not best pleased as a tax payer, I do believe that it is a positive signal for the bank.

The Foolish bottom line

As the chart below shows, all three shares have managed to outperform the FTSE 100 over the last year, though I think sentiment towards these two banks will be negative for some time as they clear out the misdemeanours of the past.

And on that basis, I’ll be looking closely at Direct Line as the market wobbles. I think that investors and the market are still positive on its prospects, buying into the management strategy of simplifying the business, reduces costs and building on its market-leading position. I expect the share price to grow going forward and the company to continue to throw off cash to its shareholders.

For those of us searching for yield, one of the best tried and tested methods is to adopt an approach towards a more diversified portfolio, tailored towards good solid income producing stocks -- the sort that will make money whatever the weather.

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Dave Sullivan has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.