Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you’ve covered all the bases.
In this series I’m subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation. How does Direct Line (LSE: DLG) measure up?
1. Prospects
90% of Direct Line’s business is in the UK. It is the market leader in UK motor and home insurance, with just under 20% market share, but the sector is highly price-competitive, driven by price-comparison websites.
Premiums follow a cyclical pattern. Even so, this year is expected to be the 19th consecutive year in which motor insurers make a loss before investment returns.
2. Performance
The main upside for Direct Line is in cutting bloated costs inherited from its ownership by RBS. Its target is to raise return on tangible equity from 10% to 15% and knock £300m off a £1.3bn cost base. Even then, operating expenses will be around 25% of gross written premiums, compared to Admiral‘s 20%.
The first set of half-year results as a listed company were promising, with the 15% target hit.
3. Management
CEO Paul Geddes has run the operation since 2009, steering its transformation into profitability and its separation from RBS. No directors have more than £150,000 invested in the company, so have little downside risk.
4. Safety
Direct Line has £1.7bn capital surplus to its IGD regulatory minimum, a healthy coverage ratio of 270%. Gearing is just 15%, down from 22% a year ago.
Investment returns are an important element of overall profitability, but funds are mostly invested in corporate bonds. Cash flow at the half year was negative and payment of the last dividend came out of net assets.
5. Valuation
The shares are 25% above last December’s float price. They are at a 16% premium to net asset value, a smaller premium than other general insurers.
The projected P/E of 8.9 is also the lowest in the sector, whilst the yield of 5.9% is typical of a sector known for high but unreliable dividends.
DLG’s shares owe their discount to its high cost base and the overhang of RBS’s remaining 48% shareholding, which must be disposed of before the end of 2014.
Conclusion
There is upside if DLG can cut costs better than expected, but difficult market conditions and impending share sales by RBS will make for a dicey ride for investors.
Most investors hold general insurer’s shares for income, but it’s necessary to keep a close eye on the risk of a cut. For a safer payout, I suggest you take a look at the Motley Fool’s top income stock pick. It’s yielding over 5% and is planning to raise the dividend at least in line with inflation, yet is in one of the safest sectors there is. That’s a great income to lock in with interest rates set to stay low.
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> Tony does not own any shares mentioned in this article.