The FTSE 100 rout on Wednesday saw the Direct Line (LSE: DLG) share price plunged 6.5% in morning trading. And it’s now down 40% over the past 12 months.
I already thought Direct Line shares were undervalued and looked like a long-term buy. So are they an even better buy now after the latest fall? I think so. But the risks have surely also increased.
New chancellor Kwasi Kwarteng’s so-called mini-budget has had a maxi impact. He might have thought home buyers would benefit from reduced stamp duty. But that’s likely to be more than wiped out by soaring mortgage costs as interest rates look certain to rise faster than previously expected.
The Kwarteng crash?
It’s all about the plunging value of the pound, which is a direct result of Kwarteng’s huge tax cuts. The government needs to rely on ballooning borrowing to pay for them, and that damages confidence in sterling.
Costs of imported goods are climbing, driving inflation even further, directly thwarting the Bank of England’s efforts to control it.
One result is a hammering for the financial sector. Insurance shares are tumbling across the board. In addition to Direct Line’s Wednesday fall, shares in Admiral Group, Aviva, Legal & General, Prudential… they’re all falling.
Tough first half
The motor insurance business was already looking tough for Direct Line in 2022. The company was seeing claims rising above levels that had been assumed in its pricing calculations. And it had little alternative but to start hiking its charges.
That’s a tough decision to make in such a competitive business. It was surely the right thing to do for the long-term health of the company. But it did lead to a share price fall at the time. And if costs in the business rise further, there must be a chance we could see further rises in insurance premiums.
Bearish? Not me
Do I sound like I’m taking a bearish view of the insurance business? I’m certainly not. In fact, I remain bullish about the long-term prospects for the sector. And I remain convinced that the best time to buy is when sentiment is at its lowest.
I thought Direct Line’s financial measures were pretty decent at the halfway stage, with an estimated solvency capital ratio of 152%. The company said it was “confident in the sustainability of its regular dividends” and maintained its interim payment.
Big dividend
With the Direct Line share price falling, forecasts put the full-year dividend yield at 11.5% now. I do think the current financial panic has the potential to dent the company’s confidence in its dividend a little. And I suspect it’s already dented public confidence.
But I see a decent safety margin there. And even if Direct Line should need to pare back its dividend a little to cope with short-term pressure, I still see the potential to beat the FTSE 100 average. And by quite some margin.
My verdict? Increased short-term risk, but solid long-term prospects. If I wasn’t already invested in the insurance business, Direct Line would be on my buy list.