This article was coproduced with Dividend Sensei.
At iREIT on Alpha and Dividend Kings, we continue to screen for value, and one sector that is appealing to us these days is the banking sector.
A few days ago we decided to write on Texas-based Cullen/Frost Bankers (CFR) in which we explained that the bank has “the highest yield in the last 20 years despite Treasury bonds trading near all-time lows. From a risk-adjusted perspective, Cullen/Frost is providing investors the best spread over government bonds in at least 25 years.“
Cullen/Frost is now yielding 4.1% with a P/E of 14.1x (normal is 16x).
Today we’re focusing on another deeply-discounted bank with a long track record of reliability and predictability.
As we write this, the market is recovering off its recent pullback. And while many companies are recovering quickly, plenty of great deals remain available.
In that light, we’re highlighting The Bank of Nova Scotia (BNS). It’s a 6.4%-yielding blue-chip with a strong economic recovery expected in 2021 and beyond.
That’s why Dividend Kings just bought into it for a fifth time in our Phoenix Portfolio – and we plan to buy it one final time next week. That will still put us ahead of three major catalysts that should propel it and its stock to impressive levels.
The bank already is a one-stop-shop for companies, governments, institutions, and high-net-worth individuals – from traditional banking services to global market underwriting (equity and bonds) to asset management.
We’re talking about:
- $1.2 trillion in assets
- $768 billion in low-cost deposits
- 95,000 global employees
- 2,905 branches
- 8,793 ATMs.
Scotiabank has proven impressive in the past already, as evidenced by its total returns since 1996, featured below.
(Source: Portfolio Visualizer)
Over the last 24 years, it has delivered 12.5% compound annual growth rate returns. Its average 10-year and 15-year returns over the past quarter-century have also been 12.5%.
And that’s precisely what analysts expect for it going forward too.
The Bank of Nova Scotia’s Exceptional Long-Term Growth Potential
Scotiabank is a legendary safe income source in Canada, having paid uninterrupted dividends since 1833. That’s 187 years… more than 9x the 20-year mark value investor Ben Graham set as a sign of high-quality stocks.
And high-quality Scotiabank is. It has an:
- A+ stable outlook from S&P
- AA- negative outlook from Fitch
- Aa2 stable outlook from Moody’s
- AA stable outlook from DBRS, Morningstar’s rating agency
No wonder then that Global Finance Magazine ranked it the 28th safest bank – out of 1,390 – in November 2019.
Keep in mind that the top eight are AAA-rated and owned by European governments that offer the power of infinite printing presses. So BNS is actually the 20th safest publicly traded bank in the world.
Moody’s lauds it for having “the most diversified earnings profile of its Canadian” bank peers. And it also approves of its “low historical earnings volatility,” which is evidence of its consistent “centralized risk management practices.”
Even Fitch with its negative outlook, says this:
“BNS’s exposure to vulnerable sectors, including oil and gas, hospitality and leisure are limited, but also presents some downside risk, in Fitch’s view. Fitch expects that exposure to these sectors is mitigated by BNS’s conservative underwriting and structuring.”
That oil exposure is just 2.6% of its loan book. And the “conservative” structure mentioned is 15% debt/capital – less than one-third the safe 50% level for banks.
Underwriting also is extremely conservative, since Scotiabank focuses on preservation of capital rather than short-term returns. Plus, it has a very strong common equity tier 1, or CET1, ratio: The new gold standard proxy for how well capitalized a bank is.
The U.S. regulatory minimum is 4.5% and, being famous for its safe banking standards, the Canadian is 9%. Yet BNS’ Q3 CET1 was 11.3%, up 0.4% from last year. According to CFO Raj Viswanathan on the Q3-20 conference call, this was “due primarily to lower risk-weighted assets and internal capital generation, partly offset by the impact of revaluation of the pension liabilities.”
Management also said that internal stress tests – including those of a global depression that creates 20% unemployment in Canada for two years – don’t show its BNS’s CET1 to fall under 10%.
As for its large profit declines in Q2 and Q3, Viswanathan said:
“On an adjusted basis, total PCLs (provisions for credit losses) of $2.18 billion increased $335 million quarter-over-quarter as we continue to add to allowances to capture the impact of COVID-19 and its future credit migration impacts.
“The PCL ration increased 17 basis points quarter-over-quarter and 88… year-over-year. With this, our allowances have increased to $7.4 billion or approximately $2.3 billion in the last two quarters. Pre-tax pre-provision profit declined (a) more modest 3% on an adjusted basis.”
BNS’ fiscal Q3 is calendar-year Q2, when everything was locked down. Yet total revenue fell year-over-year by a mere 6% and net interest income by 4%. Meanwhile:
“Total loans grew 5% with mortgages up 6% and commercial lending up 10%, while the credit card balance declined 13%. Sequentially, mortgages grew 1% and deposits grew a strong 10%.”
And, as Chief Risk Officer Daniel Moore added, its customer assistance program delinquency rates “are well below pre COVID-19 levels.”
In short, the recession’s impact on Scotiabank is being blunted to a remarkable extent by government stimulus. And BNS’s conservative lending practices more than make up for the rest.
Consider its Canadian mortgages, which have an average loan-to-value of 45%. The average down payment is 55%, and the average FICO score is super-prime, meaning over 720.
Of course, it does generate about 50% of its revenue from outside its home country. And its positions in Latin America and the U.S. – a market 10x the size of Canada – are rapidly growing. It’s now:
- One of the 15 biggest banks in the U.S.
- The third-biggest bank in Peru
- The fourth-biggest bank in Chile
- The fifth-biggest bank in Mexico
- The sixth-biggest bank in Columbia
(Source: BNS IR)
As such, its loans are incredibly diversified by geography and type and extremely conservative in terms of underwriting. Due to the oligopoly regulators permit in Canada:
- 64% of earnings are in its home market
- 10% from the U.S.
- 27% from Latin American and the Pacific Alliance.
(Source: BNS Factsheet)
Market share in its fastest-growing markets are 6%-18%. BNS is earning about 15% returns on equity in places like Latin America – almost double the 7.7% global bank average.
In fact, over the last 13 years, its median return on equity has been 14.3%. Again, that’s about double its global banking peers and well above the 10% rule of thumb for quality banks.
Profitability is currently depressed due to the recession. But management has a cost-cutting plan to improve the efficiency ratio (operating expenses/revenue) in these international markets to under 50% over time.
Basically, BNS is a global behemoth that management expects can still deliver a 7%+ compound annual growth rate over time.
Plenty of Growth to Look Forward To
While the pandemic is expected to hit Scotiabank hard this year, analysts expect to see a strong return in 2021 and 2022.
Management can achieve its long-term 7% growth goal if it executes well on its global plans.
(Source: FAST Graphs, FactSet Research)
Over the last decade, when 10-year yields averaged 2% and regulations became tighter, Scotiabank still grew at 4.2% CAGR.
In the past, it’s managed to grow at up to 8%. And, thanks to higher NIMs overseas, management thinks it can return to that once the pandemic is over (most health experts expect that in 2022).
International Net Interest Margin
(Source: BNS Factsheet)
Net interest margin has fallen sharply over the past year, though that’s to be expected during a severe recession. Besides, international banking was enjoying a 4.5% NIM before the pandemic, which is unheard of in North America.
(U.S. NIM was about 3% and Canada’s was 2.4%.)
The bottom line is BNS will likely rise like a phoenix from the ashes of this recession, just as it has every other recession before, which makes it an even more intriguing opportunity now considering how it remains highly undervalued.
A Top-Quality Bank at an Attractive Discount
Scotiabank is up 34% from its March lows. But it’s still an attractive bargain, yielding a safe 6.4% yield that’s a dependable source of long-term dividend growth.
And this when the S&P 500 is 34% historically overvalued.
(Source: BNS Factsheet)
This is possible because of its highly competent and trustworthy CEO. Brian Porter has been with the bank since 1981 and led it since November 2013. Morningstar writes:
“We like the approach Porter has taken, focusing on technology, shaking up management positions with many new appointments, and culling some of the less successful investments abroad. While the transition hasn’t been painless, with write-downs, job cuts, branch closings, and restructuring charges, we think the bank will remain cost-focused and is moving in the right direction.”
That might very well be because Porter was chief risk officer at the bank during the worst financial crisis since the Great Depression.
Over the past decade, when BNS was growing at just 4% – roughly half the rate management expects in the future – the market conservatively valued it with a 4% yield, 8.7x pre-tax profit, and 11.7x earnings.
We’re not assuming any multiple expansion in the future, just 2%-4% CAGR over time. Yet even so, it’s still looking a lot better at 33% undervalued compared to the S&P’s 34% overvalue.
BNS isn’t exactly an anti-bubble stock since it’s priced for slightly positive growth of 1.2%. But even if it fails to grow at all after 2022, it should still deliver almost 7% CAGR long-term returns.
That’s almost double what analysts expect from the S&P 500 through 2025.
If it grows at the FactSet’s medium-term consensus of 2% and returns to historical mid-range fair value of 11.5x earnings, investors could see 13% CAGR total returns, almost 3x the analyst consensus forecast for the S&P 500.
If BNS trades at the upper end of historical fair value – 12x earnings – and grows at the upper end of management guidance at 8%, it could deliver up to 17%. That’s almost 4x what analysts expect from the broader market.
And all from the 28th safest bank on earth, which is currently yielding 6.4%.
Scotiabank Risk Profile: Why BNS Isn’t Right for Everyone
The biggest fundamental risk to major banks in general right now is rising default rates on loans. For BNS in particular, it’s accounted for almost $3 billion on loan loss provisions in the past two quarters.
So far, stimulus has helped keep a cap on defaults, which have actually fallen in most cases since the pandemic began. And Goldman, JPMorgan, and Morgan Stanley recently put out notes saying they’re confident we can avoid a double-dip recession… as long as we get a stimulus package in early 2021.
Obviously, that might not happen. Also obviously, there is the chance (about 25%) of a double-dip recession. Though, on the plus side:
- That would most likely be a mild 0.5%-1% dip caused by a resurgence in the coronavirus.
- BNS and its fellow big banks have all been preparing for that possibility.
- The economic outlook is actually far more positive than many people realize.
None of this means we can avoid discussing valuation risk on Scotiabank. It’s low, but not zero, for one major reason…
The medium-term growth consensus is for 2% CAGR growth through 2022, including this year’s recession. But Ycharts shows a negative growth consensus for three of Canada’s biggest banks.
We don’t know how many analysts this consensus represents. Sometimes very extreme estimates literally come down to one bearish analyst. This is why it’s important to consult multiple sources.
In this case, we have at least four analysts expecting 19% growth in 2022. And all 12 who cover it expect 15% growth in 2021.
Moreover, Scotiabank’s long-term Ycharts consensus fell to a ridiculous -25% at the peak of the pandemic. And it’s recovered over 80% of that estimate since then. So it’s difficult to believe the current pessimistic estimate.
We just still wanted to mention it anyway. There’s always a chance that management – even one so skilled and conservative – is wrong about its estimates.
If BNS did end up growing at -4.5% CAGR over time, its Graham/Dodd fair-value formula would be 6.2. That would make it up to 42% overvalued today.
In early 2021, we’ll start getting estimates for 2023, which will likely confirm:
- More positive growth
- A stronger medium-term consensus
- Dividend growth resumption as the payout ratio falls under the safe 50% level for banks and into management’s 40%-50% long-term target range.
In the meantime, there’s still the chance of volatility (as there always is for any stock at any time). Since 1996, Scotiabank’s average annual volatility has been 20%. That makes it three points better than the average dividend aristocrat, much less the average stock.
That figure did skyrocket to 37% during the March crash though, and it was over 50% during the Great Recession. So if we do see another double-dip recession, there is the possibility of it falling another 24% to about $32.70.
That would give it a 7.9% yield with a 49% discount to fair value, which would make it even more of a buying opportunity.
Just, whatever you do, make sure to use appropriate risk management guidelines like the ones below toward maintaining a diversified and properly asset allocated portfolio for your particular needs.
The market hates financials during recessions when interest rates are low.
But guess what? Interest rates won’t remain low once the economy recovers. Take it directly from Moody’s:
“Long-term interest rates will steadily increase from 2021 onward, with the 10-year rate reaching 4.1% by 2030. Unless there is significant compression of the equity risk premium, the fundamentals will then weigh on values over the decade.”
Moody’s new base-case economic forecast is for long-term rates to climb back to 4.1% by the end of 2030. If that happens, it will trigger a lost decade for the S&P 500.
Admittedly, most economists aren’t nearly that bearish. They expect 10-year yields to return to 2%-3% after the pandemic.
But successful investing is about making high-probability/low-risk choices, so we like to keep in mind the reasonable worst-case scenarios.
Best-case or worst-case, buying the 28th safest bank on earth, with a safe 6.4% yield, at a 33% historical discount? That looks like prudent long-term income investing to us: the kind that can foster a prosperous retirement.
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BNS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Dividend Sensei is Long BNS.
Originally published on Seeking Alpha