Avoid Scotiabank Despite Its Attractive Valuation

Scotiabank (BNS) is an investment holding to which I pay very little attention. Quite frankly, if:

  • I did not receive restricted share units as part of my employee compensation package
  • an Employee Share Ownership Plan (ESOP) did not exist in which employees receive a 50% match up to a specific amount

it likely would not be one of my existing holdings.

I do not say this because I think poorly of the bank. On the contrary, it was a great place to work. I just think there are far better investment opportunities to be found.

I last reviewed BNS in my January 14, 2021 post at which time I indicated:

'BNS's share price has been under pressure since early February 2020 which has provided investors with the opportunity to acquire shares are very attractive levels. Regrettably, I think the window of opportunity to acquire BNS shares at attractive levels is slowly closing and if BNS reports strong Q1 2021 results in February, I envision BNS's share price will be bid up. Given this, in the last few days, I have added to my BNS holdings in accounts for which I do not disclose details.'

Despite the purchase of additional shares in early 2021, my aim is to gradually reduce my BNS exposure.

When I completed my August 2020 investment holdings review, BNS was my 10th largest holding. By the time I completed my Mid 2022 Investment Holdings Review, BNS was my 17th largest holding. This drop is not the result of the sale of any shares. Instead, it is because:

  • other holdings have significantly appreciated;
  • increasing (or establishing) exposure to several other holdings; and/or
  • BNS's dismal returns.

Impact Of Inflation

In my March 28, 2021 Your Investment Strategy Should Account for Inflation’s Impact post, I touch upon why it is so important to account for the rate of inflation when determining how well your investments have performed.

If you want to see how well, or how poorly, a BNS investment has performed over various timeframes you may wish to look at The Bank of Canada's Inflation Calculator.

Let's suppose you acquired shares at ~$51 in December 2011. Plug these into the inflation calculator to see BNS's inflation-adjusted return.

Naturally, looking at historical performance is not the optimal way to invest. Furthermore, using different timeframes when analyzing a company's historical results can produce very different results. For example, if we look at BNS's performance relative to the S&P500 over the August 24, 2021 - August 24, 2022 timeframe, we get an abysmal average annual total return. Change the timeframe to March 16, 2020 - August 24, 2022 and the rate of return is far superior (but still less than the S&P500); I chose March 16, 2020 as a start date because this is when office shutdowns started in Ontario, Canada.

One can make the argument that it is not fair to compare BNS to the broad index. Not a problem. Use this link to compare how BNS has performed relative to its peers (BMO, CM, RY, and TD). If you so wish, play around with the timeframes.

Financials

Q3 and YTD2022 Results

On August 23, 2022, BNS released its quarterly results which are accessible here.

Looking at the bank's Q3 2022 Earnings Release and Earnings Presentation we see weakness in the Global Wealth Management and Global Banking and Markets business lines.

While results in the Global Banking and Markets segment declined significantly relative to Q3 2021, this should not have come as a complete surprise. In my most recent Moody's post and S&P Global post, I wrote how the credit rating business at both companies had taken a tumble because of market conditions. In my Goldman Sachs post, I also wrote how the firm is actively working toward increasing its earnings resiliency and diversification so that it does not exhibit wild swings in earnings that come about from heavy reliance on credit conditions.

Investors also need to account for a higher provision for credit losses.

'Provision for credit losses on performing loans was $23 million, compared to a net reversal of $461 million. The provision was driven by
the less favourable macroeconomic forecast and portfolio growth in the retail and commercial portfolios, partly offset by provision
reversals in retail due to improved portfolio credit quality. Higher provision reversals last year were due mainly to the more favourable
macroeconomic outlook and credit migration to impaired, primarily in International Banking.'

Source: BNS - Q3 2022 Earnings Release - August 23, 2022

The bank's Q3 results might be weaker than those subsequently reported by its peers. However, investors would be wise to focus on long-term trends versus changes in quarterly results.

FY2022 Outlook

In the remainder of FY2022, and at least the first half of 2023, we are likely to continue to witness:

  • higher interest rates;
  • a reduction in government stimulus;
  • lower corporate earnings (in general); and
  • stickier than anticipated inflation.

History suggests we may end up with more frequent and deeper recessions unless inflation is controlled.

We are now in the mid-cycle of economic recovery:

  • slower economy and earnings growth;
  • extremely elevated levels of government debt; and
  • interest rate hikes and further tapering by global central banks.

On the Global Banking and Markets (GB&M) front, senior management at the FIs and credit rating agencies I follow suggest we are unlikely to witness a significant improvement in conditions for at least another few quarters. Th GB&M segment of the banking industry, however, is cyclical. Investors should not, therefore, be surprised about weak conditions after the robust conditions witnessed over the past several quarters.

As far as retail customers go...many are doing just fine financially. The concern, however, is the growing number of people with 'more month than money' and the growing disparity between those with money and those struggling to meet their expenses.

The real estate market conditions in major Canadian urban centers over the last couple of years have led some Canadians to stretch themselves financially. Many homebuyers took advantage of attractive low-rate mortgages. Many now have buyer's remorse and may find themselves in a predicament come mortgage renewal.

In addition, while the Canadian consumer, for the most part, is making financial headway, an increasing number of consumers are resorting to debt consolidation loans; there is no shortage of 'financially challenged' parties resorting to expensive debt. Publicly traded alternative lenders are the companies in which to avoid investing.

Should conditions worsen and more businesses and consumers begin to default on their obligations, BNS is likely to incur higher loan losses. BNS, however, is very conservative and is not the lender about which I would be most concerned.

Credit Ratings

Investment decisions made solely based on potential return can sometimes lead to heartache. Ask anybody who invested in some of the 'junk' companies that have imploded over the past year.

When gauging a bank's degree of risk, I always look at the Capital Ratios. Looking at the bank's recent quarterly results, we see a slight deterioration in some of the ratios. Despite this deterioration, the CET1, Tier 1, Total capital, Leverage, TLAC and TLAC Leverage ratios at the end of Q3 2022 were well above the minimum capital ratios set by the Office of the Superintendent of Financial Institutions (OSFI).

BNS - Regulatory Capital Highlights Q3 2021 - Q3 2022

Source: BNS - Supplementary Regulatory Capital Disclosures Q3 2022 For the period ended: July 31, 2022

I look at the credit ratings and outlook assigned to a company's subordinated debt by the major rating agencies. I then account for my higher risk since I am merely a shareholder.

When the subordinated debt ratings are the bottom tier of the lower medium grade investment grade, my risk level as a common shareholder is 'non-investment grade - speculative'. This risk might be acceptable to some but in my FFJ Portfolio – June 2022 Interim Report, I disclose 4 positions I exited because I deemed the risk to be unacceptable; I received shares in 3 of the 4 companies as a result of spin-offs from existing holdings.

BNS's credit ratings and outlook are acceptable for my purposes.

  • Moody's and S&P Global rate BNS's Subordinated Debt (NVCC) at the top tier of the lower medium grade;
  • Fitch's rating is the middle tier of the upper medium grade; and
  • DBRS' rating is the bottom tier of the upper medium grade.

The ratings assigned by Moody's and S&P Global define BNS as having an adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

Fitch and DBRS define BNS as having a strong capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

NOTE: Non-viability contingent capital (NVCC) subordinated debt and preferred shares are products that offer higher yields than government bonds and most high-quality corporate bonds, but also have unique risks. NVCC securities are hybrid financial securities that have elements of both debt and equity.

Dividends and Share Repurchases

Dividend and Dividend Yield

There is no dispute that BNS has an attractive dividend and dividend track record. This track record coupled with BNS's ability to service its quarterly dividend is what likely appeals to investors.

Investing solely based on attractive dividend metrics, however, is an extremely poor way to invest. Investors would be better served by looking at an investment's TOTAL potential return. Naturally, BNS might be a suitable investment if dividend income is a top priority.

While BNS's current $1.03 quarterly dividend yields ~5.40% (using the current ~$75.80 share price), the TOTAL investment return (with dividend reinvestment) is ~5.46% over a 10-year timeframe. Unless an investor were to acquire BNS shares when the share price plummeted (eg. late February 2020 - early December 2020), the total investment return would be less than stellar.

Share Repurchases

The diluted weighted average common shares outstanding in FY2012 - FY2021 (in millions) is 1,160, 1,209, 1,222, 1,232, 1,226, 1,223, 1,229, 1,251, 1,243, and 1,225. For the 3 months and 9 months that ended July 31, 2022, the adjusted weighted average number of diluted common shares outstanding was 1,203 and 1,221.

BNS does repurchase shares. However, if you prefer that management repurchase shares (when attractively valued) as opposed to receiving dividend income, there are other companies that repurchase shares to a far greater extent. Chevron and Home Depot are two companies I recently covered (see Archives) where shareholders can expect a significant reduction in the number of issued and outstanding shares.

Valuation

BNS has generated $6.39 and $6.43 in YTD GAAP earnings and non-GAAP earnings. In Q3, BNS generated $2.09 and $2.10 in GAAP earnings and non-GAAP earnings. If it were to generate $2.11 and $2.13 in Q4, FY2022 GAAP earnings and non-GAAP earnings would be ~$8.50 and ~$8.56. With shares trading at ~$75.80, the forward diluted PE and forward adjusted diluted PE is ~8.9 and ~8.86.

The bank's FY2012 - FY2021 historical PE levels based on diluted EPS are 11.01, 13.23, 11.72, 9.87, 12.96, 12.50, 9.98, 10.98, 12.98, and 11.63.

The current adjusted diluted EPS broker estimates are:

  • FY2022 - 13 brokers - mean of $8.47 and low/high of $8.21 - $8.53. Using the mean estimate, the forward adjusted diluted PE is ~8.95.
  • FY2023 - 13 brokers - mean of $8.49 and low/high of $7.98 - $8.69. Using the mean estimate, the forward adjusted diluted PE is ~8.92.
  • FY2024 - 5 brokers - mean of $8.83 and low/high of $8.01 - $9.27. Using the mean estimate, the forward adjusted diluted PE is ~8.6.

If BNS's diluted PE were to increase to 10.5, and GAAP earnings were to come in at ~$8.50, we would be looking at a share price of ~$89.25. This would represent a share price increase of ~17.7%.

Could this happen? Who knows!

I do not dispute BNS shares are attractively valued. Sometimes, however, shares are not mispriced and a company's valuation is attractive because earnings expectations are justifiably weak.

Final Thoughts

I only hold 830 BNS shares in the FFJ Portfolio. The bulk of my BNS holdings being held in various retirement accounts for which I do not disclose details.

As noted at the outset of this post, I am trying to reduce my exposure to BNS. We are employing a Registered Retirement Savings Plan (RRSP) meltdown strategy and we must withdraw funds from our RRSPs before the end of the calendar year. My mind is not firmly made up but selling some BNS shares held in retirement accounts is at the 'top of mind'.

Based on personal experience, a BNS investment might only make sense if:

  1. your risk tolerance is low;
  2. you seek dividend income and total investment return is of lesser importance; and/or
  3. you acquire shares when BNS falls out of favour with the investment community.

Option 3, however, is a stretch. Other companies that offer the potential for far superior long-term total returns could fall out of favour at the same time as BNS.

After considerable deliberation, I am slowly exiting positions I deem to be 'non-core'. In addition to exiting the 4 companies I reference in my FFJ Portfolio – June 2022 Interim Report, I also exited:

Most recently, I have exited AT&T, Verizon, and Telus but have not written a post to disclose these sales.

In early January, 3M was my 10th largest holding. Every other exit, however, was a holding in which I had minimal exposure and had no interest in acquiring additional shares. In most cases, I exited with a profit so I need to account for this when determining how much to withdraw from our RRSPs.

In my FFJ Portfolio – May 2022 Report, FFJ Portfolio – June 2022 Report and FFJ Portfolio – July 2022 Report I disclose companies in which I acquired shares. These are companies I think will generate long-term shareholder returns well above those we can expect from a BNS investment.

I do not have any immediate intention of increasing my exposure to the major Canadian banks. Should I change my mind, however, my preference is to add to my The Royal Bank of Canada and The Toronto-Dominion Bank exposures; these were my 6th and 13th largest holdings when I completed my Mid 2022 Investment Holdings Review.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long BNS.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.