Scotiabank - Still Reasonably Valued Despite Recent Run Up

The Bank of Nova Scotia (BNS.to) has generated investment returns over the last several years which have lagged the other 4 of the Big 5 Canadian banks. This is partially attributed to the bank having exited 23 countries and 7 - 8 businesses within the past several months that were deemed non-strategic.

The restructuring is complete and the bank is targeting consistent 15% ROE to be achieved within the next several months.

I view shares as being currently undervalued and have added to my position. I think the window of opportunity to acquire attractively valued shares will close if the bank reports strong Q1 2021 results on February 23 and the investment community recognizes that shares are undervalued.

We can expect the bank to increase its dividend and to resume share buybacks once regulators authorize same. This will very likely lead to shares no longer being as attractively valued as at present.

Summary

  • The Bank of Nova Scotia (BNS) has long been the Canadian bank with the most significant international presence.
  • In recent years, the bank has been exiting countries and businesses which were not deemed to be strategic. Countries recently exited are Thailand, Puerto Rico, and El Savador.
  • In addition to Canada being a core market, Mexico, Chile, Peru, and Colombia are BNS's key markets.
  • The bank has focused on growing its wealth business in recent years and in FY2020 this business line was #1 in net income growth and #2 in revenue growth relative to its peers.
  • The average annual total return with dividends reinvested/not reinvested over the past few years has significantly fallen short of the returns generated by the other four largest Canadian banks.
  • With the bank having completed its 'realignment', senior management fully expects results to be superior to those evidenced in recent years. A consistent 15% ROE is expected to be achieved within the coming quarters.
  • I think the window of opportunity to acquire attractively valued shares will close shortly and have added to my existing position.

Introduction

On November 1, 2013, Brian Porter assumed the role of CEO of The Bank of Nova Scotia (BNS.to). While the bank's average annual total return of just under 3% from the time Mr. Porter assumed the role of CEO to the present date falls short of the other 'Big 4' by ~2.4% - ~4.6%, this is somewhat attributed to the bank's transformation over the recent years. In the last several months, for example, the bank has exited 23 countries and 7 - 8 businesses in its effort to become a more focused bank. Prior to the COVID pandemic, for example, the bank exited non-strategic markets (Thailand, Puerto Rico, and El Savador) as they had low credit ratings and growth prospects were far weaker than in BNS's key markets (Canada, Mexico, Peru, Chile, and Colombia).

Although the bank has underperformed its peer group in recent years, I am of the opinion the changes it has made and the current attractive valuation are such that an investment in BNS should generate favorable returns for long-term investors.

Business Overview

A brief overview of the bank's Corporate Profile can be found here. A far more comprehensive overview can be found in the 2020 Annual Report.

CEO's Outlook

On January 11, 2021, Mr. Porter presented at The Royal Bank of Canada's Canadian Bank CEO Conference. In his comments, he indicated that the economic recovery is underway and the world is reflating with energy and copper prices and the general commodity index on the rise. This bodes well for BNS's key markets noted above. Chile, for example, should perform well as China is Chile's largest trading partner and demand for raw materials from Chile is on the rise.

These key foreign markets have also managed the COVID pandemic much better than Canada and the US.

On the domestic front, the bank's mortgage portfolio grew ~5.5% in FY2020 and results for the first couple of months in FY2021 are strong and growth is not confined solely to Toronto, Montreal, and Vancouver. Strong mortgage demand is projected for at least the next couple of quarters.

The domestic wealth business is performing extremely well with BNS having been ranked #1 in net income growth and #2 in revenue growth in FY2020 within its peer group. Senior management plans to grow this business so that within the short/medium term it will contribute 15% of the bank's overall earnings.

Net interest margin is expected to be flat and slightly higher than in FY2020. This is somewhat due to the bank's excess liquidity but as this excess liquidity is 'burned off' over the coming quarters, an improvement in net interest margin is foreseen.

Business on the capital markets front was very strong in FY2020 and is expected to remain robust in FY2021. Credit quality is strong and there is a good pipeline of activity on the domestic and international fronts.

Expenses are well controlled but with FY2020 expenses of ~$16B there are opportunities for improvement. There continues to be room to reduce and prioritize discretionary expenses and spending on technology so as to improve efficiency. On the international front, for example, the bank has accelerated the use of digital platforms which has allowed it to close over 300 branches (excluding those from the divested businesses).

As far as capital deployment goes, Mr. Porter indicated the plan is to repurchase outstanding shares if the bank's share price remains undervalued once the regulators authorize the resumption of share buybacks.

In Q1 2020, BNS reported 14.1% ROE and the bank expects to return to pre-covid levels relatively soon. The plan is to generate 15% consitent ROE in the not too distant future; one of the bank's medium term financial objectives is a ROE of 14+%.

From a capital and liquidity measure perspective we see that in FY2020, 2019, and 2018, BNS reported the following:

Common Equity Tier 1 (CET1) capital ratio (%) 11.8, 11.1, 11.1;
Tier 1 capital ratio (%) 13.3, 12.2, 12.5;
Total capital ratio (%) 15.5, 14.2, 14.3.

In the bank's FY2020 Annual Report, there is extensive discussion about the bank's risk appetite and risk management. Investors can take comfort that the bank is being extremely well managed from a risk perspective.

Credit Ratings

Even though the companies in which I invest are creditworthy and are unlikely to default on their obligations in the foresseable future, I still want to factor risk in my investment decision making process. In this regard I look at a company's senior debt credit ratings assigned by major ratings agencies and the outlook of these ratings. As a common shareholder I know my risk is greater than that of debt holders so if a company's debt is rated speculative I need to do some 'soul searching' to see if I want to acquire shares in a 'riskier' company.

BNS's credit ratings can be found here. Moody's has rated the bank's senior debt at the middle tier of the upper medium grade, S&P Global has rated it at the lowest tier of the upper medium grade, and Fitch has rated it at the lowest tier of the high grade. Despite the variance in ratings, all ratings are investment grade.

On the subordinated debt front, the bank's debt is rated by Moody's and S&P Global at the top tier of the lower medium grade. These ratings are still investment grade.

In a nutshell, the level of risk I am assuming by being an equity shareholder is statisfactory from my perspective.

Valuation

In FY2020, BNS generated diluted EPS of $5.30 versus $6.68 and $6.82 in FY2019 and FY2018. With shares currently trading at ~$69, we end up with a PE of ~13. This is slightly higher than FY2011 - 2020 levels of 11.00, 11.01, 12.90, 11.72, 9.87, 12.96, 12.50, 9.98, 10.98, and 12.98.

Management has not provided FY2021 guidance but adjusted diluted EPS estimates on the basis of input from a dozen analysts ranges from $5.70 - $6.78 with $6.11 being the mean. Using the current $69 share price and $6.11, we arrive at a forward adjusted diluted PE of ~11.3.

COVID-19 has certainly impacted current economic and business conditions but BNS appears to be managing its business extremely well. While it is difficult to predict FY2021 results I am confident the business is being managed so that the share valuation will remain somewhat in line with historical levels.

Dividend, Dividend Yield, and Share Repurchases

The bank's dividend policy and dividend track record can be accessed here. Until such time as the regulators authorize the banks to increase their dividend and resume sharebuybacks, we can likely expect BNS's $0.90/share quarterly dividend to remain in effect.

Over the last few days I have acquired additional shares at ~$68 - ~$69 thereby resulting in a dividend yield of ~5.25% when I use an average purchase price of $68.50. This dividend yield is not as attractive as when I acquired additional shares in July and October 2020 but, nevertheless, I will gladly accept a dividend yield in excess of 5% for an investment in a company as safe as BNS.

As noted above, Mr. Porter has indicated that the repurchase of outstanding shares when they are undervalued, and when regulators authorize same, is an attractive method of rewarding shareholders. In FY2018, the weighted average number of diluted shares outstanding was 1,229 million. This rose to 1,251 million in FY2019 but dropped to 1,243 million in FY2020.

Final Thoughts

BNS has underformed its peers over the past several years but the bank has been undergoing a transformation as it has exited markets/businesses deemed to be non-core. With divestitures now complete, senior management expects results to improve. Fortunately, 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. Regretably, 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.

Even before the recent purchases, my total BNS holdings were generating low 5 figures in annual dividend income.

I have not recently undertaken a review of my overall holdings to determine whether BNS is still one of my top 10 holdings (it was 10th when I last did a comprehensive analysis of my holdings in August 2020) but I am confident it is at least within my top 11 - 20 holdings.

Stay safe. Stay focused.

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

Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long BNS.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.