Published June 13th, 2016 By Dirk S. Leach
It is difficult to find safe investments with 3%+ dividend yields and solid growth prospects.
Many equities today are priced on the rich side of valuations resulting in lowered dividend yields. Low interest rates have made bonds a poor value for income seeking investors.
The benefits of investing in high quality stocks with above average yields and good growth prospects – trading at fair or better prices – are well-known to long-term investors.
What if you could quickly identify an entire group of these stocks? This article takes a look at one such group the market is overlooking:
The Canadian banking sector.
There are 3 large Canadian banks that rank as a in the Top 30 high quality dividend stocks using The 8 Rules of Dividend Investing.
This article gives an overview of the favorable investment prospects of the Canadian banking system. It also analyzes 1 of the 3 highly ranked Canadian Banks in detail: Bank of Nova Scotia (BNS).
Why Canadian Banks ?
With all the banking names in the United States, why focus on Canadian banks for potential investments?
The short answer is that the Canadian banking system is recognized as number 1 in the world for financial strength and safety, has a significantly smaller fraction of non-performing loans than their EU and US peers, and Canadian banks have historically paid outsized dividends compared to their US counterparts.
I covered these attributes of Canadian banks in greater detail in the first article of this series.
In addition, while Canada is not the US, it is also not all that different in its business culture, laws, regulations, and values.
Narrowing the Field
In the first article, I screened the 5 largest Canadian banks looking at 10 year compound annual growth rates for revenue, EBITDA, EPS, dividends paid, and the most recent dividend payout ratio.
That list of 5 includes:
- The Bank of Montreal (BMO)
- The Bank of Nova Scotia (BNS)
- Canadian Imperial Bank of Commerce (CM
- The Royal Bank of Canada (RY)
- Toronto Dominion Bank (TD)
The summary of the screening data is provided in the table below.
Based on that screening, I selected BNS, RY, and TD for more detailed analysis. I covered RY in detail in the first article.
Today, I’ll cover BNS in additional detail and plan to cover TD in the final article of the series.
Bank of Nova Scotia
BNS is Canada’s third largest bank by assets with a market capitalization of $63B in US dollars. BNS has the largest international exposure of the big five Canadian banks with offices in the United States, Mexico, Latin America, the Caribbean and Central America, and Asia-Pacific with more than 23 million customers worldwide.
BNS was founded in 1832, is headquartered in Toronto, Canada and offers a broad range of advice, products and services, including personal and commercial banking, wealth management and private banking, corporate and investment banking.
Over the last 10 years, BNS has managed to achieve steady growth of its revenue, EPS, and dividend payments while maintaining a conservative dividend payout ratio. These metrics are shown in the charts below. Readers will note that the dip in EPS and the spike in the dividend payout ratio was due to the impact of the 2009 financial crisis. Note that the bank quickly recovered its EPS.
BNS maintains a Common Equity Tier 1 of 10.1% (exactly the same as RY) which well exceeds the Basel III accord requirement of 6% and BNS carries an A+ credit rating from Standard and Poor’s. While this is one notch lower than RY’s credit rating, an A+ stable rating is very solid. BNS’s cash flow remains strong and BNS recently raised its quarterly dividend to $0.72 CDN from $0.70 CDN continuing its history of rewarding its share holders. BNS’s annual dividend yield is currently a healthy 4.3%.
The reader should note that all of the above data is based on financials reported in US dollars and is therefore impacted by the exchange rate between the Canadian dollar and the US dollar. As an example, the dividends per share chart above shows the annual dividend paid in US dollars at $2.12 based on the current exchange rate.
The annual dividend paid in Canadian dollars is $2.76 TTM. This does have implications in understanding the charts above. While the charts show that revenue, EPS and dividends have all turned and headed south over the last several quarters, that result is true only in US dollars due to the recent strength of the US dollar compared to the Canadian dollar.
The bottom line is that the reader needs to factor in the impact of the exchange rate to fully appreciate the charts above. I was unable to find a comparable website to GuruFocus with data in Canadian currency but I’ve included a more complete discussion on exchange rate impacts and risks in the next section of this article.
This summary investment thesis, while brief, indicates that BNS is healthy and growing. For a more complete picture of BNS’s financials, the reader should spend some time browsing through the most recent investor presentation on the BNS website.
Potential Risks to Investors
Investments that are a “sure thing” seldom come along; I’ve yet to find one in 30+ years.
Investors should look at the possible risks of any potential investment. I covered the generic risks of investing in the Canadian banking sector in detail in the first article of the series including the risk of economic downturn and the potential risk of a Canadian housing bubble collapsing. In this article, I will only cover the risk related to BNS’s loans to the oil and gas industry and exchange rate risks.
Canadian oil producers are in no better shape than those in the US. While both RY and TD have relatively low loan exposure in the oil and gas industry, BNS has relatively high exposure at about 10%. BNS’s 10% exposure to the oil and gas industry has been a challenge for BNS over the last couple of quarters and last quarter BNS raised its loan loss reserves by 40% primarily to cover expected defaults in the oil and gas industry.
With BNS having increased their loan loss reserves last quarter along with the price of oil slowly rising over the last quarter, BNS appears to be better positioned to ride out this latest oil and gas downturn than it was 6 months ago. Readers should note that loan exposure is one of the primary reasons that BNS has a higher dividend yield than either RY or TD. That higher yield is the price the market assigns for BNS’s higher oil and gas loan exposure.
The last potential risk I’ll cover is the exchange rate risk. Today, the Canadian dollar is weak compared to the US dollar. This has had a couple of impacts that should be considered by US investors looking to invest in Canadian companies. Canadian companies pay dividends in Canadian dollars. The strong US dollar has made those Canadian dividends worth less to us on the southern side of the border. However, the strong dollar has also lowered the share price of Canadian companies for US investors. Today, our strong US dollar buys us more equity or shares of Canadian companies. So, is this a risk or a benefit?
If a US investor bought shares of BNS today and the US dollar continues to strengthen relative to the Canadian dollar, the dividends paid in Canadian dollars would be worth less and the principal value of the investment could also drop. However, if the Canadian dollar strengthens relative to the US dollar, those Canadian dollar denominated dividends will be worth more and the price of the equity would likely rise in US dollar terms. To take a look at a graphical representation of this I’ve included a graphic below.
From this chart one can see the impact of the strong dollar on the value of the dividends paid to US investors. While BNS has continued to increase dividends paid out in Canadian dollars, the value to US investors has fallen. This is due to the strong US dollar and the current exchange rate where $1 Canadian is worth only about $0.785 US. Those US investors that bought into BNS in 2014 are probably not pleased with the impact from the strong US dollar as the value of their investment is down in US dollars.
However, for those US investors that are considering an investment today, the reward potential has improved due to the rise in the value of the US dollar. The US dollar strength relative to the Canadian dollar has been higher in the past 10 years but not by very much. The chart below shows the value of the Canadian dollar versus the US dollar over the last 10 years. While the dollar has fallen in the last couple of months we are still close to a 10 year peak in the value of the US dollar versus the Canadian dollar.
The question each investor has to answer to determine if the exchange rate issue is a risk or a benefit is … “Which way will future exchange rates go?”
As a result of the US Federal Reserve Open Market Committee (FOMC) finally figuring out that the global and US economies, while growing, are not sufficiently robust to warrant a series of interest rate increases, the US dollar valuation against the Canadian dollar has recently dropped. In the longer term, as the Canadian economy strengthens, I believe the Canadian dollar will strengthen relative to the greenback. So, long term, I believe the exchange rate will work in my favor as a US investor in BNS.
As with most financial ratios and metrics, it is likely the USD/CAD exchange rate reverts towards its mean value.
The Canadian banking sector is strong, healthy, and conservatively managed.
Of the big five Canadian banks, I believe BNS stands out as having strong investment potential and manageable risk of impact from oil and gas sector loans. BNS has shown the ability to grow revenue, EPS and their dividend payments while maintaining a conservative payout ratio.
While past performance is not a guarantee of future performance, it is a good indication that the company is being managed well.
Click here to download a 1 page PDF snap-shot summary of BNS, including: competitive advantage, estimated fair value, recession performance, expected total returns, and more.
Finally, I believe the potential risks of investment in BNS to be low and, at least in the longer term, the exchange rate will work in favor of US investors.
These factors together make Bank of Nova Scotia a top ranked international stock using The 8 Rules of Dividend Investing.