TD - It's The Best Time In 4 Years To Buy 7% Yielding Scotiabank

2023-11-24 07:00:00 ET

Summary

• The right way to play recessions is to not "play" them at all; focus on owning world-class dividend blue chips in a diversified portfolio.
• Dividends are like royalty, returning your money and reducing the risk of losing it over time.
• Bank of Nova Scotia, aka Scotiabank, is a reliable investment with a 7% yield and a strong track record of dividend stability.

This article was coproduced with Dividend Sensei.

It's always and forever a market of stocks, not a stock market.

That's why I am still recommending great companies even with the S&P 500 (SP500) up three weeks in a row and now 11% overvalued.

And that's assuming we avoid the recession of 2024 that the bond market is 99% confident is coming.

I know that many investors want clarification about whether or not a recession is coming and how to play it in their portfolios.

The answer is simple. While no one can say with precision when the next recession will arrive or how bad it will be, the right way to play recessions is to not "play" them at all.

Gamblers Play, Income Investors Grow Rich

Wall Street is a casino, but not how you think. It's a world of statistics, probabilities, and facts. In the short term, crazy stuff can happen, such as someone winning 20 hands of blackjack.

In the long term, the house always wins. You become the house if you buy world-class dividend blue chips in a diversified and prudently risk-managed portfolio appropriate for your needs.

Imagine you had magic powers. You can predict with 100% perfection the exact start and stop of recessions. Imagine what kind of returns you could have made in the stock market over the last 100 years.

Ignoring the Great Depression, a perfect economist investor would have earned 10.6% annually since 1930.

A buy-and-hold investor earned 11.7%.

If you include the Great Depression, a 25% GDP collapse that caused an 87% stock market collapse, the perfect economist investor outperformed the market by 1% per year.

Do you know what that means?

If you had God-like powers and could have predicted every last century's recession and avoided the Great Depression crash, you would have made 133% more than a buy-and-hold investor.

• God-like economist investor turned $1 into $710 adjusted for inflation

• Buy and hold investor, despite an 87% crash, turned $1 into $305.

And this was over 93 years, a period of time the average American can't hope even to live, much less invest.

The Easiest Way To Stop Gambling And Start Investing

Stocks are ownership in a real business. To become a better investor, stop thinking like Dave Portnoy (owner of Barstool Sports) and start thinking like a venture capitalist on Shark Tank.

The company you own isn't a ticker on a screen that jumps up and down. It's an actual business run by real management teams, with real customers and profits.

Sales, profits, cash flow, and dividends. Ultimately, these create intrinsic value, and the stock price will always, eventually, track intrinsic value.

Dividends are wonderful because they are like royalty. They return your money, reducing the risk of losing it to zero over time.

"In order to win the game, first you must not lose it." - Chuck Noll.

Let me give you a great example of the power of dependable dividends.

Altria 1985 to 2022 Dividends Per $1,000 Investment

(Source: Portfolio Visualizer Premium.)

Invest $1,000 in Altria Group (MO) in 1985 and adjust for inflation; by the end of last year, you had received almost $8,000 in cash back.

And you still own your shares, growing their dividends from an inflation-adjusted 76% yield on cost by 4% per year long term.

That is the right way to think about dividend stocks.

Short-term stock prices are vanity, cash flow is sanity, and dividends are reality.

Today, I recommend you consider buying some shares of The Bank of Nova Scotia ( BNS , BNS:CA ), AKA Scotiabank.

Why Scotiabank Is A Rich Retirement Dream Stock

BNS recently hit a yield of 7.5%.

Today, it yields 7%.

In the Pandemic, in an unprecedented global crisis with global lockdowns laying waste to the economy, the yield peaked at 7.4%.

For context, BNS peaked at a yield of 10% in the Great Recession, when it looked like global capitalism might not survive.

Does it make sense for BNS to trade at Pandemic-low valuations right now?

How about 70% of the valuation of the darkest days of the Great Financial Crisis?

Scotiabank Is A 7% Yield You Can Trust

Scotiabank was founded in 1832 in Halifax, Nova Scotia, and has one central claim to fame.

It has not cut its dividend...ever. Not in 190 years, through Canada's last banking crisis (the 1840s), two world wars, a flu pandemic that killed 5% of humanity, the Great Depression, the Great Inflation of the 1970s, the Great Recession, or the COVID-19 pandemic.

Interest rates of 20%? BNS has been through it.

Oil prices of -$38? BNS has been through it.

Inflation as high as 15%? Or as low as -4%? BNS has lived through it all.

In Canada, investors joke that BNS will cut its dividend when the sun burns out.

That is indeed the level of dependability income investors enjoy from the 3rd largest bank in Canada and the one with the most global market exposure.

In recent years, BNS has been doubling down on Canadian wealth management with its MD Financial and Jarislowsky Fraser acquisitions.

It's been expanding its operations in Chile and Columbia while pulling back on riskier and less profitable Latin American operations.

BNS is a master of risk management . That's not just seen in a nearly two-century perfect dividend record but also in its credit ratings.

Every year, Global Finance Magazine uses the combined credit ratings of the three big rating agencies to rank the safest banks in the world.

BNS is #26 this year, and keep in mind the top 10 are entirely government-owned and can only fail if their governments cease to exist.

• BNS is the 16th safest bank on earth you can own a part of.

Risk Management That's The Stuff Of Legend

Managing risk is what good banking is all about.

You borrow at a low rate (like checking deposit rate) and then use that money to lend at higher rates.

Banking is a spread business. But the difference between the broke and billionaires is in the risk management.

DK uses S&P Global's global long-term risk-management ratings for our risk rating.

• S&P has spent over 20 years perfecting its risk model

• which is based on over 30 major risk categories, over 130 subcategories, and 1,000 individual metrics

• 50% of metrics are industry-specific

• This risk rating has been included in every credit rating for decades.

The DK risk rating is based on the global percentile of a company's risk management compared to 8,000 S&P-rated companies covering 90% of the world's market cap.

BNS scores 92nd Percentile On Global Long-Term Risk Management

S&P's risk management scores factor in things like:

• supply chain management

• crisis management

• cyber-security

• privacy protection

• efficiency

• R&D efficiency

• innovation management

• labor relations

• talent retention

• worker training/skills improvement

• occupational health & safety

• customer relationship management

• business ethics

• climate strategy adaptation

• sustainable agricultural practices

• corporate governance

• brand management

• interest rate risk management.

(Source: DK Research Terminal.)

Canadian banks have robust risk management in their blood.

These six mega-banks own 90% of the Canadian banking system. They are protected by regulators from competition, ensuring some of the highest profitability on earth. However, they are also highly regulated and essentially a public utility.

There are 3 million medium and small businesses in Canada, compared to 30 million in the U.S.

• The U.S. has 33 million small businesses.

Canada's big six banks lent $1.5 trillion to those small businesses last year ($15 trillion equivalent in the U.S.).

• 74% of all private debt in Canada mortgages

• 16% lines of credit/personal loans

• 4% credit cards.

Scotiabank is the most international of Canada's banks, with about 43% of revenue from outside of Canada.

• 57% Canada

• 28% U.S.

• 15% Latin America.

Scott Thomson is the new CEO of Scotiabank, taking over for Brian Porter, a 40-year company veteran who stepped down in January.

One of the reasons that BNS is likely trading at such incredibly attractive valuations is that Thomson is a relative outsider.

• Joined the Board in 2016

• Former president of a major Caterpillar distributor called Finning International

• Former president at BCE (BCE, BCE:CA) aka Bell Canada Enterprises

• Former CFO of Talisman Energy (oil company)

• Former VP at Goldman Sachs.

Thomson needs to have the track record of other Canadian bank CEOs.

But do you think BNS would select a complete idiot who doesn't know how to run a bank or a business in generate?

"A multiyear turnaround effort is likely as shareholder returns have lagged peers materially for years. We expect a more detailed update before the year is over. In our view, this wasn't an obvious or predictable transition, and it will be interesting to see what Thompson will bring to the table and if he can materially improve Scotiabank's overall positioning." - Morningstar .

And this multi-year turnaround is both the catch and opportunity with BNS.

The Catch With Scotia Bank

Analysts appear to be very bearish on BNS's growth outlook. However, before you panic, remember that the volatility in growth estimates can be extreme for cyclical industries, especially financials.

Over at Ycharts, the consensus growth rate for BNS in the last four years is between -22% and 18%.

What does the new CEO, who has only hinted at his major vision for Scotiabank, mean for BNS's fundamentals?

BNS had a long-term goal of a 50% efficiency ratio (50% of non-interest revenue going to costs), but analysts think it will take much longer to achieve that former management goal.

Former management guidance was also for 7% to 10% growth compared to the historical 6.5% over the last 20 years.

In the short term, some costs might be associated with a new vision with a new CEO. But I wouldn't go as far as to call Scotiabank "speculative."

BNS is expected to keep growing the dividend at a steady 3.6% per year in 2023 and 2024. No dividend cuts are expected through the payout ratio, which is expected to reach 61% in 2025, above most Canadian banks' 40% to 50% policy.

BNS's earnings would likely decline in a recession, and the payout ratio might climb to about 73%.

• 33% to 64% range over the last 20 years.

We're using the 3.6% dividend growth rate as a proxy for long-term growth potential until management updates the new plan for BNS moving forward.

A Wonderful Company At A Wonderful Price

The market is acting as if Thomas, a surprising choice for CEO, is going to run the bank into the ground.

• Pandemic: Unprecedented Economic Shock

• Great Financial Crisis: worst financial shock in 75 years

• 2023: A surprising CEO...an existential risk to BNS?

Here's the bottom line: 66% upside return potential in the next two years, or a Peter Lynch-like 29% annually.

In contrast, the S&P's return potential is just 19% or 9% per year.

It's clear that, while there is some uncertainty surrounding the new CEO and his plans for streamlining BNS in the future, the market valuing BNS as if the world is ending is a tad of an overreaction.

BNS Fundamental Summary

• yield: 7.0% (4.5X S&P 500 and above SCHD or VYM)

• dividend safety: 100% very safe (1% dividend cut risk)

• overall quality: 87% low-risk Ultra SWAN dividend aristocrat

• credit rating: A+ stable (0.6% 30-year bankruptcy risk)

• S&P LT Risk management global percentile: 92nd = very low risk (exceptional risk management)

• long-term growth consensus: 3.6%

• long-term total return potential: 10.6% vs 10.2% S&P 500

• current price: $44.54

• fair value: $61.50

• discount to fair value: 28% discount (potential very strong buy) vs. 11% overvaluation on S&P

• 10-year valuation boost: 3.3% annually

• 10-year consensus total return potential : 7.0% yield + 3.6% growth + 3.3% valuation boost = 13.9% vs 9% S&P

• 10-year consensus total return potential: = 267% vs 134% S&P 500.

If you're comfortable with BNS's risk profile, it's the best time in years to buy one of the world's most dependable banks.

Risk Profile Summary

"Canadian banks face two primary risks: macroeconomic risks and risks related to future acquisitions .

Canada has some of the highest median housing prices/annual median household income ratios in several major housing markets, and mortgage debt levels have consistently increased for over a decade. While low-interest rates have kept debt servicing ratios under control, this puts the economy in a riskier position as rates rise.

We also see the leverage of the Canadian consumer as a risk , as consumers have slowly leveraged up for more than a decade.

Scotiabank's international portfolio helps diversify the loan book, giving the bank one of the most minor exposures to Canada's domestic real estate market.

While there are uncertainties related to consumer debt levels and the mortgage market, we view them as a threat to future growth and not an existential risk to the Canadian banking system.

Further, the Canadian banking system has historically been one of the more stable systems in the world and is designed to protect industry profit levels and promote economic stability.

As such, we assign our Canadian banks a Low Uncertainty Rating. We admit, with the rising mortgage risks, the banks are closer to Medium today than they were previously. Morningstar (emphasis added).

BNS Risk Profile Includes

• Economic cyclicality risk: during recessions/bear markets, earnings can decline due to the naturally leveraged nature of banking

• M&A execution risk: from future bolt-on acquisitions

• Regulatory risk: finance is the most highly regulated sector in the world, CA regulators have been raising capital buffer requirements

• Talent retention risk in the tightest job market in 54 years

• Cyber-security risk: hackers and ransomware

• Currency risk.

What about the risk of a housing crisis?

While that could be a major issue for banks in a worst-case scenario, mortgages work differently in Canada than in the U.S., running up to the GFC.

In Canada, banks have to own a significant amount of a loan on their balance sheet. Also, if a homeowner can't afford to make payments, regulators require banks to work with homeowners to restructure payments to minimize foreclosure.

The chances of home prices falling off a cliff, triggering a wave of defaults and CA banking losses, are very low.

• 0.6% risk according to S&P, Fitch, Moody's, and DBRS.

Canadian home prices fell 18% after interest soared and are now rising again. There is no crash in Canada's housing market for the same reason U.S. home prices are rising again.

Canada has 500,000 people per year moving there with insufficient new housing supply.

Imagine if the U.S. had 5 million annual immigrants arriving. How worried should you be about a protracted decline in home prices?

Well, that's the case in Canada.

High rates make borrowing more complicated for new buyers and existing homeowners.

If existing home buyers can't afford to move, then they won't put their home up for sale. That means the only supply for housing is new construction, far below demand levels.

So you can see why neither rating agencies, management at the banks themselves, analysts, or the bond market is too worried about the 0.6% chance of a housing crisis.

Bottom Line: It's The Best Time In 4 Years To Buy 7% Yielding Scotiabank

There are three reasons that bears might give for why Scotiabank might not make a good buy right now.

• the technical analysis indicates it might not recover immediately

• in a recession, its earnings are likely to fall

• the new CEO might not be able to restore BNS to its historical 7% growth rate.

I don't care about how pretty the technical charts are; I look at the business fundamentals to evaluate the intrinsic value, dividend safety, and the reward/risk ratio.

A recession is irrelevant unless it destroys a perfect 190-year dividend dependability record.

What about the new CEO?

I'll admit he was a surprising choice, and I understand if some people would rather not have the former CEO of a Caterpillar distributor running their bank.

Ultimately, for an institution legendary for excellent risk management and bulletproof dividend safety for almost two centuries, I am confident that Thomson is a good CEO.

Worst case, Thomson tries to pivot away from Latin America, takes some writedowns, adds a bit of cost associated with a turnaround, and needs to be replaced.

But BNS's rock-solid conservative underwriting isn't going to blow a Citigroup or AIG-sized hole in the balance sheet .

And if the worst-case scenario is that BNS doesn't grow for a few years?

Then, you are still buying a solid bank for 8.6X earnings, pricing in 0.2% long-term growth when analysts seem to expect 3.6%.

I consider that a reasonable and prudent long-term income growth opportunity when you can get paid 7% to wait to see which scenario plays out.

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It's The Best Time In 4 Years To Buy 7% Yielding Scotiabank