It is becoming clear that Bank of Nova Scotia (BNS-T) is an outlier among Canada’s biggest banks, and not in a good way. The tricky question is whether this unfortunate status offers investors a bargain or more misery.
Scotiabank kicked off the fourth-quarter reporting season for the banks earlier this week on a sour note. Reported net income slid 34 per cent from the same period last year, provisions for credit losses – money set aside to cover loan defaults – surged by 53 per cent from the previous quarter, and expenses jumped 21 per cent over the same stretch.
Paul Holden, an analyst at CIBC Capital Markets, called it a “bad set of results,” and the stock fell 4.4 per cent on Tuesday.
Royal Bank of Canada (RY-T) and Canadian Imperial Bank of Commerce (CM-T) beat analysts’ expectations with their financial results later in the week, providing some relief to the sector. But Scotiabank still stands out as a troubled stock.
Gabriel Dechaine, an analyst at National Bank of Canada, pointed out that Scotiabank’s payout ratio – the portion of its earnings that funds the quarterly dividend – could be above 60 per cent for some time, if management’s expectations for lacklustre profit growth in 2024 hold true.
Since the bank’s targeted payout ratio is between 40 per cent and 50 per cent, the elevated ratio could hold back dividend hikes for an extended period.
If that sounds dismal, the stock’s long-term trend is also unattractive. Over the past five years, Scotiabank’s share price has declined by more than 10 per cent, not including dividends, making it the only big bank stock that is down over this period. The performance trails the average for the Big Six banks by 34 percentage points.
The strategy of buying a bank stock that is trailing its peers has an intriguing long-term record of outperformance, as laggards tend to bounce back. But Scotiabank hasn’t delivered the rebound investors have been hoping for.
As a result, the stock is languishing with valuation metrics that are reflecting deep caution on the part of investors. A highlight: The dividend yield rose as high as 7.4 per cent this week as the shares fell. That is remarkably high for a big bank stock, especially given that the current average yield among Scotiabank’s five peers is just above 5 per cent.
Just as remarkable, there doesn’t appear to be a rush to take advantage of the high yield. Mr. Holden reiterated his “neutral” recommendation on the stock, which is a lukewarm assessment at best.
“Is now the time to be opportunistic and buy? It feels to us like that is jumping the gun,” Mr. Holden said in a note this week.
Canada’s banking sector has been struggling over the past 22 months as soaring inflation and rising interest rates have darkened the economic outlook.
On Thursday, Statistics Canada reported that Canada’s gross domestic product contracted by a surprising 1.1 per cent in the third quarter, at an annualized pace, reflecting the impact of higher interest rates on economic activity.
“Without the surge in government spending, the picture would be much bleaker. Indeed, without government support, domestic demand is contracting,” Matthieu Arseneau, deputy chief economist at National Bank Financial, said in a note.
For banks, which are essentially plays on economic activity, this isn’t good news.
Bank of Nova Scotia stands out with other challenges, too. Its expansion into international markets – notably, Mexico, Colombia, Peru and Chile – has been met with investor skepticism over growth prospects. Relatively new leadership at the bank, along with a new strategic plan coming on Dec. 13, mean that investors have little to chew on right now.
Nonetheless, there is a case for buying the stock, starting with the obvious: The high dividend yield, along with a low price-to-book ratio, point to a stock that has a lot of misery already priced in. That limits the downside risk and could lead to a rally at the first sign of operational improvement.
The economic backdrop could help too. Inflation has subsided, and economists expect that the Bank of Canada will cut interest rates next year, providing relief to indebted consumers and potentially spurring loan growth, especially if the economy avoids slipping into recession.
If the Federal Reserve also cuts rates next year, the value of the U.S. dollar next to other currencies could slip, providing some economic relief to developing markets where Scotiabank is active.
Of course, these conditions will probably help other Canadian banks, too. Perhaps Scotiabank’s greatest challenge is appealing to investors when the entire sector is out of favour but poised for a comeback.
David Berman