Thursday, March 26, 2015

Bank of Nova Scotia (BNS) Dividend Stock Analysis

It feels really great to be in a position to continue to put fresh capital to work!
Stocks across the board aren’t cheap, but I’m fortunate in that, as a dividend growth investor, I’m only buying one stock at a time. Thus, I only need to find one attractively valued stock at a time. Much easier than buying the market, which might involve buying hundreds, or even thousands, of stocks at once.
As always, I look at the stock market like any other market or store. It offers a plethora of merchandise, some expensive, some not so expensive. I tend to shop in the back of the store, where one can find the clearance specials.
Furthermore, “expensive stocks” is very much a first world problem. If you’re in a position to even save money and buy stocks on a regular basis, you’re really extremely blessed.
As such, I’m blessed to note that I recently picked up shares in another world-class business.
I purchased 15 shares of Bank of Nova Scotia (BNS) on 3/10/15 for $49.51 per share.

Overview

Bank of Nova Scotia is a diversified financial services institution based in Canada that offers a range of financial products and services to retail, commercial, and corporate customers. These customers number more than 21 million across over 55 countries.
They are Canada’s most international bank with more than 2,000 international branches and offices and more than 1,100 branches and offices in Canada.
The bank operates in four segments: Canadian Banking (31% of fiscal year 2014 net income), Global Wealth & Insurance (26%), International Banking (21%), and Global Banking & Markets (21%).
56% of the company’s income comes from Canadian operations. The rest is from US and international operations.

Fundamentals

BNS actually has some really solid fundamentals, especially in comparison to some of the larger US financial institutions. This appears to be due to a variety of factors, ranging from regulation in Canada to the Canadian economy. But I also think it comes down to prudent management.
So let’s take a look at what kind of growth the company has managed across the top and bottom lines over the last 10 fiscal years.
Revenue was $10.726 billion CAD in fiscal year 2005, which increased to $23.958 billion CAD in FY 2014. That’s a compound annual growth rate of 9.34%, which is especially impressive considering this stretch includes the financial crisis.
Earnings per share increased from $3.15 CAD to $5.66 CAD over this period, which is a CAGR of 6.73%. Again, this is admirable considering the period we’re talking about.
S&P Capital IQ anticipates that EPS will compound at a 5% annual rate over the next three years
Now, where the bank really shines is in their dividend history, which is one of the richest and longestaround.
First, they’ve been paying a dividend since 1833. Let that sink in for a second.
The dividend growth record, however, isn’t very lengthy due to the fact that management decided to prudently maintain the payout throughout the financial crisis. However, this is obviously preferable to a dividend cut or outright elimination. That said, they’ve been increasing the dividend since, with five consecutive years of dividend increases.
And the five-year dividend growth rate stands at 7.9%. That’s pretty strong considering the current yield of4.36%. Generally speaking, the sum of the yield and dividend growth rate is a proxy for long-term total return, assuming a static valuation. Add the two up and you get a sum north of 12, which is attractive. Furthermore, the bank has been increasing its dividend twice per year lately, with the most recent dividend increase announced just earlier this month, upping the quarterly dividend from $0.66 CAD to $0.68 CAD, or 3%.
The payout ratio is 47.8%, which isn’t only low in absolute terms, but also fairly low for a stock that yields north of 4%. It’s not common that you find a high-quality stock yielding 4%+ with a payout ratio below 50%.
BNS’s balance sheet is also solid, and a further indication of their quality. The long-term debt/equity ratio is0.21. And their credit ratings, which can affect the company’s access to capital markets and borrowing costs/terms, are strong: They have an A+ rating from Standard & Poors and a Aa2 by Moody’s.
The company’s profitability compares well with any of the major Canadian banks, with return on equity that’s averaged 18.62% over the last five years.
Assets have grown from $314.025 billion CAD to $805.666 CAD over the last 10 years, which is a CAGR of11.04%.

Qualitative Aspects

Canadian banks operate under a basic oligopoly structure, with BNS operating as one of the “Big Six” banks in Canada. These banks collectively control approximately 90% of the country’s banking assets. This allows a healthy competitive environment where products and services can be marketed at a reasonable premium.
The domestic Canadian banking sector is particularly attractive for investors since the big banks already in existence will probably remain the major players for the foreseeable future due to strong regulation that limits foreign competition.
But what I really like about this bank in particular is their healthy international exposure. As pointed out above, almost half of the company’s income comes from international operations. Their Latin America exposure is particularly promising, where the bank continues to see strong loan growth. This geographical diversification helps cushion the bank from any major domestic issues, which is important considering that Canada’s economy is somewhat commodity based with a housing market that is potentially in a bubble.
Larger banks tend to stay larger – and grow – due to the sticky nature of their business. Once someone is banking with a particular company, it’s somewhat unlikely that they’ll switch bankers as long as the respective bank is providing product and services at a level that customers expect. Furthermore, there are only so many institutions – especially in Canada – that can provide the size and quality of loans that commercial and corporate customers need.

Risks

There are concerns about household consumer debt in Canada, which recent reports have cited as thehighest in recent history. This appears primarily due to the housing market which has been on an incredible run, though there are some concerns that the Canadian housing market displays some similar qualities to the US housing market before the housing crash that became part of the financial crisis. The national average sales price of housing in Canada, which includes all housing types, is $431,812 as recently as February.
Any major problem with housing could impact BNS since almost half of their loan portfolio is related to residential mortgages. However, Canada’s current situation is different from what the US experienced during the housing crash in a number of ways, such as the lack of high-volume subprime lending, higher down payment requirements, and the fact that the vast majority of mortgages are non-recourse. Though, because mortgages are commonly variable rate, any rise in rates could constrain borrowers’ ability to pay.
The stock has taken a beating over the last six months – US shares are down some 25% over that period – due apparently in some part to worries over the slowdown in the oil & gas industry and how that will affect BNS’s loan portfolio. It’s important to keep in mind, however, that O&G accounts for approximately just 3% of BNS’s loan portfolio. Though, there could be an effect there where unemployment affects other parts of BNS’s business lines.

Valuation

The stock’s P/E ratio of 11.12 is low not only in absolute terms, but also relative to the broader market and BNS’s five-year average of 12.3. The stock has slowly seen a P/E ratio compression over the last few years, but this really can’t continue much further, meaning an expansion of the ratio is more likely when looking out over the long term. The current yield is also high by recent historical measures.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term growth rate. This rate appears fair considering the company’s recent historical growth in EPS and the dividend, as well as the moderate payout ratio. Short-term headwinds could cause slower growth, but I think this is an appropriate growth rate when looking out over the long haul. And the payout ratio should cushion any temporary slowdowns, though any major crash in the domestic housing market could cause major issues. The DDM analysis gives me a fair value of $65.73.
Overall, shares appear attractively valued here, which is why I added to my position for the first time since initiating a stake in BNS back in February 2013. The recent weakness across Canadian bank stocks gave me an excellent opportunity to average down. I also want to note that this transaction is much smaller than usual due to the fact that I had some free trades with my brokerage, Scottrade. A reader kindly used a referral code upon opening a new account to give us both a few free trades. I’m not working with as much capital as I used to, but I had a chance here to put a little capital to work and keep the snowball rolling.

Conclusion

It’s just not often you find a company that’s been paying out a dividend for almost two centuries. In addition, it’s rare to find a high yield, low valuation, and moderate payout ratio all at the same time like this. Generally, stocks with 4%+ yields have higher payout ratios, but that’s not the case here with BNS. And the yield is still high even after factoring in the recent strong USD performance. When this moderates itself and the exchange rate between the USD and CAD returns to normal, the actual income provided by these shares will actually increase. So I view this almost like a high-yield stock that actually flies under the radar as a stock that yields even higher over the long run.
While the risks here should be taken seriously, Canada’s economy has remained resilient over the long term, with the most recent financial crisis being a fairly good test. I think there’s a good chance that growth moving forward could be somewhat lower than what we’ve seen over the recent past, but I still think that an attractive valuation, yield north of 4%, moderate payout ratio, and entrenched business model in an oligopoly warrants attention.
This purchase adds $32.40 to my annual dividend income, based on the current $0.54 quarterly dividend. That factors in the current exchange rate of $1 CAD to $0.78 USD.
I’m going to include two current analysts’ valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates BNS as a 3/5 star value, with a fair value estimate of $55.00.
S&P Capital IQ rates BNS as a 4/5 star Buy, with a fair value calculation of $59.10.
I’ll update my Freedom Fund in early April to reflect this recent purchase.
Full Disclosure: Long BNS.
What’s your opinion of BNS here? Think the valuation is attractive? Is it a good buy? 
Thanks for reading.
Photo Credit: Stuart Miles/FreeDigitalPhotos.net

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