Friday, October 7, 2022

The Bank of Nova Scotia - Thoughts

Although I try not to spend too much time hanging out on Twitter, @thedividendguy had an interesting question last week about why people buy the Bank of Nova Scotia ("BNS") over other Canadian banks. The question was worthwhile given BNS has underperformed its peers over the past five years, and is down about 20% over that period if you don't include dividends received. Reading through the answers of others, and then writing my own, made me wonder if BNS was worth owning at all. Without diving too deep into numbers, I thought it would be worthwhile to think about some of the top reasons BNS is worth investing in, and the key risks it currently faces.

1. Total return potential: As of the time I'm writing this, BNS has a dividend yield just north of 6%, and it looks pretty safe given it only represents about 50% of net earnings. Not only is BNS priced relatively low compared to its Canadian banking peers (current P/E is ~8%), its multiple is below its own historical average of ~10% - 11%. Assuming BNS makes it through what feels to the inevitable recession in Canada, you'd be looking at a 9-10% return if the bank can get back to its own historical multiple. 

2. New CEO incoming: Although I don't profess to know very much about incoming CEO Scott Thomson, I wonder if Brian Porter "retiring" isn't a chance for the bank to move past some of their past missteps taken under Porter's leadership. It seems fair to say that Porter's bets in Latin America have at best underperformed, and the bank exiting all but four markets in the region (Peru, Chile, Mexico and Colombia) appears to be a first step in admitting a mistake. Call me crazy, but I think Mr. Thomson is more likely to consider exiting one or more of those remaining markets, and blaming the miscue on his predecessor. 

3. Canadian results remain strong: Although BNS reports on four segments, their Canadian banking segment results accounted for almost half their net profits through Q322, growing 23% year-over-year. As stated above, I do think Canada will inevitably go though a recession in the next year, but BNS has the capital base and experience to make it through to the other side. Between their expansive branch network, ability to cross-sell through various subsidiaries and platforms (Tangerine, Scotia Itrade, etc.), and their credit card business, it's hard to avoid dealing with the bank.

1. Reliance on Canada for profit generation: In fairness to BNS, I think this is a material risk for all Canadian banks, and Scotia might be the least exposed to the Canadian economy of any of the big six banks. That said, a long recession in Canada, a severe correction in home prices, or a series of large corporate defaults would greatly impact BNS's results.

2. New CEO could be ineffective: Based on a recent article in the Globe that explored how Mr. Thomson went from running the Board of Directors committee responsible for hiring a new CEO, to being named the new CEO of BNS, in a manner of months, I'm unsure if he represents an upgrade from Mr. Porter. Although he has some banking experience with Goldman Sachs in his distant past, it's rare for Canadian banks to hire relative outsiders as CEOs. Apparently, his former company also struggled with some issues in the South American countries it operated in. Lastly, as a Board member at BNS, I would think he would have shared any ideas to improve the bank's results with Mr. Porter, instead of saving them in case he eventually took over the bank.

3. Regulatory / ESG Risks: From December 2020, to November 2021, the Office of the Superintendent of Financial Institutions, that regulates banks in Canada, halted banks from increasing their dividends in order to conserve capital. After his Liberals won the last federal election, Prime Minister Justin Trudeau announced that banks (and insurance companies) would see a 3% increase in the tax rate they pay on their profits in excess of $1B. When considering how ESG concerns have made banks decrease financing of environmentally unfriendly industries is added to the two examples of regulatory risk outlined above, I become concerned that BNS will have a difficult time managing new rules/regulations/standards imposed on them. 

Although on balance I think the reasons one might invest in BNS slightly outweigh the apparent risks, the risk/reward relationship is far from optimal, with little margin of safety. For this reason, although I don't intend to sell my position at this time, I'm not confident enough to add to it either.