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Bank of Nova Scotia: High-Yield Bank Stock

- By Ben Reynolds

Bank of Nova Scotia (BNS) posted lackluster results in the first two quarters of fiscal 2019.

Consequently, the stock has lost 15% since it peaked in September and is now trading around its three-year lows. Nevertheless, its disappointing performance has mostly resulted from non-recurring expenses related to acquisitions and divestments.


Therefore, as the stock is trading at a markedly cheap valuation and has exciting growth prospects, investors should take advantage of the buying opportunity for one of the best Canadian bank stocks.

Business overview

Bank of Nova Scotia is the third-largest financial institution in Canada, behind the Royal Bank of Canada (RY) and the Toronto-Dominion Bank (TD), with a market capitalization of $63 billion. It is also the seventh-largest bank by assets in the Americas and the 10th-largest bank by market capitalization. It generates more than 90% of its earnings in the Americas, with 49% of its earnings coming from Canada.

Moreover, it is a leading bank in the high-growth markets of Mexico, Peru, Chile and Colombia, which have a total population of 230 million people. Bank of Nova Scotia has been gaining market share in these markets and has ample room to grow further.

Furthermore, the bank has chosen to exit several markets, which are characterized by either low returns or high operational risk, in recent years. More precisely, in the last five years, Bank of Nova Scotia has exited 18 countries, including Russia, Turkey and Egypt. This strategy has greatly improved its risk profile.

On May 28, Bank of Nova Scotia reported financial results for the second quarter of 2019. The company increased its revenue 11% from the prior-year quarter thanks to strong growth in both interest and non-interest income. International banking achieved double-digit earnings growth thanks to strong momentum in Mexico, Peru, Chile and Colombia.

Adjusted earnings per share, however, slipped from $1.71 to $1.70, which was 4 cents lower than the analysts' consensus. The return on equity fell from 15% to 13.6%. The poor bottom-line performance was attributed to expenses related to several acquisitions and divestments. These type of expenses have persisted for a while and has caused the company to miss expectations for three consecutive quarters. It is important for investors to realize, however, that these expenses are non-recurring in nature and, therefore, are likely to diminish in the coming years.

Growth prospects

The bank has a remarkably differentiated growth strategy from its peers in the Canadian financial sector. While other banks try to expand in the U.S., Bank of Nova Scotia has focused primarily on growing in emerging markets. These markets are characterized by higher population growth, higher gross domestic product growth and wider net interest margins than the U.S.

Bank of Nova Scotia is large enough to take advantage of the fragmented status of these markets and keep growing for several years. For perspective, the company is the third-largest bank in Chile, the second-largest card issuer in Peru and the fourth-largest bank in the Dominican Republic.

Moreover, the bank has ample room to continue growing in its major market, Canada, where it generates essentially half of its total earnings. In the first half of the year, the company grew its deposits 11%, its loans 3% and its credit cards 6%. As its $7.5 billion credit card portfolio represents only 3% of the retail loan book in Canada, it is evident the bank has ample room for future growth in this market.

Thanks to these factors, Bank of Nova Scotia has exhibited a remarkably consistent growth record over the last decade. It has grown earnings per share in every single year except for 2013, when earnings fell 1%. Moreover, it has grown earnings per share at an average annual rate of 9%. In addition, management said its long-term goal is at least 7% annual earnings per share growth thanks to more than 7% growth in Canada and more than 9% growth in international banking. Given the consistent growth record, investors can rest assured the company will at least meet its own guidance.

Dividend

Bank of Nova Scotia has grown its dividend for nine consecutive years and is currently offering an attractive 5% dividend yield. Over the last nine years, the bank has raised its dividend at an average rate of 6.6% per year. Moreover, the payout ratio currently stands at a healthy 47%, which is in line with the long-term target of 50%. Thanks to the bank's solid growth trajectory and its low payout ratio, investors can rest assured the dividend will continue growing at a meaningful pace for several more years.

Overall, Bank of Nova Scotia offers an appealing dividend yield and is likely to keep raising it at a significant rate year after year. Therefore, income-oriented investors should consider purchasing the stock.

Valuation and expected returns

Bank of Nova Scotia has traded with an average price-earnings ratio of 12 over the last decade. Due to its lackluster business performance in recent quarters, the stock is now trading with a price-earnings ratio of 9. As the charges from acquisitions and divestments are expected to stop hurting the bank's results in the coming years, we anticipate the stock will revert to its historical valuation level. Even if it takes five years to do so, the stock will enjoy a 6% annualized gain thanks to the expansion of its price-earnings ratio.

Given the minimum expected 7% annual earnings per share growth rate, the 5% dividend yield and a 6% annualized gain from valuation, the stock is likely to offer an approximately 18% average annual return to shareholders over the next five years. This is an exceptional return, which should satisfy even the most demanding investors, particularly given the current phase of the decade-long bull market.

Final thoughts

Over the last several quarters, Bank of Nova Scotia has been punished by the market for its disappointing results. The bank, however, has an exceptional growth record and ample room to keep expanding for several years. As the poor recent results were caused by non-recurring factors, the market will soon focus on the long-term prospects of the stock.

When that happens, Bank of Nova Scotia will reward investors with exceptional returns.

Disclosure: No positions in any stocks mentioned.

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This article first appeared on GuruFocus.