Growth and Income You Can Bank On

06/03/2011 5:18 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Shares of Bank of Nova Scotia (BNS), Canada’s third-largest bank, have modestly lagged the Canadian banking sector in 2011. I think that’s about to change. (I think these shares are a good switch if you’re holding shares of big US banks, too.)

On May 31, the bank, which does business as Scotiabank, announced that net income for its second quarter (the three months ended on April 30) climbed 41% from the second quarter of 2010 to a record C$1.54 billion ($1.58 billion.)

The surge had two sources.

First, like its peers, Toronto-Dominion (TD) and Bank of Montreal (BMO), Bank of Nova Scotia reduced the amount that it set aside for loan losses in the quarter. Additions to reserves in the quarter fell to C$262 million from C$338 million in the same quarter of 2010. The bank is nearing the inflection point where it stops adding to reserves and instead starts to reduce them and add the cash back to its bottom line.

Second, Bank of Nova Scotia saw a huge surge in international banking revenue, up 56% to a record C$402 million. Much of that growth came from the bank’s business in emerging economies in Asia, Latin America, and the Caribbean.

So far in 2011, this exposure has led shares of Bank of Nova Scotia to trail its peers in the Standard & Poor’s/Toronto Stock Exchange Banks index (a 3.3% gain through May 30 for Bank of Nova Scotia versus a 7.9% gain for the index). The bank’s competitors either don’t have the same exposure to non-Canadian economies (Bank of Montreal, for example, gets 90% of its revenue from Canada) or have their overseas exposure concentrated in the US market (Toronto-Dominion, for example).

But going forward, I think it’s this emerging markets exposure that will let Bank of Nova Scotia beat its Canadian peers. Loan growth in Canada and the US is sluggish—and seems likely to stay that way for the rest of 2011.

Canadian banking revenue at Bank of Nova Scotia fell by 4% year-to-year in this most recent quarter. Net income dropped 1.6%. But international banking revenue climbed 16% and net income climbed by 56%.

Canada is a relatively closed (just six banks dominate the Canadian market) and high-return banking market with conservative regulation. That helped Canadian banks avoid a US-style mortgage bubble. (Canadian mortgages are limited to 80% of value unless they’re insured via the Canadian government.) Over the last ten years, the Canadian banking sector has averaged a 14% return on equity.

With loan growth slowing, the challenge for most Canadian banks will be finding places to invest those fat profits at something like that rate of return. (By the way, this analysis suggests that US banks are going to have trouble finding much in the way of growth, too). I don’t think the US market will be a good place to look since loan growth in the US economy is also likely to be slow.

Bank of Nova Scotia’s emerging markets business—already 22% of net income—provides exactly that kind of re-investment opportunity through organic growth and through acquisitions. In 2010, the bank acquired R-G-Premier Bank in Puerto Rico and an interest in Siam City Bank in Thailand.

If Bank of Nova Scotia were to trade at a modest premium at a 15 price-to-earnings ratio to the Canadian banking sector’s multiple of 14.3—instead of its current discount at 13.9 times trailing 12-month earnings, the stock would appreciate by 12.1% from today’s price of $61.26 by the end of 2011. Add in the stock’s 3.2% current dividend yield and these shares look like a very conservative path toward a potential 15% return.

Of course, if you can get them cheaper on any pullback, that would be even better. As of June 3, I’m adding these shares to my Watch List.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Bank of Nova Scotia as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio here.

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