Bank of Nova Scotia (TSX:BNS) recently raised its dividend, but the stock continues to trade way below the 2022 peak. Contrarian investors who missed the big rally off the 2020 market crash are wondering if BNS stock is now undervalued and good to buy for a portfolio focused on passive income and total returns.
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Bank sector outlook
The share prices of most banks are down over the past year. The initial pullback occurred, as the Bank of Canada and the U.S. Federal Reserve started to aggressively raise interest rates in an effort to get high inflation under control.
Higher interest rates can be good for banks when they are able to grow their net interest margins. However, the steep increase that has occurred over such a short period of time is putting borrowers with tight cash flows under pressure. Businesses and homeowners with variable-rate loans take an immediate hit as soon as a rate hike is announced. Borrowers with fixed-rate mortgages get hammered when they need to renew the loan. The longer rates remain elevated the more likely it is that defaults will rise.
Central banks are trying to cool off the economy and rebalance the jobs market. Economists say there is normally a period of 12-18 months before the economy feels the full impact of the rate hikes. Investors are concerned the central banks could go too far and push the economy into a meaningful recession. If that happens and unemployment spikes, banks could face a larger wave of loan defaults than is anticipated.
The recent failures of some regional banks in the United States is also keeping bank investors on the sidelines. Everyone is waiting to see if more trouble is on the way. The catalyst could be loans on office buildings with high vacancy rates.
Bank of Nova Scotia
Bank of Nova Scotia generated solid fiscal second quarter (Q2) 2023 results. Revenue was in line with the same period last year, but net income slipped to $2.16 billion from $2.75 billion due to a $490 million increase in the company’s provision for credit losses (PCL). This is cash the bank sets aside to cover potential bad loans. Interest rates could still move higher and remain in place until the second half of 2024. If that turns out to be the case investors could see the PCL number drift higher over the coming quarters.
Bank of Nova Scotia finished fiscal Q2 2023 with a common equity tier-one (CET1) capital ratio of 12.3%. Canadian banks are required to have a CET1 ratio of 11%, so Bank of Nova Scotia should have ample capital to ride out some tough times.
The board put a new chief executive officer in charge this year, and big changes are expected at the bank after the completion of a strategic review. Pundits speculate that Bank of Nova Scotia might decide to sell some of its Latin American operations and use the funds to target growth in different markets, potentially the United States, where the other large Canadian banks have made large investments.
BNS stock trades near $66 at the time of writing compared to $93 in early 2022. The stock is probably oversold at this point given the steady revenue stream and solid earnings. Bank of Nova Scotia just raised the quarterly dividend from $1.03 to $1.06 per share, so the management team can’t be overly concerned about the revenue and earnings outlook. Investors who buy at the current level can get a 6.4% dividend yield.
Should you buy BNS stock now?
Bank of Nova Scotia could see additional downside in the coming months, but contrarian investors with a buy-and-hold strategy might want to start nibbling on the stock while it is out of favour. The dividend should be rock solid, and you get paid well to wait for the rebound.
