07 February 2009

Barron's on Scotiabank

Barron's, Vito J. Racanelli, 7 February 2009

A Canadian Bank Plays It Safe…and Smart

During each ephemeral rally in financial stocks, hope springs anew for U.S. banks, whose shares keep getting battered. Investors pore over the same, ever-cheaper names, hoping to discover a diamond under the TARP -- the Troubled Asset Relief Program. Yet most of these banks seem to suffer similar afflictions: exposure to a decomposing economy; tens of billions in "toxic-asset" write-downs, with more to come; dividends cut or eliminated; and the need for huge capital infusions.

North of the border, however, there's a nice alternative: Toronto-based Bank of Nova Scotia, a big lender mostly free of the woes afflicting its U.S. peers. Scotiabank, as it's called, is Canada's third-biggest bank by assets, but isn't as well known as its similarly sized red, white and blue cousins. BNS, with a market capitalization of U.S. $25 billion, didn't leverage up the way American banks did, and sports a strong capital base, with a Tier 1 ratio of 9.3%. [The ratio, which measures shareholders' equity plus preferred stock as a percentage of total assets, reflects balance-sheet strength.] BNS also has a solid domestic-banking business, a 6.4% dividend yield, and a diversified geographic base.

What BNS lacks is even more attractive: Among big Canadian banks, it's the least exposed to assets south of the border, with no U.S. subprime residential debt. It doesn't need billions in government aid to survive, and won't have to take huge write-downs on exotic instruments gone bad. Thus, it should sail relatively smoothly through today's choppy seas, and shine when the global economy rebounds.

It doesn't hurt that the bank is tight-fisted and old-fashioned, and has boosted its earnings and dividends consistently for more than a decade, in part from traditional loans. Even without much of a pickup in lending, its Toronto-traded shares could generate a total return of 20% to 25% in next 24 to 30 months, rising to 36 Canadian dollars from the current C$30. A Canadian buck is worth about 81 U.S. cents. (The bank has American depositary receipts, which trade on the Big Board, also under the ticker symbol BNS .)

Many big U.S. banks have taken charges in the tens of billions of dollars on bad investments such as collateralized debt obligations (CDOs) tied to subprime mortgages. Markets fear that billions more are on the way. In comparison, Scotiabank charged off $822 million of soured assets, after tax -- mostly stemming from the Lehman Brothers bankruptcy and collateralized-debt obligations unrelated to subprime mortgages -- in the fiscal year ended October 2008. Charge-offs this year could be of similar magnitude.

Despite the bank's relative health, its shares have slid 45% from their record high of C$54.50, hit in May 2007. "Investors have convinced themselves that a bank is a bank is a bank," says Dom Grestoni, a portfolio manager with QV Investors in Calgary, which owned about 50,000 shares at the end of the third quarter. "Opinions have soured" on BNS because of its international operations, which are mostly in Latin America and contribute about 32% of net income, Grestoni says. (Scotia Capital, BNS's wholesale and investment bank, kicks in another 21%, with a significant portion of that earned outside Canada.) Investors fret that loan losses will rise this year in Mexico, Peru, Chile and other countries, as the global economy worsens.

Jackee Pratt, a fund manager with Toronto-based Mavrix Fund Management, notes that the bank's after-tax loan losses were C$630 million in 2008; she says that they could hit C$1 billion in 2009, though some analysts think the number could be higher. Even so, Pratt says, this should be counterbalanced by BNS's having avoided the subprime and derivatives write-downs afflicting other banks. Mavrix owns 24,500 Bank of Nova Scotia shares.

Bank of Nova Scotia'S CEO, Rick Waugh, won't be specific, but says there will be a "significant but manageable" increase in loan-loss provisions, which are incorporated into BNS's guidance for earnings per share to rise 7% to 12% in 2009.

Emerging-market economies are slowing, but geographic diversity, along with the quality of loans, contributes to the bank's ability to provide a "secure dividend," he adds. The bank currently pays C$1.92 a share.

Its global reach should help BNS shine in an economic recovery, particularly because some of its markets are under-penetrated. "Having that diversity is not a bad thing long-term, and it's certainly better than being in the U.S.," says Peter Jackson, a portfolio manager at Toronto-based Cumberland Private Wealth Management, which has about 29,000 BNS shares.

Canada's economy is inextricably linked with that of the U.S., and has slowed appreciably. It, too, could soon be in a recession. Yet, the Canadian housing market is in far better shape. Moreover, the northern nation's banking industry is much more consolidated than that in the U.S., notes Colum McKinley, a portfolio manager with Sionna Investment Managers in Toronto. There are just five major Canadian banks, and some have direct and significant exposure to the U.S. Only 7% of BNS's loans, however, have been made to American customers.

So far, McKinley adds, BNS's focus on Latin America has played out well and has helped the bank to avoid many of the problems that have emerged in the U.S. There could be a "spillover effect" in emerging markets from weakening commodity prices, but Bank of Nova Scotia is a better relative risk than some of the other Canadian banks, McKinley says. In fact, BNS is the only bank that Sionna rates Overweight. In the longer term, it could pick up share in Latin America at the expense of U.S. competitors.

In the year ended October 2008, BNS derived about 58% of its net income from its Canadian operations and the rest from its international units -- it had a small loss in the U.S. Overall, it posted net profits of C$3.14 billion, or C$3.05 per share. That's down from C$4.05 billion, or C$4.01 in fiscal 2007.

To boost profitability, BNS can cut costs. Waugh expects to ratchet down the bank's productivity ratio -- costs as a percentage of revenue -- to 58% from an already stingy 59%, with such a drop worth "hundreds of millions."

"It has a frugal culture," says Matt McCormick, a portfolio manager at Bahl & Gaynor Investment Counsel, in Cincinnati, which owns about 68,000 shares and has been buying more. "It's low-risk, and one of the few banks we own," he adds.

McCormick fondly recalls an initial visit to meet BNS management: "There was no food spread, and I was asked to share a bottle of water....It's the kind of place that reuses paper clips." McCormick expects the stock to return 20% to 25% in the next two or three years.

"Coming out of this [global recession], BNS has to make up less ground, has no TARP-related restrictions on its activity and doesn't have to reinvent the model," he says. Analysts' expectations of C$3.50 a share this fiscal year are probably still too high in his view, but McCormick figures that BNS can make about C$3 a share, while most big American banks will be in the red.

Mavrix's Pratt puts BNS's real value at roughly C$36 -- 20% above its recent price -- not including dividend returns. Although the bank's 10-year average price/earnings ratio is 13 to 14 times, she thinks it should sell for a more conservative 11 times analysts' fiscal '09 estimates of C$3.25 to C$3.85 a share.

One worry for Scotiabank is its auto-loan exposure of C$15.6 billion. A good chunk -- C$6.6 billion -- is from General Motors Acceptance Corp. (GMAC), "where we took credit enhancements," Waugh notes. That means the loans carry better collateral than normal car loans. Much of the remaining exposure involves consumer-auto loans and lending to car dealers. Although adequately reserved and performing in line with Bank of Nova Scotia's expectations, such assets tend to produce increased provisions during recessions. Yet, Sionna's McKinley thinks that the bank is unlikely to generate "big surprises on the balance sheet and write-downs."

So long as investors hate banks and their shares, Bank of Nova Scotia may continue to trade on emotions. But it is likely to remain nicely profitable -- and profitable enough to cover its lush dividend. When the global economy perks up, BNS will be ahead of the game, and so will its shareholders.

The Bottom Line:

Bank of Nova Scotia's Toronto-listed shares could rise to C$36 in the next two years, from C$30. Meanwhile, investors will be collecting a fat 6%-plus dividend yield.

Financial Post, Jonathan Ratner, 6 February 2009

They may have lost nearly 50% of their market capitalization since the end of May 2007 but Canadian banks continue to outperform their global peers.

The share of Canadian banks in the market capitalization of all the world’s banks hit a 22-year high of 6.2% in January, according to National Bank Financial. Canada is enjoying a sizeable lead on Swiss banks – traditionally considered a safe haven – for the first time since the mid-1990s.

So is it time to reallocate some banking exposure out of Canada? National Bank’s chief economist and strategist Stéfane Marion doesn’t think so.

“In our view, solvency standings coupled with high potential for domestic market share gains still argue for a continued overweight position in Canadian banks,” he told clients.
Financial Post, Eoin Callan, 4 February 2009

Bank of Nova Scotia has emerged during the credit crisis as one of the top 10 most stable banks in the world, according to a global ranking of the financial sector.

Canada's third-largest bank ranks alongside the likes of Berkshire Hathaway, run by celebrated investor Warren Buffett, as one of the steadiest investments for shareholders, according to the report.

The ranking reflects Scotia's efforts to draw on diverse sources of liquidity and develop sophisticated risk management systems that have held up relatively well during one of the worst financial crisis in decades.

The bank's performance has also been more steady to date because it is less exposed to corners of financial system hardest hit by the credit crisis like the wholesale banking markets in New York and London.

Scotia also performs better than its Bay Street rivals in the unique index because it does not have a retail branch network in the economically-weakened United States, and is instead spread more thinly across emerging markets like Latin America.

The ranking is increasingly closely watched because of the premium investors are placing on steady performance amidst extreme volatility in financial markets.

"If two firms have produced the same absolute return to shareholders, the one whose returns are less volatile is ranked higher," according to Oliver Wyman Group, the consultancy that developed the index.

To some extent, Canada's banking sector has not experienced as severe disruptions as the financial systems of other countries because its shareholder base is dominated by large domestic institutional investors seeking steady returns.

Oliver Wyman's forecast for the year ahead for Canada's banking sector is mixed but relatively rosy.

It notes that provisions increased last year for "credit losses and ill-fated structured product exposures" and that net income fell to about US$17-billion from US$22-billion, but added earnings have been "sufficient to maintain dividends and contribute to capital ratios".

But it cautioned that the "deteriorating employment picture will almost certainly lead to an increase in consumer defaults".

Moody's Investors Service Wednesday warned the strength of Canadian credit card portfolios would be tested in the year ahead as an economic downturn "lead[s] to higher delinquency and loss rates."
The Globe and Mail, Fabrce Taylor, 4 February 2009

Tipping the scales at an average 172 pages, a big-bank annual report is no cure for narcolepsy, but it might be cause for head trauma. I don't mean the damage done as your head bounces off the desk every time you doze off, although that hurts. I mean the brain-numbing effort of trying to understand what you're reading.

Banking sounds like a simple business: Borrow low, lend high, earn spread. That semblance of simplicity is rattled when you cast your eyes on the financial statements.

It's shattered when you venture into the notes. As investors we're always told to buy what we know. Do we really know with banks? Doubtful. We just have to buy their shares on a great leap of faith.

Take Royal Bank's balance sheet (you could take any one of them. This choice is random): The first line item on the asset side of the ledger is "cash and due from banks." That's pretty straightforward, as is "interest-bearing deposits with banks." The next item: "Assets purchased under reverse purchase agreements and securities borrowed." It's that "securities" item that is troubling. There are two kinds: "Trading" and "available for sale." Together they add up to $170-billion. So what are these "securities?"

For clarity, we turn to Note 3. I'd quote it but it's several pages long (and there are even notes to the notes). Let's just say that in the trading account, there are lots of government bonds, Canadian, U.S. and OECD. No major red flags there.

You'll also find some asset-backed and mortgage-backed securities - a little more complex but small in numbers, so, uh, not to worry. Equities? $42-billion of those, or a third of the portfolio. There's no breakdown. I'd like to know how much is the shares of other Big Five banks, but I'm more curious about the $39-billion "other" category.

I didn't find much clarity on that subject, mainly because I was distracted by another "other" category of assets on the balance sheet, which includes, among other things, $136-billion worth of derivatives. That sounds like a lot, about four times shareholders equity. It seems like a lot compared with last year too, when the derivatives balance finished the year at roughly half that much.

Off to Note 7 for an explanation. Again, I'd quote but it's four pages long. To summarize, there are a few different kinds of derivatives. Most are on the books to help bank clients hedge some kind of risk, it seems. But we also learn that more than $4-billion of the "replacement cost" of derivatives is tied to counterparties who lack investment grade ratings. I assume replacement cost means receivable. But I don't know. It doesn't say.

Finding the notes wanting, I head for the management discussion and analysis for insights into the inner workings of this mighty machine, whose shares I own. Looking for guidance, I found only headaches.

Consider, for instance, this: "The majority of our financial instruments classified as held-for-trading, other than derivatives and financial assets classified as available-for-sale, comprise or relate to actively traded debt and equity securities, which are carried at fair value based on available quoted prices. As few derivatives and financial instruments designated as held-for-trading using the FVO are actively quoted, we rely primarily on internally developed pricing models and established industry standard pricing models, such as Black-Schöles, to determine their fair value."

So it sounds like some of these assets are carried on the books at prices that may not be realistic; perhaps too high, perhaps too low. How much? About $20-billion of the bank's financial assets that are measured at fair value are done so using what are called "pricing models with significant unobservable market parameters," which, if I'm following, means there's nothing close to a market quote for them. Sadly, the bank's fair value liabilities appear to have much more accurate valuations.

I could go on but you get the picture. Or not. In any case, don't feel bad. Bank analysts far smarter than us probably don't have a total understanding of this mystery meat. Neither do most professional investors. And bank directors? I'll let you decide.
Reuters, 3 February 2009

Bank of Nova Scotia has again expanded its international presence by doubling its stake in a Thai bank for about $270 million, Canada's third-largest bank said on Tuesday.

Scotiabank said it has acquired an additional 24 percent stake in Thailand's Thanachart Bank, a subsidiary of Thanachart Capital .

That raises Scotiabank's stake to 49 percent, up from 24.98 percent, in Thailand's eighth-largest bank by assets and leading auto-finance lender.

Currently, Thanachart Capital Public Company Ltd is the largest shareholder of Thanachart Bank with a 50.9 percent interest. Retail investors hold the remaining 0.1 per cent.

"The Thai market has solid fundamentals with good long-term growth prospects. Scotiabank's increased investment in Thanachart Bank is a great opportunity for us to capitalize on the strength of the Thai market," Rob Pitfield, group head of international banking at Scotiabank, said in a statement.

The Canadian bank bills itself as the most international of its Canadian peers, with a long-term strategy of operating in some 50 countries around the world. Scotiabank's operations span 11 countries in the Asia-Pacific region, and the company has had a presence in Thailand since it opened a representative office in Bangkok in 1981.

Thanachart Bank plans to open 40 more branches by the end of the year to increase its total network to 255. It will also concentrate on maintaining its market share in automobile financing.

Thanachart Bank said it aims to grow its lending portfolio and step into corporate finance, housing loans, and trade finance.

Scotiabank's increased stake in Thanachart, now at the regulatory limit for foreign banks in Thailand, also gives it a third seat on the Thai bank's board of directors.
Reuters, 2 February 2009

Royal Bank of Canada's chief executive plans to forfeit nearly C$5 million in compensation as the country's biggest bank looks to weather the global financial crisis.

Gord Nixon will forgo his 2008 variable compensation package, made up of deferred share units and 10-year stock options, totaling C$4.95 million. It is part of his mid- and long-term compensation package at RBC.

He received a cash bonus of C$2.4 million in December, part of his short-term incentive package and down 40 percent from the prior year. Nixon said he will use the after-tax proceeds to buy Royal shares.

Nixon had a base salary of C$1.4 million in 2008 and his total direct compensation was listed at C$8.75 million in the proxy circular.

Battered by fallout from the global financial crisis and economic downturn, Royal Bank shares hit their lowest level in more than five years last week, but have since recovered a little. Royal was down 1 percent at C$30.10 on the Toronto Stock Exchange late afternoon on Monday.

"I have confidence in the future performance of Canada and RBC, but feel my decision is appropriate at this time," Nixon said in a statement that accompanied the bank's management proxy circular, adding his move was a "personal" decision.

"I believe as the global economic performance turns around, RBC has significant opportunities, given its strong businesses and relative global strength. And, as its CEO and a significant shareholder, I would benefit from any recovery."

Royal Bank reported more than C$4.5 billion in profit in 2008, though down 17 percent from the year before. Results in the latest quarter were down 15 percent on higher loan loss provisions.

The bank missed on its 2008 target to grow diluted earnings per share and return on equity, but topped expectations on its dividend payout ratio.

Bank of Montreal also announced on Monday that CEO Bill Downe would give up both his mid-term and long-term compensation of C$4.1 million for 2008.

"While BMO delivered solid financial performance in 2008 ... my decision to forgo this compensation is a result of my reflection upon the current economic environment," Downe said in a statement.

The banks said Downe plans to invest his 2008 short-term compensation of C$1.4 million in BMO's share units and common stock.

At Bank of Nova Scotia, CEO Rick Waugh's total compensation was cut to about C$7.5 million, down 20 percent from the previous year and in line with the bank's performance.

Due to the "unprecedented" economic environment last year, several key targets were not met at Scotiabank, including its missed aims for EPS growth and return on equity.

Waugh, the CEO at Canada's third-largest bank, will continue to earn a base salary of C$1 million in fiscal 2009, the circular said.

Canada's banking sector, described as one of the strongest in the world, has endured the financial crisis better than many of its international peers, which have needed massive amounts of government aid.