The average bank has a dividend yield of around 2.5%, using SPDR S&P Bank ETF (KBE -1.19%) as an industry proxy. What if you could own a bank with a yield of 6.1%? What if it was conservatively run, had a strong core business, and was a reliable dividend payer? You would probably jump at the chance to own a high yield bank like that... No problem, buy Bank of Nova Scotia (BNS 0.06%). And here's why now is a great time to take the leap.
Why is Bank of Nova Scotia's yield so high?
Bank of Nova Scotia, more commonly known as Scotiabank, has been a laggard relative to other banks. A big part of the reason for this is that it went in a different strategic direction from its Canadian bank peers. Most of the major Canadian banks chose to expand southward into the U.S. market. Scotiabank skipped over the U.S. and started to build a business in Central and South America.
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The logic is solid, given that the U.S. is a highly competitive market that is also fully developed. The markets where Scotiabank went were developing and less competitive, suggesting that there was the potential for more long-term growth. While that might have been true, and perhaps still is true, these less developed markets weren't as profitable as hoped. Scotiabank has lagged its peers on key metrics like earnings growth, return on equity, and return on risk adjusted assets.
And thus, despite being one of the largest banks in Canada (with an entrenched industry position thanks to strict Canadian banking regulations), Scotiabank is offering a dividend yield of 6.1%, more than twice the yield of the average bank. And never mind the fact that the bank has paid a dividend every year since 1833, has a generally conservative ethos (another function of being a Canadian bank), and that it has an investment grade rated balance sheet. Indeed, the risk here seems rather modest for the high yield reward.
What is Scotiabank doing about its laggard performance?
Of course the problem for investors is that Scotiabank hasn't been performing particularly well relative to peers. But management isn't ignoring the problem. In fact, it has taken the issue head on and is working in a new direction. Simply put, it is exiting weaker markets (such as Columbia) and putting more effort into expanding in better markets (such as Mexico). The company is also going to be following its peers by building a greater presence in the United States.
That last part is important to Scotiabank's approach because it wants to create a dominant North American bank that reaches from Mexico to Canada... and through the United States. In this way it can serve a regional trading block with a geographically integrated product. This is where Scotiabank just made a big splash.
Instead of trying to build a business from the ground up, it has agreed to buy just shy of 15% of Keycorp (KEY -1.09%). The move will take place across two transactions and it is expected to be immediately accretive to Scotiabank's earnings. Plus, it provides a lifeline to Keycorp, which needed to shore up its own finances. Basically a win/win. However, the real benefit is likely to be longer-term in nature.
Right now Scotiabank's investment is just that, an investment in another bank. However, it hopes that it can find ways to work with Keycorp to offer products and services together. Notably, Keycorp is more consumer oriented while Scotiabank is more business focused, so the two banks won't be stepping on each other's toes. Any partnership would be additive to each bank's business. There's a five-year standstill clause in the agreement, so Keycorp can't do much more than this, for now. However, it is hard not to envision Scotiabank at least considering a buyout of Keycorp at some point in the future, a move that would instantly give it a large presence in the U.S. market.
The future is going to look very different for Scotiabank
Investors should never read too far into an investment like the one Scotiabank has just made. But it is a clear statement that management intends to shift gears in a dramatic and rapid fashion as it seeks to narrow the performance gap with peers. It's going to be a multi-year effort, for sure, but with such a forceful push out of the gate from a financially strong high-yield bank, investors that think in decades and not days might want to dig in now. That fat dividend yield may not last as long as you think if Scotiabank's business starts to turn around amid an aggressive push to improve performance.
