TD Bank (TSX:TD) and Bank of Nova Scotia (TSX:BNS) are down considerably from their 2022 highs. Contrarian investors are wondering if TD stock or BNS stock is now undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.
Bank sector outlook
The Bank of Canada and the U.S. Federal Reserve raised interest rates aggressively over the past year, and more hikes are likely on the way as they try to take some momentum out of the economy and loosen up the tight jobs market. Too much demand drives up prices for products. Not enough workers and the higher cost of living leads to a surge in wages, which can push prices even higher for goods and services, leading to more demand for wage hikes. If left unchecked, the inflation spiral can get out of control.
Boosting interest rates is the preferred tool for central banks to cool off the economy. As borrowing costs surge, people and businesses spend less. This leads to fewer job vacancies, or even a jump in unemployment, which in turn reduces consumption.
Markets are concerned that the central banks will be forced to push the economy into a severe recession to get inflation back down to the target 2% rate. If rates move too high and stay elevated for too long they could trigger a wave of commercial and residential loan defaults as businesses and home owners struggle to pay the higher mortgage rates.
In Canada, household debt was already historically high before the pandemic. A surge in unemployment and meltdown in property prices would likely hit the Canadian banks due to their large portfolios of residential mortgages.
For the moment, the economy and housing market are holding up well despite the surge in interest rates. Economists widely expect a soft landing for the economy as inflation drops back to the target rate.
Based on this outlook, the drop in the share prices of TD and Bank of Nova Scotia appear overdone.
TD trades near $84 per share at the time of writing compared to $108 in early 2022. The stock is off the 12-month low around $76, but still looks cheap today.
TD has the largest capital cushion among the large Canadian banks due to its decision to abandon the US$13.4 billion takeover of First Horizon, an American regional bank. The excess funds ensure TD has the capital to ride out a downturn, but the cash hoard is so large that it is putting pressure on revenue and profit growth.
TD now plans to use the funds to expand its existing American business organically through the opening of new branches over the next few years. The bank is allocating some of the extra cash to buy back stock, and investors could see a dividend increase or a bonus dividend emerge before the end of the year. TD might also look for alternative acquisitions in different markets while bank valuations are under pressure.
Investors who buy TD stock at the current level can get a 4.5% dividend yield.
Bank of Nova Scotia
Bank of Nova Scotia trades for close to $63 per share at the time of writing, which is a new 12-month low for the stock. In the first part of 2022 BNS stock was as high at $93, so the pullback over the past 18 months has been significant.
A new CEO took control at the beginning of 2023 and the bank is now going through a strategic review of its operations. Given the lagging performance of the stock compared to its peers over the past several years, it is likely the new leadership team will make substantial changes. Investors will probably find out later this year, but pundits speculate the bank could decide to sell some of its international businesses that are heavily focused on Mexico, Peru, Chile, and Colombia.
Mexico is expected to remain part of the long-term growth strategy, but Bank of Nova Scotia might decide to exit the other three countries due to ongoing political and economic volatility. Funds from the sale of the international assets could be used to target acquisitions in other markets. Canada’s four other large banks have invested heavily in the United States in recent years.
Bank of Nova Scotia is still very profitable and the board increased the dividend when the bank reported the fiscal Q2 2023 results. This suggests the executive team is comfortable with the earnings outlook even with the current asset portfolio.
Investors who buy the dip can now get a 6.7% dividend yield from BNS stock.
Is one a better pick?
TD and Bank of Nova Scotia both pay attractive dividends that should continue to grow. Investors focused on passive income should probably go with Bank of Nova Scotia as the first choice for the high yield.
TD is probably the safer bet right now for investors who are more focused on total returns. Bank of Nova Scotia is in a transition phase, and it will be some time before investors see the results of any strategy shifts that could be on the way.
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The Motley Fool recommends Bank of Nova Scotia. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker has no position in any stock mentioned.