Has This High Yield Stock Just Changed The Playing Field?

The average bank has a dividend yield of about 2.5%, using SPDR S&P Bank ETF (NYSEMKT:KBE) as an industry proxy. What if you could own a bank with a 6.1% yield? What if it was conservatively managed, had a strong underlying business, and was a reliable dividend payer? You would probably jump at the chance to own such a high-yield bank. No problem — you can buy Bank of Nova Scotia (NBS -0.26%). Here’s why now is a great time to make the leap.

Why is Bank of Nova Scotia’s yield so high?

Bank of Nova Scotia, more commonly known as Scotiabank, has lagged behind other banks. A large part of the reason for this is that it went in a different strategic direction than the banks in Canada. Most of the big Canadian banks have chosen to expand south into the US market. Scotiabank moved beyond the US and began building a business in Central and South America.

Image source: Getty Images.

The logic is sound, given that the US is a highly competitive market that is also fully developed. The markets that Scotiabank went into were developing and less competitive, suggesting long-term growth potential. While this may have been true, and perhaps still is, these less developed markets were not as profitable as hoped. Scotiabank lagged its peers on key metrics such as earnings growth, return on equity and return on risk-adjusted assets.

Thus, despite being one of Canada’s largest banks (with an entrenched position in the industry due to strict Canadian banking regulations), Scotiabank offers a dividend yield of 6.1%, more than twice the yield of the average bank. The bank has paid a dividend every year since 1833, has a generally conservative ethos (another feature of being a Canadian bank), and has an investment-grade balance sheet. Indeed, the risk here seems quite modest for the high-yield reward.

What is Scotiabank doing about its lagging performance?

Of course, the problem for investors is that Scotiabank hasn’t performed particularly well compared to peers. But management is not ignoring the problem. In fact, he has taken the problem and is working in a new direction. It exits weaker markets (like Colombia) and puts more effort into expanding into better markets (like Mexico). The company is also following its peers by building a larger presence in the United States.

That last part is important to Scotiabank’s approach, as it wants to create a dominant North American bank that reaches from Mexico to Canada and across 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 scratch, he agreed to buy just 15% of the KeyCorp (KEY -3.33%). The move will come in two deals and is expected to be immediately accretive to Scotiabank’s earnings. In addition, it provides a lifeline to KeyCorp, which was supposed to support its own finances. This is basically a win/win. However, the real benefit is likely to be of a longer-term nature.

Now the Scotiabank investment is just that, an investment in another bank. However, it hopes it can find ways to work with KeyCorp to offer products and services together. In particular, KeyCorp is more consumer-oriented, while Scotiabank is more business-focused, so the two banks won’t be stepping on each other’s heels. Any partnership would be additive to each bank’s business.

There’s a five-year standstill clause in the deal, so KeyCorp can’t do much more than that, for now. Still, it’s hard not to imagine Scotiabank considering buying KeyCorp at some point in the future — a move that would instantly give it a big presence in the US market.

The future will look very different for Scotiabank

Investors should never read too much into an investment like the one Scotiabank just made. But it’s a clear statement that management plans to shift gears dramatically and quickly as it tries to close the performance gap with peers. It will be a multi-year effort, for sure. But with such a strong push from a high-yielding, financially strong bank, investors who think in decades rather than 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.