Income Investing: Why Canada?

The basic outline of the long-term Canadian investment story–from an American perspective, although much of what follows is of a “good for the Yank, good for the Canuck” variety–is as follows.

Emerging markets, led by China and India, are consuming more and more resources as their respective middle-class populations expand.

Canada has a lot of the stuff that these countries, and others, need to accommodate new appetites for food, but also to build more urban housing, to provide better transportation infrastructure and to keep it all powered up.

A combination of established, reliable public and private institutions has shepherded Canada’s resource wealth in a manner that benefits the whole country while at the same time recognizing the entrepreneurial vigor required to properly exploit it.

Amid a tumultuous reordering of global economic leadership, relatively stable government and a recent history of prudent fiscal and monetary policy make Canada a safe harbor for American investors concerned about the direction of the US dollar.

There are many ways for income investors–investors of all stripes, for that matter, who are interested in building wealth–to get exposure to the Canadian story. We cover more than 120 in Canadian Edge, including high-yield, high-risk commodity plays as well as solid, reliable real estate investment trusts whose returns and prospects shame their American counterparts.

Canada is a veritable crossroads in this structural shift in the global economy. It will continue to benefit from what is and should remain, for the next decade, the biggest bilateral trade relationship in the world, its dealings with the US. And it will enjoy new demand from emerging markets that will reduce its reliance on its southern neighbor. It features emergent characteristics–such as high export potential for critical resources–along with developed institutions.

The Mexican Connection

Canada’s financial system is widely recognized as among the soundest in the world. Income investing is about dividend payment and growth that carries share prices higher. This requires stability and predictability as well as realistic pursuit of opportunities to grow the underlying business. A lot of Canadian dividend-payers deserve recognition for their ability to live up to such standards operationally and financially.

Chief among the institutions that comprise Canada’s now notorious financial system is one bank that’s taking lessons learned building a solid franchise at home into emerging markets in Asia and in Latin America.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS), the third-largest of Canada’s Big Six banks reported solid numbers from its Mexico unit in April. Scotiabank is unique among its Big Six peers in that its international expansion strategy focues on emerging markets in Latin America and South Asia rather than the US, where Toronto-Dominion Bank (TSX: TD, NYSE: TD), which after the merger of its TD Banknorth and Commerce Bank units now has more branches south of the border than in Canada, Royal Bank of Canada (TSX: RY, NYSE: RY), via a large presence in the Southeast, and Bank of Montreal (TSX: BMO, NYSE: BMO), through its Chicago-area Harris Bank operation, have established large retail footprints.

Although from time to time we’ve had “buy” recommendations on the whole group, in Canadian Edge we’ve consistently favored Scotiabank among the Big Six because of its emerging-market exposure. If nothing else, Scotiabank isn’t exposed to still-unwinding US subprime mortgage fiasco that continues to impair performance for its America-centric Canadian peers.

Meanwhile, demand for mortgages and commercial loans are increasing in Mexico along with a recovering local economy. The Mexican government reported Thursday that gross domestic product grew at an annualized rate of 4.6 percent in the first quarter, up from 4.4 percent in the fourth quarter of 2010. Although analysts anticipated 5 percent growth, it was the seventh consecutive positive quarter, a solid stretch after the Mexican economy contracted by 6.1 percent during the global recession.

Fiscal and monetary stimulus in the US has led to increased demand for Mexican exports. Meanwhile, an improving employment situation has at the same time triggered domestic demand. The Mexican peso, along with many currencies, has surged more than 5 percent against the US dollar in 2011, and that, too, has stimulated consumers and companies.

Grupo Financiero Scotiabank Inverlat is seeing more mortgage and commercial loan applications; the unit forecast lending growth at least double the rate of Mexico’s gross domestic product growth in 2011.

Scotiabank’s 710 locations and outstanding loans of 110.4 billion pesos (USD9.4 billion)–5 percent of the market total–make it the seventh-largest in Mexico. The growth plan focuses on the country’s “under-banked” population. To attract more deposits and engagement of bill-paying services Grupo Financiero has negotiated arrangements to put mini-branches in 1,600 stores all over the country; the ultimate goal is to establish 10,000. Also under consideration is a plan to enable customers to transact via mobile phones. Mexican regulators are currently considering such technology and should approve soon.

Scotiabank reported in April that first-quarter profit from Grupo Financiero improved by 7.1 percent over the same period in 2010 to CAD75 million. Higher net interest income and lower provisions for bad loans were the primary factors in the better performance. The parent will report an CAD84 million quarterly profit when it submits fiscal second-quarter numbers and hosts a conference call to discuss same on May 31.

After boosting its dividend by 6.1 percent at the time it announced fiscal 2011 first-quarter results in March, Scotiabank now pays CAD0.52 per share per quarter. That’s a 3.6 percent yield as of Friday’s intraday trade. It’s a great way for risk-averse income investors to establish some exposure to emerging markets, while backing that risk with solid domestic retail banking operations. Deposit growth at local branches, after all, is the foundation of a healthy bank.

A good foundation in Canada and an innovative approach to international expansion set Bank of Nova Scotia apart from the rest of the Big Six.