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The Bank of Nova Scotia Offers the Most Promise for Investors

Despite dire predictions by a number of analysts and market pundits that Canada’s housing market is in a bubble and will collapse imminently, the boom times continue to roll on. There appears to be no end in sight for Canadian’s love affair with residential property.

But in our unrelenting appetite for residential property, Canadians have taken on ever-growing mountains of debt, which is helping to fuel record profits among Canada’s Big 5 banks. Demand for credit has also been fueled by lower-than-expected unemployment and relatively stable economic growth, a boon for the banking sector.

Can Canada’s housing market continue driving bank profitability?

As mentioned, there is a growing concern among analysts that Canada’s property market is overheated. According to The Economist, Canadian housing prices in real terms have risen by 52% over the past 10 years, while prices against average incomes have risen by 29% — indicating that Canada’s residential property market is fast becoming unaffordable for lower- to middle-income families.

Of greater concern is that debt-to-disposable income of Canadian households has hit a staggering 164%. This is even higher than Australia’s 147% — and Australia is a country where households are renowned for their love affair with property and credit. That tells me that the market for credit is saturated and any significant growth in lending by Canada’s banks is becoming increasingly difficult to sustain. As such, the days of record profit growth may be behind the banking sector.

How will Canada’s banks grow profits?

A saturated mortgage market and heavily indebted Canadian households are forcing Canada’s banks to look elsewhere to identify a means of profit growth. The low-interest-rate environment being maintained by the Bank of Canada is also making it difficult for the banking sector to grow profits.

Low interest rates reduce the margins that banks are able to derive from their loans, forcing a ‘quantity over quality’ type of approach to lending just to maintain the profitability of their loan books. Obviously, this impacts profitability and incentivizes banks to take higher risks in lending.

Acquisitions, cost-cutting, and tax management are key to growing earnings

The key strategies being implemented by Canada’s banks are primarily focused on cost-cutting, tax management, and bolstering their wealth management assets through acquisitions.

In 2013, TD Bank (TSX:TD)(NYSE:TD) acquired U.S. asset manager Epoch for USD$668 million. TD hopes this acquisition will give it increased access to wealthy U.S. clients and boost earnings throughout 2014.

The positive impact of this acquisition is already evident in TD’s wealth management earnings for the full year, which popped by 15% on the back of higher fee revenue, increased trading activity, and the acquisition of Epoch.

Canada’s third-largest lender, Bank of Nova Scotia (TSX:BNS)(NYSE:BNS), acquired ING Direct in 2012 and will rebrand the unit as Tangerine in 2014. It also continued focusing on bedding down its international acquisitions.

Cost-cutting and better tax management remains king among Canada’s banks as a means of boosting profitability. However, the boost to earnings given by these strategies are known as ‘low-quality earnings’ because they don’t grow the value of the underlying business. They solely rely on squeezing every possible cent from existing earnings. Already all of Canada’s top five have flagged that they will embark on cost-cutting strategies in 2014 as means of maintaining profitability.

The Bank of Nova Scotia’s international strategy continues to stand out

However, Scotiabank is not solely reliant upon the domestic, or even North American market to build its underlying business and earnings. The bank has considerable exposure to a number of rapidly growing and under-banked emerging markets, thanks to its aggressive international acquisition strategy.

Already, international banking makes a significant contribution to its bottom line, which for the full year ending October 2013 amounted to 29% of the bank’s total net income.

For 2014, Dieter Jentsch, group head of international banking, has flagged that in 2014 the bank will focus on completing the integration of the more than 20 acquisitions it has made over the last five years. These acquisitions have given the bank a credible presence in Latin America including the high growth economies of Peru and Colombia.

A key element of this strategy is not only focusing on traditional banking products in those markets, but driving increased wealth management and insurance penetration. Coupled with an integration strategy focused on driving growth and scale in Latin America and Asia, the international business’s earnings should continue to grow.

Foolish final thoughts

It is increasingly clear a saturated domestic credit market is forcing Canada’s banks to look elsewhere to grow earnings and profits. While tax management and cost-cutting can make important contributions, it is strategies which grow the underlying business that are most important.  Click here for a look at more of the challenges and opportunities facing all of the Canadian banks.

Growing wealth management is one means of building fee revenue, but I believe that it is the Bank of Nova Scotia’s international strategy focused on emerging markets that offers the most promise for investors.

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Fool contributor Matt Smith does not own shares in any of the companies mentioned.  The Motley Fool does not own shares of any of the companies mentioned.

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