According to recent data, as of April 15, a staggering 45.1 million shares of Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) have been sold short. This means investors are betting against the bank and, based on the number of shares sold short, BNS is currently the fourth most-shorted equity on the TSX and the second most-shorted bank (behind TD Bank).
This pessimism around BNS is also reflected in the valuation of the shares. Over the past 10 years, BNS has had a forward price-to-earnings ratio that was consistently about 3% above its peer group of Canadian banks. Now, that premium has evaporated, and BNS currently sits at about a 2.8% discount to its peer group average with a price-to-earnings ratio of 10.8 (based on estimated 2016 earnings). The big question is, why are investors so pessimistic on BNS?
BNS has fairly heavy oil exposure
The most obvious reason to be pessimistic about BNS is due to its relatively heavy oil exposure as well as its exposure to Alberta. How much oil exposure does BNS have? Currently, about 3.6% of BNS’s total loans are oil and gas loans, and this amounts to about $17.9 billion (with an additional $14.1 billion of undrawn exposure). BNS’s overall peer group has about 2% exposure to the sector; TD Bank only has 1% exposure.
As a percentage of tier 1 capital (or the portion of total assets that are actually are actually owned by the bank), BNS’s oil and gas loans are 44%, well above the peer group average of 26.3%.
It is also important to look at exposure to consumer loans (like mortgages, HELOC’s, and auto loans) in the province of Alberta. The effect of oil exposure is not only felt through direct weakness in oil and gas loan books, but also through rising unemployment rates.
Currently, BNS has about 21% of its Canadian loans in Alberta and the Prairie provinces, which is above its peer group average of about 18%.
Should investors be concerned?
Oil and gas loans as a percentage of total loans and tier 1 capital, as well as Albertan exposure as a percentage of total loans is high for BNS compared with its peer group. But does this mean BNS’s risk is higher? Not necessarily.
Looking at BNS’s consumer exposure to Alberta, 59% of those mortgages are insured, with the uninsured mortgages having a very low loan-to-value ratio of 53%. This means over half of BNS’s mortgages are protected, and the unprotected mortgages are worth slightly more than half of the value of the underlying home on average.
The bank indicated it has about $2.5 billion in unsecured lending in Alberta (like credit cards and lines of credit), but this balance is less than 1% of Canadian retail loans, making it fairly insignificant.
Moving over to commercial lending to oil and gas companies, while BNS does have higher exposure than its peers, its credit quality is doing well. The bank had $336 million of impaired oil and gas loans, which is only 1.9% of the bank’s oil and gas loan book. This is actually better than most of BNS’s peers, with the exception of TD Bank.
The bank indicated that its risk is fairly low due to the fact that most of its oil and gas exposure is investment grade (60% of drawn exposure and 75% of undrawn). For the non-investment grade portion, BNS stated that it is confident in the quality of its loan book due to the fact that it does not do subordinate lending.
This means the bank is the senior lender in the capital structure of the businesses it lends to, which also means that in the event of default, the bank would have to be paid in full before other lenders.
Overall—and especially given that oil prices are recovering—this means that any worry about BNS and oil exposure is mostly unnecessary.
