Bank stocks generally outperform during rising rate periods. However, this time it’s indeed different. Rapid rate hikes, coupled with adamant inflation, are expected to result in a recession. Already some leading economic indicators suggest an economic downturn. Canadian banks, especially the Big Six, look well-placed ahead of an impending downturn.
But if you want to prepare for one and sit out the recession with an attractive dividend-paying bank stock, which one should you pick? Let’s compare two top Canadian bank stocks – the biggest of them all, Royal Bank of Canada (TSX:RY), and the top-yielding, Bank of Nova Scotia (TSX:BNS). Royal Bank currently yields 4%, while Scotiabank yields 6.3%.
Which is a better buy: BNS or RY stock?
What matters while analyzing dividend stocks is their earnings stability and balance sheet strength. BNS and RY are stable-growing, mature businesses and have stable payout ratios. However, despite the higher yield, RY looks like a more appealing bet in the current environment.
Royal Bank is Canada’s largest bank by market cap and has a significant scale advantage. Its net income has grown by 8%, compounded annually in the last decade. The bank’s stable earnings growth makes its dividends more reliable and predictable.
Royal Bank’s credit profile and diversified revenue base play well for its steady earnings growth. RY stock’s long-term average payout ratio is around 46%, in line with the industry average. At the end of its fiscal Q1 2023 earnings, Royal Bank reported a common equity tier 1 (CET1) ratio of 12.7%, fairly higher than the regulatory requirements. The ratio indicates the bank’s ability to withstand economic shocks.
Earnings stability and asset quality
Canada’s fourth-largest bank, Scotiabank, on the other hand, has a geographically diversified earnings base. It derives 60% of its earnings from Canada and the US, while the rest comes from Latin and Central America. Its earnings have grown by 5% compounded annually in the last 10 years, and the payout ratio averages around 52%. BNS’ dividends have increased by around 8% compounded annually in the last decade, similar to Royal Bank’s. In terms of its ability to absorb shocks, BNS has a CET1 ratio of 11.5%, lower than RY and the industry average.
Note that BNS has a superior yield mainly because of its recent stock price fall. Also, its exposure to Latin American countries makes its credit profile relatively riskier. As a result, we saw higher provisions for credit losses from Scotiabank in the last few years. The disproportionate impact of the pandemic in those countries heavily weighed on BNS stock.
In comparison, RY has a more stable earnings profile, thanks to its large exposure to Canada and the US. This drives steady dividend growth and relatively lesser volatility in stock price movement. Investors can expect stable dividend growth from Royal Bank for the longer term.
RY outperforming in the long term
In the last 12 months, RY stock has returned 2%, while BNS has returned -15%. Interestingly, RY has outperformed BNS in the longer term as well. It has returned 12% compounded annually in the last decade, almost double that of BNS.
