For different stocks, investors should seek different discounts for the risk they’re taking. For example, I bought units in Brookfield Renewable Partners (TSX:BEP.UN) late last year as a core position in the renewable utility sector.
It is one of the largest and most diversified renewable power companies with about US$77 billion of assets under management across major technologies. Importantly, it is well-managed and has been paying an increasing cash distribution consistently since it began trading on its own for about 13 years. For reference, its five-year cash-distribution growth rate is 5.1%.
It is also awarded an investment-grade S&P credit rating of BBB+. Because of its quality and large scale, I might seek a discount of about 20% before considering the stock.
Investors should require a bigger margin of safety from riskier stocks
Northland Power (TSX:NPI) is also a player in the renewable energy space, but it focuses primarily on wind generation. Its S&P credit rating is also one notch lower at BBB. This means it’s a riskier investment. Therefore, I require a bigger margin of safety in its valuation before I’d consider taking a position in the stock.
Recently, I started a position in Northland Power, because it became sufficiently undervalued after falling off a cliff post its earnings report earlier this month. The dividend stock has fallen more than a third from its peak in 2022!
From this level, analysts believe the stock can climb 40% over the next 12 months. Even if it took three years to hit that target, it would still be a price appreciation return of 11.9% per year. Including its 4% dividend yield in the form of monthly dividends, it would equate to annual returns of 15.9%! If this return were to materialize it would be roughly double the average long-term market returns of about 8%.
Today, investors can choose between BEP.UN that trades at a discount of about 17% or NPI that has a discount of almost 29%. The valuation discrepancy suggests that Northland Power is no doubt a riskier investment. Interestingly, BEP.UN offers a higher cash distribution yield of 4.3%.
BNS stock
The big Canadian bank stocks are generally good long-term investments. Currently, compared to its peers, Bank of Nova Scotia (TSX:BNS) trades at the biggest discount. Specifically, it trades at a discount of 23% from its long-term normal valuation.
The fact that the market prices Scotiabank stock at the largest discount suggests it may be the riskiest big Canadian bank to buy now. Indeed, because its stock price is weighed down, it offers the largest dividend yield of 6.3% after raising its quarterly dividend by 2.9%.
The bank has greater exposure to international economies compared to its peers. So, it could have greater downside, as recessionary scenarios play out. Investors could pick stocks wisely elsewhere in the sector for slightly smaller discounts and dividend yields. At the very least, BNS appears to have the ability to protect its generous dividend by having a sustainable payout ratio and a large reserve in retained earnings.
Investor takeaway
Northland Power and Bank of Nova Scotia are undervalued stocks that can boost returns from long-term price appreciation via multiples expansion if they are able to execute their growth strategies on better economic/operating conditions. Investors of the shares today could potentially get outsized returns while getting paid to wait.
Brookfield Renewable trades at a smaller discount than Northland Power. However, it provides a higher-quality portfolio and greater diversification that allows investors to sleep better at night.
