These 2 Foreign Dividend Stocks Offer Good Risk-Adjusted Returns

With the CAPE ratio of the S&P 500 back up over 30x as the market tries to touch all time highs, I’m finding fewer attractively-priced stocks over this past month. Consequently, I’m building up cash levels.

However, there are always some great stocks lying around that aren’t bidding up quite like others are. Lately, many of these bargains are outside of the United States, because in this globally slowing environment, everyone seems to want to be in U.S. stocks regardless of valuations.

While these aren’t some of my more explosive ideas, I find these two stocks to be attractive picks at the current time for good long-term risk-adjusted returns and reasonably high dividends that pay you while you wait.

The dividend stock segment of my real-money newsletter model portfolio has outperformed the Vanguard Total U.S. Stock Market ETF (VTI) by about 15% since inception a little over 6 months ago, and I’m adding these names and a few others this week.

Stock #1) Bank of Nova Scotia (BNS)

The Canadian housing market has grown to very high valuations over the past decade, fueled in part by Chinese buyers. This chart from the St. Louis Fed shows U.S. real estate prices (red) vs Canadian real estate prices (blue), indexed to a shared baseline in 1995:

As you can see, the U.S. housing market got ahead in 2007 during the subprime bubble and then blew up to the downside. Canadian banks were much better-managed, and the Canadian housing market has had a more gradual climb ever-higher.

But lately it’s showing signs of cracking for a variety of reasons, and Canadian real estate prices have fallen for six consecutive months. Lower oil prices and pipeline opposition have put pressure on the large Canadian energy sector. Trade pressure and internal deleveraging have put pressure on Chinese investors to slow down foreign buying. Various layers in the Canadian government have also taken measures to purposely cool the housing market, especially in Vancouver and Toronto, as the prices have been considered to be unsustainable. 

So what are investors to do? Sell the Canadian banks, right?

In the short term, perhaps. Long-term, this dip is likely another buying opportunity. Additionally, not all Canadian banks are equal. I'm not a fan of banks with most of their exposure to the Canadian housing market, but I'm a fan of some of the others. 

My favorite at the current time is Bank of Nova Scotia. They only get half of their earnings from Canada, only a portion of that is tied to the housing market, and only a portion of that portion is actually at risk. The rest of their earnings come from abroad, especially from South America where the bank has increased market share in recent years.

Source: BNS 1Q2019 Presentation

Canadian banks have been among the best performers in the world. Bank of Nova Scotia in particular has been very well run with 15% average return on equity (ROE), although it hasn’t kept up in recent years because it has less exposure to the Canadian housing market than many of its peers. That was bad when the housing market was booming, but it’s good now that the housing market is weakening. 

Source: BNS 1Q2019 Presentation

Over the past two decades, the stock price of Bank of Nova Scotia crashed three times even as its fundamentals weakened only modestly. The first was in 2008 during the global financial crisis. The second was in 2015 during the collapse in energy prices. The third is currently as worldwide economic growth slows and Canada’s housing market comes under pressure.

Source: F.A.S.T. Graphs (black line = stock price, blue line = average valuation)

The other two times were good buying opportunities and I think this one is as well. The P/E ratio is 10, the dividend yield is just under 5%, and the bank targets 7% annual earnings growth.

If in 2-3 years the fundamentals remain sound and the stock returns to its normal P/E ratio of closer to 12, while paying out solid dividends, then total returns could be 40-50% or more. That’s a bullish case.

A worse case is that Canadian housing fundamentals fall apart more than expected, South America slows down as well, and the stock’s P/E drops further to 9x like it did in 2015 or 7x like it did in 2008. In that case, investors would be in for a bumpy ride but I’d likely be looking to increase my position.

Overall, I consider Bank of Nova Scotia stock to be an above-average stock pick at the current time for patient investors with a 5-year time horizon. However, investors would be prudent to leave some room in their position size in case an opportunity to add at crisis-level valuations comes for a third time. 

Stock #2) Unilever PLC (UL)

Investors that have followed my work for a while know that I’m not a big fan of most consumer staples companies. Few of them offer the returns I expect from investing in individual stocks compared to simply buying an index, and I’ve been aware for a while now that many of their brands are weakening faster among younger buyers than some analysts seem to realize, including Warren Buffett in this case.  

When you go to a physical store, big brands dominate the shelves and consumers just buy what they are familiar with. This formula has worked well for a century. But when you shop online, these big brands command less digital "space" compared to upstart competitors, and buyers can instead peruse products based on reviews, ingredients, etc. 

I’ve avoided Kraft, Procter and Gamble, Coca Cola, Pepsico, and other similar stocks. I was particularly critical of Coca Cola in an article in 2017 called, “Sugar is the New Tobacco: Coca Cola Faces Headwinds” and explained the hurdles against the company as it keeps trying to reformulate its products and expand into low-sugar and no-sugar products. The stock has since underperformed the S&P 500.  

But, I’m buying Unilever for a small part of my portfolio. Unilever is a UK and Dutch company with numerous brands ranging from Dove to Ben & Jerry’s. I want a bit more diversification away from my overweight sectors, and this is my consumer staples company of choice for a couple of reasons.

One reason is that it consistently generates higher returns on invested capital (ROIC) than American competitor Procter and Gamble. Unilever’s ROIC has been between 17% and 27% every single year over the past ten years while Procter and Gamble has shuffled around with a respectable-but-not-exciting 7-17% range for that metric.

It’s no surprise that Unilever stock has outperformed Procter and Gamble stock over the long-term:

Despite this, Unilever currently trades at a 15% discount to Procter and Gamble along with a 15% higher dividend yield (over 3% in Unilever’s case) and a similarly strong balance sheet. Why? Because Unilever is not an American stock and so there’s less capital in index funds propping up its price, and there’s the ongoing specter of Brexit hanging over it.

Secondly, Unilever has huge emerging markets exposure:

Source: UL 4Q2018 Presentation

Unilever is not strongly tied to the fate of the UK/European economy. It has great exposure to places with stronger demographics and faster growth. Some people see this as a risk but I view it primarily as long-term opportunity for continued growth.

I’m willing to add a small exposure to this defensive name at today’s prices and consider it fairly valued:  

Source: F.A.S.T. Graphs (black line = stock price, blue line = average valuation)

I’m long BNS and UL.