Scotia’s $3 million accelerated return notes on bank ETF offer value, margin of safety

By Emma Trincal

New York, Sept. 11 – Bank of Nova Scotia’s $3 million of 0% Accelerated Return Notes due Nov. 12, 2021 linked to the SPDR S&P Bank ETF offer attractive gains not just due to the upside leverage but also because the underlying fund is undervalued, making the investment attractive for a short-term contrarian play, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par of $10 plus triple any fund gain, up to a maximum return of 30%. Investors will be exposed to any fund decline, according to a 424B2 filing with the Securities and Exchange Commission.

Leverage

The combination of a short tenor and an undervalued underlying increased the odds of a positive outcome for investors.

“It’s already a relatively unpopular sector so it reduces the probabilities of too much of a drop. It’s not out of the question. But the risks are limited despite the lack of downside protection,” he said.

Kaplan said he also liked the potential return.

“They’re giving you a generous cap on the upside. The leverage is high enough to give you a decent return even if the ETF is not moving up much,” he said.

Inflation

Kaplan believes a bear market has already started. But he does not see its full impact unfolding over the short-term investment time frame.

“I think the 14 months period is reasonable,” he said.

A lot of it had to do with the sector pick.

“A bet on tech stocks would be a totally different story. But banks are still cheap right now,” he noted.

Moreover, banks’ earnings may benefit from some macroeconomic conditions.

“Fourteen months should be enough time for inflation to pick up. If prices are up, banks will generate more profits. That’s how banks make money. They lend money. If the rates are higher, they make more.

“People think inflation will not come back, that it’s a thing of the past. It’s not probably the case.

“I think the rate of inflation will increase in 2021, and that should support banks.”

Resilience of the laggards

But banks also present an attractive value play, which could pay off even in the midst of a bear market.

“The collapse of the tech stocks is going to be the big story and it will drag other sectors. The Nasdaq is overvalued. It will drop a lot. But it won’t happen overnight. We already had a big sell-off and the market has regained some strength,” he said.

Meanwhile and before a full-blown bear market, banks could do well, he noted.

“It’s not uncommon during bear markets to see a sector plunging while others do quite well. In 2000 when the Nasdaq crashed, some undervalued areas of the economy did go up. Value shares did well at the end of the two-year bear market. Ship builders did well... shipping companies, energy, mining companies did well... emerging markets finished positive.”

Some sectors continue to offer bargains today, he noted, although not so many.

“Banks are one of them,” he said.

14-months

It should also take some time for the bear market to fully destroy value across various areas of the economy, he noted.

Even if the average length of a bear market is below two years, Kaplan does not foresee a mild bear market neither in time nor in magnitude given the length and strength of the bull cycle.

“While 14 months from now, the most ridiculously overpriced sectors will be down a lot, think Microsoft, Amazon and Tesla, the worst of the bear market won’t have totally run its course yet. There will still be a long way to go. If you are in in an undervalued sector, this is not a bad time to take that kind of leveraged bet,” he said.

Regionals are even better

Kaplan however would have preferred a bet on a sister fund, which tracks the returns of regional banks – the SPDR S&P Regional Banking ETF.

“Regional bank trade at lower valuations. They’re even more unpopular, and more insiders are buying them, which is good if you are a contrarian investor,” he said.

Insiders are buying shares of bigger banks too but not to the same extent, he added.

There may be more insider activity with smaller banks simply because they’re more in touch with their local communities.

“If I had the choice, I would pick the regional bank ETF,” he said.

Slow recovery

Overall, though, all bank stocks are relatively unpopular, he said.

“People have been dumping bank stocks based on this idea that rates have been low for a very long time and will continue to be low forever. I think it’s a big mistake.

“Short-term U.S. rates have dropped but that’s not to say long rates won’t rise,” he said.

Another factor weighing on bank stocks is the anticipation and often the realization that business activity is going to contract due to the pandemic.

Banks took large provisions for loan losses in the first half of the year.

As a result, shares of bank stocks have dropped more deeply than the broader market.

The SPDR S&P Bank ETF shed 34.6% for the year. It has only regained 3.75% of its value from its low of March 23.

Meanwhile, the S&P 500 index has surged 52.5% since March 23. It is now up 3.4% year to date.

“As much as tech is overpriced, the bank sell-off is overdone,” he said.

“14 months is plenty of time for the sector to recover.”

The trade could be replicated with options through the simultaneous purchase and sale of calls at different strike prices, he said.

“But it’s never easy for retail investors.

“This product gives you a chance to make money if the sector recovers, which I think it will,” he said.

BofA Securities, Inc. is the underwriter.

The notes settled on Sept. 11.

The Cusip number is 06417R419.

The fee is 1.25%.

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