It is difficult to find safe investments with 3%-plus dividend yields and solid growth prospects.
Many equities today are priced on the rich side of valuations resulting in lowered dividend yields. Low interest rates have made bonds a poor value for income-seeking investors.
The benefits of investing in high quality stocks with above average yields and good growth prospects – trading at fair or better prices – are well-known to long-term investors.
What if you could quickly identify an entire group of these stocks? This article takes a look at one such group the market is overlooking: the Canadian banking sector.
There are three large Canadian banks that rank as a "Buy" using The 8 Rules of Dividend Investing.
This article gives an overview of the favorable investment prospects of the Canadian banking system. It also analyzes one of the three highly ranked Canadian Banks in more detail: Toronto Dominion Bank (TD, Financial).
Why Canadian banks?
With all the banking names in the U.S., why focus on Canadian banks for potential investments? The short answer is that the Canadian banking system is recognized as No. 1 in the world for financial strength and safety, has a significantly smaller fraction of nonperforming loans than their EU and U.S. peers, and Canadian banks have historically paid outsized dividends compared to their U.S. counterparts. I covered these attributes of Canadian banks in greater detail in the first article of this series.
In addition, while Canada is not the U.S., it is also not all that different in its business culture, laws, regulations and values.
Narrowing the field
In the first article, I screened the five largest Canadian banks looking at 10-year compound annual growth rates for revenue, EBITDA, EPS, dividends paid and the most recent dividend payout ratio. That list of five includes the Bank of Montreal (BMO, Financial), the Bank of Nova Scotia (BNS, Financial), Canadian Imperial Bank of Commerce (CM, Financial), the Royal Bank of Canada (RY, Financial) and Toronto-Dominion Bank. The summary of the screening data is provided in the table below.
Source: Author
Based on that screening, I selected Bank of Nova Scotia, Royal Bank of Canada and Toronto Dominion Bank for more detailed analysis. I covered Royal Bank of Canada in detail in the first article and Bank of Nova Scotia in the second article. Today, in this last article, I’ll cover Toronto Dominion Bank.
Toronto-Dominion Bank overview
Toronto Dominion Bank is Canada’s second-largest bank by assets with a market capitalization of $83 billion in U.S. dollars, one of the top 10 banks in North America and ranked 19th globally with more than 22 million customers worldwide.
Toronto Dominion Bank is technically the youngest of the three banks in this series having been founded in 1955 via the merger of the Bank of Toronto and the Dominion Bank which were founded in 1855 and 1869.
Today, Toronto Dominion Bank offers a broad range of advice, products and services including personal and commercial banking, wealth management and private banking, corporate banking and investment banking and has a 30% interest in the TD Ameritrade retail brokerage.
Over the last 10 years, Toronto Dominion Bank has managed to achieve steady growth of its revenue, earnings per share and dividend payments while maintaining a conservative dividend payout ratio. These metrics are shown in the charts below. Readers will note that the dip in earnings per share and the spike in the dividend payout ratio was due to the impact of the 2009 financial crisis. Toronto Dominion Bank recovered its earnings per share to pre-crash levels after roughly three years.
Source: GuruFocus
Toronto Dominion Bank maintains a Common Equity Tier 1 of 10.1% (exactly the same as Royal Bank of Canada and Bank of Nova Scotia) which well exceeds the Basel III accord requirement of 6% and Toronto Dominion Bank carries an AA- credit rating from Standard and Poor’s, one notch above Bank of Nova Scotia and the same credit rating as Royal Bank of Canada.
Toronto Dominion Bank’s cash flow remains strong, and Toronto Dominion Bank recently raised its quarterly dividend to 55 cents CDN from 51 cents CDN, an increase of 7.8%, continuing its history of rewarding its shareholders.
Toronto Dominion Bank’s annual dividend yield is a respectable 3.9%. Toronto Dominion Bank has the second-highest dividend growth rate and the lowest dividend payout ratio of the three banks analyzed in this series.
The reader should note that all of the above data is based on financials reported in U.S. dollars except where noted and is therefore impacted by the exchange rate between the Canadian dollar and the U.S. dollar. As an example, the dividends per share chart above shows the annual dividend paid in U.S. dollars at $1.59 based on the current exchange rate. The annual dividend paid in Canadian dollars is $2.12 TTM.
This does have implications in understanding the charts above. While the charts show that revenue, EPS and dividends have all turned and headed south over the last several quarters, that result is true only in U.S. dollars due to the recent strength of the U.S. dollar compared to the Canadian dollar.
The bottom line is that the reader needs to factor in the impact of the exchange rate to fully appreciate the charts above and all Canadian bank financial data quoted in U.S. dollars. I was unable to find a website comparable to GuruFocus with data in Canadian currency, but I’ve included a more complete discussion on exchange rate impacts and risks in the next section of this article.
This summary investment thesis, while brief, indicates that Toronto Dominion Bank has a solid balance sheet, is growing earnings and increasing its distributions to shareholders. For a more complete picture of Toronto Dominion Bank’s financials, the reader should spend some time browsing through the most recent investor presentation.
Potential risks to investors
When someone tells you that an investment is a “sure thing,” my recommendation is that you run, not walk, to the nearest door. I’ve yet to find a “sure thing” in the roughly 30 years I’ve been investing. Investors should always look at the possible risks of any potential investment before committing their hard-earned cash.
I covered the generic risks of investing in the Canadian banking sector in detail in the first article of the series including the risk of economic downturn and the potential risk of a Canadian housing bubble collapsing. In this article, I will only cover the risks specific to Toronto Dominion Bank’s loans to the oil and gas industry and exchange rate risks.
Canadian oil producers are in no better shape than those in the U.S.
Both Royal Bank of Canada and Toronto Dominion Bank have relatively low loan exposure in the oil and gas industry with Royal Bank of Canada having about 1.6% of its outstanding loans in the oil and gas industry and Toronto Dominion Bank having less than 1% of its gross loans in the oil and gas industry. Toronto Dominion Bank’s total loans in the sector are about $6.6 billion CDN and roughly 47% of that is with firms that carry an investment grade credit rating.
Toronto Dominion Bank’s most recent investor presentation has a more detailed presentation of the bank’s oil and gas loan exposure. Readers should note that low loan exposure to the oil and gas industry is one of the primary reasons that Toronto Dominion Bank has lower dividend yield than either Royal Bank of Canada or Bank of Nova Scotia. The market has judged that Toronto Dominion Bank’s oil and gas loan risk is small.
The second potential risk I’ll cover is the exchange rate risk. Today, the Canadian dollar is weak compared to the U.S. dollar. This has had a couple of impacts that should be considered by U.S. investors looking to invest in Canadian companies. Canadian companies pay dividends in Canadian dollars. The strong U.S. dollar has made those Canadian dividends worth less to us on the southern side of the border.
However, the strong dollar has also lowered the share price of Canadian companies for U.S. investors. Today, our strong U.S. dollar buys us more equity or shares of Canadian companies. So is this a risk or a benefit?
If a U.S. investor bought shares of Toronto Dominion Bank today and the U.S. dollar continued to strengthen relative to the Canadian dollar, the dividends paid in Canadian dollars would be worth less and the principal value of the investment could also drop.
However, if the Canadian dollar strengthens relative to the U.S. dollar, those Canadian dollar denominated dividends will be worth more and the price of the equity would likely rise in U.S. dollar terms. To take a look at a graphical representation of this I’ve included a chart below.
Source: Author
From this chart one can see the impact of the strong dollar on the value of the dividends paid to U.S. investors. While Toronto Dominion Bank has continued to increase dividends paid out in Canadian dollars (the red bars), the value to U.S. investors (the green bars) has not kept up and actually fell in 2014 and 2015.
This is due to the strong U.S. dollar and the current exchange rate where $1 Canadian is worth only about 78.5 cents U.S. Those U.S. investors who bought into Toronto Dominion Bank in 2014 are probably not pleased with the impact from the strong U.S. dollar as the value of their investment is down in U.S. dollars.
However, for those U.S. investors who are considering an investment today, the reward potential has improved due to the rise in the value of the U.S. dollar. Today, U.S. dollars buy more of Toronto Dominion Bank than they did in 2014 and a lot more than they did in 2012. The U.S. dollar strength relative to the Canadian dollar has been higher in the past 10 years but not by much.
The chart below shows the value of the Canadian dollar versus the U.S. dollar over the last 10 years. While the dollar has fallen in the last couple of months we are still close to a 10-year peak in the value of the U.S. dollar versus the Canadian dollar.
Source: XE.COM
The question each investor has to answer to determine if the exchange rate issue is a risk or a benefit is "Which way will future exchange rates go?"
As a result of the U.S. Federal Reserve Open Market Committee finally figuring out that the global and U.S. economies, while growing, are not sufficiently robust to warrant a series of interest rate increases, the U.S. dollar valuation against the Canadian dollar has recently dropped. In the longer term, as the Canadian economy strengthens, the Canadian dollar will strengthen relative to the greenback. So, long term, the exchange rate will work in my favor as a U.S. investor in Toronto Dominion Bank.
As with most financial ratios and metrics, it is likely the U.S. dollar/Canadian dollar exchange rate reverts toward its mean value.
Final thoughts
The Canadian banking sector is strong, healthy, and conservatively managed. Of the big five Canadian banks, Toronto Dominion Bank stands out as having strong investment potential and a low risk of impact from oil and gas sector loans.
Toronto Dominion Bank has shown the ability to grow revenue, EPS and dividend payments while maintaining a payout ratio lower than its four peers.
While past performance is not a guarantee of future performance, it is a good indication that the company is being managed well.
Toronto Dominion Bank ranks highly using The 8 Rules of Dividend Investing thanks to its solid growth prospects, high dividend yield. and reasonable payout ratio.
Finally, the potential risks of investment in Toronto Dominion Bank are low and, at least in the longer term, the exchange rate will work in favor of U.S. investors.
(Published June 16 by Dirk S. Leach)
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