Canada's Best Dividend Growth Stocks for 2017 (and Beyond)

(This is a guest contribution from The Financial Canadian.)

Throughout this post I will be providing investment research. However, this research is not valid without the assumption that readers will be investing with a long-term horizon (meaning a minimum of three years).

“The single greatest edge an investor can have is a long-term orientation.” – Seth Klarman (Trades, Portfolio)

Long-term systematic investing is extremely important. Investors can lose out on outstanding long-term returns by trading too often. With a short-term horizon, we are subject to the whims of the market and investor psychology.

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” – Benjamin Graham

Over the long run, however, better businesses outperform the overall market. This is especially true in the world of dividend growth investing. Reinvesting those dividend payments results in a snowball of compound earnings that can eventually grow into a substantial passive income.

This is not possible with a short-term horizon so keep that in mind as you read the rest of this post.

Criteria

This post is titled “Canada's Best Dividend Growth Stocks for 2017 (and Beyond).”

The word “best” is ambiguous by nature so before continuing I wanted to define the criteria by which I would be judging these stocks. Longtime Sure Dividend readers will notice that my criteria are similar to the Eight Rules of Dividend Investing. This is no coincidence. I selected these stocks by looking for:

1. High dividend yield.
2. Low payout ratios.
3. Strong history of dividend growth.
4. Attractive valuations based on price-earnings (P/E) and price-book (P/B) ratios.
5. Wide economic moat and strong competitive advantage.

Note that none of these criteria are completely stiff. If a stock is lacking in one category, this may be compensated for with fantastic performance in another.

Let’s dig into the first stock.

Toronto-Dominion Bank

The Toronto-Dominion Bank (TD, Financial) is a diversified financial services provider with operations in both Canada and the U.S. From its website, the business is divided into three main segments:

• Canadian Retail including TD Canada Trust, Business Banking, TD Auto Finance (Canada), TD Wealth (Canada),TD Direct Investing and TD Insurance.
• U.S. Retail including TD Bank, America’s Most Convenient Bank, TD Auto Finance (U.S.), TD Wealth (U.S.) and TD’s investment in TD Ameritrade.
• Wholesale Banking including TD Securities.

Toronto-Dominion Bank has a pleasant blend of both organic growth and growth through acquisition. Organically Toronto-Dominion Bank continues to mature in the Canadian markets, being the largest bank by assets and the second-largest bank by market capitalization (behind Royal Bank of Canada). Its acquisitions are predominantly in the U.S. Retail segment and include the privatization of TD Banknorth, Commerce Bank N.A. and The South Financial Group Inc. to form TD Bank N.A.

Key stats

• P/E ratio: 13.11.
• P/B ratio: 1.628.
• Dividend yield: 3.78%.
• Payout ratio: 43.16%.

In my recent analysis of the financial performance of the “Big Five” Canadian banks over the past three fiscal years, the Toronto-Dominion Bank came out on top. I was encouraged to read that Sure Dividend is a supporter of this bank as well, as Ben detailed in his Sept. 7 post “Why TD Bank Is a Buy at Current Prices.” Let’s dig into why we both like this stock.

Investment thesis

A safe, growing dividend

First of all, in recent history Toronto-Dominion Bank has had the best dividend growth among its peer group. More importantly, its payout ratio has been among the best in its peer group. In 2015, only the Canadian Imperial Bank of Commerce had a lower payout ratio than Toronto-Dominion Bank. Take a look at the data:

This low payout ratio means that Toronto-Dominion Bank has plenty of room to grow its dividend. It also means that it might have sources to reinvest its money at high rates of return. The U.S. Retail Banking segment comes to mind.

A world-class management team

Toronto-Dominion Bank’s senior management team has gone through two serious changes in the past few years.

First and foremost, Bharat Masrani succeeded Ed Clark as the president and CEO of Toronto-Dominion Bank effective Nov. 1, 2014. This means that the 2015 fiscal year was Masrani’s first full year as CEO. Though he is new as CEO, Masrani is no newcomer to the bank. After joining the bank in 1987, he most recently served as the head of its U.S. Retail Banking segment and the bank’s chief operating officer. The bank’s performance was fantastic during Masrani’s first full year at the helm as the bank set a record for adjusted earnings.

The second major change was a shakeup at the executive suite of Toronto-Dominion Bank, which reflects a focus on technology. These changes were announced in November of last year and were highlighted by the departure of Tim Hockey, the former head of Toronto-Dominion Bank’s Canadian Retail operations. Hockey has assumed the role of president and CEO of TD Ameritrade, in which TD has a 40% ownership interest. There were a few other changes, which are outlined in this helpful article from Newswire.

Both changes are positive. Toronto-Dominion Bank’s management team remains one of the best in the business.

A strong economic moat

In Canada, banks enjoy some of the largest barriers to entry of any industry. The banking industry is dominated by the “Big Five” – Toronto-Dominion Bank, the Royal Bank of Canada (RY, Financial), the Canadian Imperial Bank of Commerce (CM, Financial), the Bank of Nova Scotia (BNS, Financial) and the Bank of Montreal (BMO).

In the U.S., there are many more smaller competitors, but barriers to entry are still significant. The U.S. barriers to entry are regulatory in nature, not due to an oligopoly as in Canada.

In some senses it is advantageous that there exist smaller counterparties in U.S. banking, as this presents acquisition opportunities for the bank (more on that later).

Fantastic growth prospects in U.S. banking

Toronto-Dominion Bank’s presence in the U.S. was initiated with its purchase of Banknorth Group Inc. in 2005, which it successfully privatized in 2007. It later purchased Commerce Bancorp and a slew of Florida banks until its operations ran across the entire Eastern seaboard of the U.S. Fast forward to today, and it now has more U.S. branches than it does in Canada.

At the present, there is tremendous opportunity for growth in the U.S. retail bank for Toronto-Dominion Bank. Since it has been progressing through a combination of acquisitions and organic growth, the bank’s penetration in its U.S. business is not at the level of the Canadian counterpart. In an interview with the Financial Post, the bank’s CEO said:

“We’re not as mature in our U.S. business as we might be in Canada so just penetrating basic banking products for our customers would be huge progress.” – Bharat Masrani

I’m excited to see how Toronto-Dominion Bank is able to maximize the potential of its U.S. operations.

Attractive value relative to market

The last point I’ll make about Toronto-Dominion Bank is on the topic of its valuation.

In terms of the bank’s book value, it is attractively priced compared to its peers. Its P/B value is the second lowest in the Big Five, behind only Bank of Montreal.

This P/B valuation combined with the fact that Toronto-Dominion Bank is the largest Canadian bank by assets means this valuation is promising.

Based on earnings, though, the valuation story is different. Toronto-Dominion Bank actually has the highest P/E multiple among the Big Five.

Source: Google Finance

Toronto-Dominion Bank is preferred over the rest of the Big Five by many investors, and that demand explains the valuation premium. There are three main reasons why.

First of all, Toronto-Dominion Bank derives a large portion of its earnings from its stable Canadian Retail Banking segment. In fiscal year 2015, only 9% of its earnings came from the more volatile Wholesale Banking segment:

Source: TD Bank 2015 Annual Report

Other banks derive a larger portion of their earnings from more volatile segments like capital markets. Investors are willing to pay a little extra for the lower earnings volatility that comes with such a high concentration in retail banking. This explains part of Toronto-Dominion Bank’s valuation premium.

Second, Toronto-Dominion Bank has a lower portion of its loan portfolio exposed to the oil and gas industry compared to the other Canadian banks. As of July 31 Toronto-Dominion Bank had $4.1 billion of drawn credit exposure to the energy sector, which represents less than 1% of the bank’s overall loan portfolio; $1.4 billion of this credit was to investment-grade borrowers, and the remaining $2.7 billion was to noninvestment-grade borrowers. Comparing this to Royal Bank of Canada, Toronto-Dominion Bank’s main competitor, who has $7 billion of drawn oil and gas exposure, and it’s easier to get comfortable with Toronto-Dominion Bank’s exposure to the oil and gas industry.

Third, Toronto-Dominion Bank investors are willing to pay a growth premium due to the bank’s successful entry into the U.S. banking industry. As I’ve mentioned before, Toronto-Dominion Bank now has more branches south of the border than in Canada. The bank’s earnings growth in the U.S. is also encouraging. In the third quarter:

• Canadian Retail net income was $1.5 billion, down from $1.6 billion one year ago.
• U.S. Retail net income was $788 million, up from $674 million one year ago.

Source: TD Q3 Report to Shareholders

Toronto-Dominion Bank’s Canadian Retail segment had a tough quarter due to the insurance claims from the Fort MacMurray wildfires in Alberta, but this was more than made up for from growth in its U.S. Retail bank.

Altogether, Toronto-Dominion Bank is a fantastic dividend growth prospect.

Enbridge

Enbridge (ENB, Financial) is an energy transportation company based in Calgary, Alberta. It is in the business of transporting energy across North America – this includes crude oil, liquid hydrocarbons and natural gas. Enbridge owns Canada’s largest network of natural gas.

While Enbridge operates in the broader energy industry, it has been largely isolated from the downturn in energy prices due to the nature of the business it is in. It also has fantastic dividend growth prospects.

Key Sstats

• P/E ratio: 42.16.
• P/B ratio: 3.854.
• Dividend yield: 3.68%.
• Payout ratio: 85%.

Investment thesis

Strong future growth prospects complemented by Spectra purchaseÂ

Enbridge has been popular in the media lately because of its decision to purchase Spectra Energy Corp. (SE, Financial). Both shares of Enbridge and shares of Spectra jumped at the news, which signals that investors were pleased.

I’ll dive into the details after, but first – this does an exceptional job of displaying the potential benefits of the purchase:

Source: Enbridge Investor Document

The purchase of Spectra will turn pro-forma Enbridge into Canada’s fourth-largest publicly traded corporation by market capitalization:

Source: Enbridge Investor Document

The purchase of Spectra will create an energy transporation giant that moves natural resources across North America. It will have a fantastic competitive advantage, and synergies after the purchase should result in significant savings for the pro-forma company.

The Spectra purchase affects many of the other points of my investment thesis so that’s all I’ll write about it here.

A safe and growing dividend

Enbridge has a fantastic history of growing its dividend over time. The growth of its dividend from 35 cents in 2001 to $1.86 in 2015 represents a cumulative annualized growth rate (CAGR) of 12.6%.

Source: Enbridge Investor Document

A dividend growth rate of 12.6% is fantastic – and Enbridge is poised to continue this growth in the years ahead.

One of the highlights of the proposed Spectra purchase is the impact on dividend. Enbridge management is promising an immediate 15% dividend increase when the deal closes (expected to be in the first quarter of next year) and a further 10% to 12% annual dividend growth through 2024. In the best-case scenario, a 15% dividend increase followed by seven years of 12% dividend increases will grow the annual Enbridge dividend to $5.39 in 2024:

Source: Enbridge Investor Document

Source: Enbridge Investor Document

And since dividend yield plus dividend growth is a good proxy for total return expectations (according to Morningstar), then if the Spectra deal is closed, investors should be able to expect total returns from Enbridge exceeding 15% (yield of >3% plus growth of 12%). That being said, there are a lot of variables at play here – most notably whether the Spectra deal will actually close. Only time will tell.

I’ve spoken a lot here about dividend growth prospects – but the subhead says “A safe and growing dividend.” So what about the safety of Enbridge’s dividend?

Let’s consider its payout ratio. Enbridge reported earnings on July 29 for the six-month period ending June 30 with adjusted earnings per share of $1.25 for the first half of the year. To that point, Enbridge paid two dividends of 53 cents each for a total of $1.06. This means that for the first half of this year, Enbridge has a payout ratio of 85%. Looking over the fiscal year 2015, the dividend payout ratio was identical at 85%, with $1.86 of dividends per share and $2.20 of adjusted earnings per share.

While this is much higher than I would like, I am confident in Enbridge’s low-risk business model (more on that later), and earning volatility will never require a dividend cut for this pipeline company.

A low-risk business model

As far as companies in the energy sector go, Enbridge operates a remarkably low-risk business model. This is mostly because it is in the business of energy transportation, not production or exploration. Enbridge makes money based on how much product it can move from Point A to Point B – the market price of the product it is moving does not affect its earnings.

Enbridge also hedges against changes in interest rates and foreign exchange, further reducing the risk of investing in this company. Because of this business model, Enbridge has survived and prospered, though many of its peers in the energy industry have struggled.

As long as the deal closes, I am confident that Enbridge is one of the best dividend growth stocks in Canada.

Canadian National Railway

The Canadian National Railway Company (CNI, Financial) is a Class I railway corporation with headquarters in Montreal. It was incorporated as a Crown corporation in 1919 and went public through an IPO in 1995.

Canadian National Railway has experienced a tough year to date because of a slowdown in the Canadian economy, mostly related to the drop in demand for oil. This has reduced railway volumes, effecting Canadian National Railway’s bottom line: its second-quarter net income for this year was 858 million Canadian dollars ($650.8 million in U.S. currency) compared to 886 million Canadian dollars a year ago. Management expects EPS to remain constant year over year at $4.44.

Key stats

• P/E ratio: 18.96.
• P/B ratio: 4.33.
• Dividend yield: 1.78%.
• Payout ratio: 41.20%.

Investment thesis

Limited competition

Canadian National Railway is the beneficiary of an extremely wide economic moat. Entrance into the railway industry needs such massive capital requirements that newcomers are rare. Railways are also subject to strict regulatory requirements.

The North American railway industry is an oligopoly; the market share is held almost exclusively by the Class I railways:

• Amtrak.
• BNSF Railway, owned by Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
• Canadian National Railway.
• Canadian Pacific Railway (CP, Financial).
• CSX Transportation.
• Kansas City Southern Railway.
• Norfolk Southern Railway.
• Union Pacific Railroad.
• Via Rail.

Of the Canadian names on this list, the only ones that operate nationwide are Canadian National Railway and Canadian Pacific Railway. This creates what is, in essence, a duopoly.

Operational diversification

Canadian National Railway’s operations span three major coasts – the Pacific, the Atlantic and the Gulf of Mexico – and connects all three North American Free Trade Agreement (NAFTA) countries. Canadian National Railway's scope is vast.

Operationally, Canadian National Railway presents ample diversification. Its transportation revenue comes from seven diversified commodity groups, and in 2015 no single commodity group contributed more than 23% to overall revenue. Geographic diversification is also present – from its 2015 annual report: “Eighteen percent of revenues relate to U.S. domestic traffic, 33% transborder traffic, 18% Canadian domestic traffic and 31% overseas traffic.”

A safe and growing dividend

Source: Canadian National Railway website

Canadian National Railway pays a quarterly dividend that it typically raises once per year in January. So far this year, the Canadian National Railway board of directors has approved quarterly dividend payments of 37.5 cents for the first, second and third quarters, which means it is on pace to meet its $1.50 annual dividend from the chart above. At Canadian National Railway’s current price of around $85, this equates to a yield of 1.76%. Not excellent, but the focus here is on Canadian National Railway’s dividend growth.

From 2000 to 2016 (expected), Canadian National Railway has raised its dividend from 11.75 cents per share to $1.50 per share on a split-adjusted basis. This is a cumulative annual growth rate (CAGR) of 17%, which is a fantastic rate of dividend growth. While this rate is likely to slow in the future as the company matures, it is certainly promising that Canadian National Railway’s management has a promising track record of returning cash to shareholders.

At current levels, the dividend is also safe. Assuming that Canadian National Railway meets its guidance of adjusted diluted EPS of $4.44 (as stated in its second-quarter earnings release) and that it does not raise its dividend again this year, it has a current dividend payout ratio of 33.8% ($1.50/$4.44). This indicates that Canadian National Railway has plenty of room to further raise its dividend payments, or participate in share buybacks to further return money to shareholders.

The bottom line

These three stocks represent some of the best dividend growth stocks in Canada right now. Put together, they should provide ample diversification since they do business in three independent industries. Keep an eye on them – buying on dips provides an even better value proposition. Click here to read more investment analysis from the Financial Canadian.

Disclosure: I am not long any of the stocks mentioned in the article. The Financial Canadian is long Toronto-Dominion Bank and intends to initiate a position in Enbridge in the near future.

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