(Published by Nick McCullum on July 24)
Blue-chip stocks received their name because, in the game of poker, the blue chips have historically had the highest value.
Despite the association with poker, blue-chip stocks are for those not looking to gamble on unproven businesses.
In the stock market, blue-chip stocks are valued for their low volatility, stable performance profile and lower relative risk because of their entrenched position in the broader economy.
Unfortunately, there is no formal definition for a blue-chip stock. The term is subjective by nature.
At Sure Dividend, we define a blue chip-stock as a business that:
- Has been operating for over 100 years.
- Pays a 3% dividend yield.
Generally speaking, comprehensive lists of blue-chip stocks can be a great source of investment opportunities.
The Toronto-Dominion Bank (TD, Financial) – or TD Bank for short – is a Canadian financial institution that satisfies our requirements to be a blue-chip stock.
This stock has been a darling for its investors. Toronto-Dominion has delivered market-beating total returns over long periods of time while simultaneously performing very well during the 2007-2009 financial crisis.
Business overview
The Toronto-Dominion Bank is Canada’s largest bank by total assets and second-largest bank by market capitalization.
The company reports earnings in three main segments:
- Canadian retail
- U.S. retail
- Wholesale banking
The company also separately reports its share of earnings from TD Ameritrade (AMTD, Financial), which it has a significant ownership stake in.
TD Bank has a wide geographic footprint, with 2,413 retail locations across North America at the time of its last quarterly earnings release.
In addition, the company has 39,227 employees in Canada and 25,745 employees in the United States who work together to serve its approximately 22 million customers.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 3
The company’s peer group among the large Canadian financial institutions is comprised of:
- The Royal Bank of Canada (RBC, Financial)
- The Bank of Nova Scotia (BNS, Financial)
- The Bank of Montreal (BMO, Financial)
- The Canadian Imperial Bank of Commerce (CM, Financial)
TD Bank differentiates itself from its peers with its extensive presence in the U.S.
While the Canadian banking market is attractive from a number of perspectives, it is undoubtedly quite saturated, with the Big Five holding the majority of the market share.
The bank’s exposure to the U.S. will be its largest driver of growth moving forward.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 5
Growth prospects
TD Bank’s presence in the U.S. is fundamentally different from the presence of many of its peers.
Since 2005, the company has been strategically investing in the retail banking industry south of the border. This began with TD Bank’s acqusition of 51% of Banknorth in 2005, which it eventually privatized as TD Banknorth.
Since then, its U.S. acquisitions have increased in magnitude and intensity. A full timeline of TD Bank’s U.S. expansion is below.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 8
Today, the bank has more branches in the U.S. than it does in Canada. In addition, the company is more focused on retail than ever before.
The following diagram shows the growth of the bank’s earnings over time, broken down by operating segment. It is evident the majority of its profits are generated by the retail bank.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 11
Looking ahead, TD Bank is likely to continue delivering satisfactory growth through its ongoing U.S. expansion efforts.
Competitive advantage and recession performance
TD Bank has two significant competitive advantages relative to its peers in the Canadian financial services industry.
First, the company has a significant presence outside of Canada, which will be the driver of fundamental growth moving forward. Relative to its peers, Toronto-Dominion is arguably the Canadian bank with the highest concentration in the U.S.
Second, the company is laser-focused on retail banking.
Retail banking has a number of qualitative characteristics that make its earnings higher quality than wholesale or capital markets earnings. Most notably, retail earnings are much less volatile over time, which gives TD Bank a "premium" earnings mix relative to its peers.
The bank’s earnings mix during the 2016 fiscal year is displayed below.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 7
As far as financials go, the bank is a highly recession-resistant institution.
During the Great Recession of 2007-2009, while many banks were experiencing a complete meltdown, TD Bank’s only symptom was to freeze its annual dividend increases for a single year.
The bank’s long-term dividend history is presented below.
Source: TD Bank Group Second-Quarter Earnings Presentation, slide 13
TD Bank’s ability to keep its dividend constant during the global financial crisis was due to its strong earnings performance. The company’s adjusted earnings per share through the financial crisis are below:
- 2007 adjusted EPS: 2.78 Canadian dollars ($2.22)
- 2008 adjusted EPS: CA$2.46 (11.5% decrease)
- 2009 adjusted EPS: CA$1.75 (28.9% decrease)
- 2010 adjusted EPS: CA$3.24 (85.1% increase)
The comapny’s earnings experienced a 37% peak-to-trough decline in adjusted EPS during the financial crisis, but rebounded to a new record high in 2010. Clearly, this bank is a conservatively financed and well-managed financial institution.
Valuation and expected total returns
The Canadian financials are a unique universe of investments because:
- They are exceptionally high-quality businesses.
- They trade at persistently low valuations based on earnings.
Buying these stocks based on the expectation of valuation expansions is likely to be a mistake; however, the consistently low price-earnings (P/E) ratios of these companies allow them to have the rare combination of high dividend yield and low payout ratio.
Case in point: TD Bank is currently trading at a dividend yield of 3.6%, yet is paying out only 49% of 2016’s adjusted EPS.
The company’s valuation based on price-earnings is equally compelling. TD Bank reported adjusted EPS of CA$4.87 in fiscal 2016. Using the company’s Canadian-listed security price on the Toronto Stock Exchange of CA$65.35, the bank is trading at a P/E ratio of 13.4.
On a forward-looking basis, TD Bank’s valuation is even more appealing.
The bank aims to achieve 7% to 10% growth in EPS. Applying the bottom of this growth expectation (7%) to 2016’s adjusted EPS gives a 2017 earnings estimate of CA$5.21. Based on this estimate, TD Bank is trading at a forward P/E ratio of 12.5.
The following diagram compares TD’s current valuation – using both 2016 and 2017’s earnings – to its long-term historical average.
Source: YCharts
TD Bank’s current valuation is slightly above its 10-year average whether you use 2016’s earnings or a reasonable estimate of 2017’s earnings.
Regardless, I believe the company still presents reasonable value in today’s market and will deliver market-beating total returns moving forward. These will be composed of:
- 7% to 10% EPS growth (management’s expectation, which I believe they will achieve).
- 3.6% dividend yield.
For total returns of 10.6% to 13.6% per year over full economic cycles for long-term investors.
Final thoughts
The Toronto-Dominion Bank fits our two criteria to be a blue-chip stock:
- 100-year operating history: TD Bank’s predecessor, the Bank of Toronto, was founded in 1856.
- Over 3% dividend yield:Â the bank currently pays a dividend of 3.6%, making it an excellent stock for income investors.
Further research reveals the company has compelling growth opportunities in its U.S. expansion and has historically performed better than its American peers in economic downturns.
Moreover, TD Bank’s fundamental financial statistics are attractive. The company is trading at a P/E ratio of 13.4 and is paying out approximately 49% of 2016’s earnings as dividend payments (a conservative payout ratio relative to the broader stock market).
Accordingly, this stock holds significant appeal for conservative investors focused on income or total returns.
Disclosure: I am not long any of the stocks mentioned in this article.
