Up until the financial crisis, when many U.S. banks were nearly destroyed by disastrous amounts of leverage and risky bets on mortgage backed securities and complex derivatives, banks were a favorite sector among dividend investors thanks to their generous yields and solid histories of payout growth. The memory of the great financial crash is still fresh in the minds of many, which is why some income investors have sworn off banking stocks entirely. While most bank stocks fall outside of my circle of competence and have opaque balance sheets, there are a select few banking institutions that have truly impressive track records of very conservative banking principles and deserve a high Dividend Safety Score. Toronto-Dominion Bank (TD) could be one such bank, but because it’s headquartered in Canada, many investors overlook it.
Let’s take a look to see if this bank, which yields nearly 4%, deserves to be on your radar and in our list of safe high dividend stocks.
Founded in 1855 in Toronto, Canada, Toronto-Dominion is one of Canada’s six oligopolistic mega-banks. Strict regulations largely protect these top banks and have allowed them to enjoy 90% of Canada’s domestic banking market share (Toronto-Dominion’s market share is 40%).
Today, Toronto-Dominion’s 65,384 employees serve about 22 million global customers through its network of 2,411 branches, and 5,571 ATM machines.
However, thanks to its 2007, 2008, and 2016 acquisitions of Banknorth, Commerce Bancorp, and Scottrade’s online bank, respectively (as well as its 42% stake in TD-Ameritrade), Toronto-Dominion has diversified successfully into the U.S. and grown to become the 5th largest bank in North America.
While the majority of the bank’s earnings still come from its home market, Toronto-Dominion is making great strides to quickly grow and diversify its foreign businesses in order to become a true global financial force.
It’s worth noting that over 85% of the bank’s earnings are from retail activities, too. Unlike many mega banks, TD doesn’t really have meaningful exposure to trading operations and investment banking, which are generally riskier, more volatile activities.
Instead, Toronto-Dominion focuses on simple lending businesses, such as residential mortgages, credit cards, home equity lines of credit, indirect auto loans, and more.
Banks primarily make money by gathering deposits and loaning them out for interest income. Their customers want to borrow money at the lowest rates possible and receive reliable access to financing.
Essentially, banking is a commodity business, one in which the lowest cost and most conservatively managed operators tend to win out in the long run.
Toronto-Dominion has the largest and fifth largest deposit bases of any bank in Canada and the U.S., respectively, providing it with numerous cost advantages.
TD’s extensive operating history, respected brand, and convenient ways to bank (both physical branches and online) have enabled a steadily growing stream of low-cost deposits from consumers and businesses that it can lend out at higher interest rates.
In 2016, Toronto-Dominion paid 0.5% interest on the $193.6 billion Canadian dollars of personal deposits it held in Canada and 0.11% interest on its $206.8 billion Canadian dollars of personal deposits in the U.S. Interest paid on deposits made to businesses was also under 1%.
Meanwhile, the company’s total interest-earning assets had an average rate of 2.68%. The company’s cheap funding base ensures it can continue generating a healthy profit spread even in today’s low interest rate environment.
As long as management remains conservative with the loans it makes, Toronto-Dominion should be well positioned to continue making a lot of cash from the cheap funds it has on its balance sheet.
Toronto-Dominion’s disciplined approach to low costs helped it to lower its adjusted efficiency ratio (operating costs/revenue) from 54.9%, to 53.9%. That is not just an impressive year-over-year increase, but also among the lowest efficiency ratios of any global bank, reflecting the firm’s scale, low-cost deposit base, and conservative operations.
|Bank||Operating Margin||Net Margin||Return On Assets||Return On Equity|
|US Industry Average||NA||15.0%||0.5%||6.3%|
The company’s amazing efficiency and high operating margins from its core market (made possible by its wide regulatory moat) mean that Toronto-Dominion’s profitability puts most U.S. banks to shame.
More importantly, those high margins and returns on capital don’t come with excessive risk taking.
In fact, the bank’s net charge off ratio (loan losses/total loan value) was just 0.41% in 2016. That’s below the 0.6% the bank has averaged since 2013 and indicates that management remains firmly committed to strict quality underwriting standards.
Now it’s true that Canada is heavily dependent on the energy industry, which is experiencing the worst oil crash in over 50 years.
However, just 1% of Toronto-Dominion’s loans are to oil companies, meaning that its fundamental profitability hasn’t been hurt much during the downturn.
In addition, the bank continues to strengthen its vault-like balance sheet over time (more on this later), despite the fact that it sailed through the financial crisis with flying colors.
Canada actually has not had a single banking crisis since 1840, while the U.S. has had a dozen, likely driven by regulatory differences.
Regardless, Toronto-Dominion’s conservative management is exactly what dividend investors should demand of any banks in their portfolios.
There are a few risks to be aware of before investing in Toronto-Dominion Bank.
The first is that the bank has exposure to foreign currency fluctuations, due to the majority of its business being in Canadian dollars. While this will decrease over time as its U.S. business continues growing, investors need to be aware that their dividend amount received each quarter will fluctuate based on the exchange rate between the U.S. and Canadian dollar.
And speaking of dividends, don’t forget that Canadian companies will withhold 15% of dividends to pay Canadian taxes.
Fortunately, the U.S./Canadian tax treaty allows for U.S. investors to take a $1 for $1 tax credit against some of their annual dividend tax burdens on your 1040 form.
Of course that is only if your annual foreign withholdings are $300 ($600 if married filing jointly) or less. If your foreign withholdings are above that limit, then you need to fill out a 1116, adding additional tax complexity, unless your broker is one of the few that does this for you automatically such as JPMorgan Chase or Merrill Lynch.
Investors can learn more about withholding taxes here.
As for specific risks to Toronto-Dominion, there are mainly two to keep in mind. First, understand that most of the bank’s strong profitability derives from its home market, where strict regulations make it very hard for foreign banks to compete.
However, growth in the Canadian business could slow in the coming years, thanks to the fact that Canadians have been leveraging themselves with more and more debt, using home equity to gain low cost loans.
That’s not to say that Toronto-Dominion can’t continue finding strong growth in its U.S. and wholesale markets, especially since U.S. consumers have been aggressively deleveraging and thus have relatively greater ability to take on debt. However, TD’s U.S. business has much lower margins due to the lack of the same beneficial regulatory moat it enjoys in Canada.
The second important risk is that Canada has been building up what could turn out to be a housing bubble. In fact, unlike the U.S. housing bubble which popped in 2008 and has seen housing prices only recently return to previous valuations, Canada’s housing bubble has been inflating ever since the early 2000’s.
The majority of this bubble has been fueled by two main markets, Toronto and Vancouver, where foreign investment, including from many Chinese buyers seeking to shield their assets from the falling Chinese Yuan, have bid up real estate prices into the stratosphere.
Toronto-Dominion has $186 billion in Canadian residential mortgages on its books, or 15.8% of its assets. That’s about half the proportion of assets that U.S. banks had when they got in trouble during the bursting of the U.S. housing bubble.
While this large exposure to a potential Canadian housing bust could result in falling earnings for several years, it probably wouldn’t result in a dividend cut. The majority of TD’s residential mortgage portfolio is also insured, reducing the risk of material deterioration in Canadian housing prices.
However, it could very well slow the rate of dividend growth and result in a weaker investment thesis. Investors could be especially shocked if such a scenario unfolded because Canadian banks haven’t faced a crisis in more than 175 years.
Investors should also note that Toronto-Dominion recently came under pressure for its aggressive sales practices. This is not unlike the situation that weighed on Wells Fargo’s stock last year.
It’s hard to know the truthfulness of these allegations and how widespread the problem might be. There could be an impact to the company’s brand and retail growth over the near term, but I tend to think this is an issue that will not affect TD’s long-term earnings power.
Let’s take a closer look at the company’s dividend.
Toronto-Dominion’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Toronto-Dominion Bank has a Dividend Safety Score of 62, indicating the dividend is quite safe. The company’s score could even be a bit of an understatement when you consider the bank’s notable dividend track record.
In fact, Toronto Dominion has been paying a dividend every quarter since 1857 and has been raising it every year since at least 1969.
This means that Toronto-Dominion is effectively a dividend aristocrat, at least in Canada.
TD’s remarkable consistency and dependability is due to two main factors. The first is management’s conservative payout policy.
Specifically, management targets a 40% to 50% EPS payout ratio and has exceeded that goal in recent. The trailing 12-month payout ratio of 47% indicates that the dividend is very well insulated from any short-term earnings volatility, which could occur if the Canadian real estate bubble suddenly popped, for example.
The second protective key to Toronto-Dominion’s dividend safety is the bank’s fortress-like balance sheet.
Like most Canadian banks, management is very conservative when it comes to leverage, (current leverage ratio of 4.0). That’s in contrast to most U.S. banks whose leverage ratios are five to six, and before the financial crisis that ratio was often over 10 in the U.S.
That balance sheet security is also represented by the bank’s Tier 1 capital ratio, which compares the bank’s equity (net assets) and retained earnings against its risk-weighted assets.
U.S. regulations under the Dodd-Frank law require a minimum of 8%, and Toronto-Dominion finished 2016, 2015, and 2014 with Tier 1 ratios of 12.2%, 11.3%, and 10.9%, respectively.
TD’s U.S. loans have an even higher Tier 1 ratio of 13.2%. In other words, not only is management committed to a strong, low risk balance sheet, but it is also strengthening the firm’s risk profile over time, far above what is likely necessary to survive future economic downturns.
In fact, during 2016’s Federal Reserve’s annual bank stress test, which models a far more severe and longer economic downturn than occurred in The Great Recession, TD’s American holdings’ Tier 1 ratio never fell below 8.4%, more than double the regulatory minimum of 4.0%.
Overall, Toronto-Dominion’s conservative financial management and extensive track record of maintaining and growing its dividend during all manner of global economic cycles suggests this is a high-yield dividend you can depend on.
Toronto Dominion’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Toronto-Dominion Bank has a Dividend Growth Score of 73, indicating that income investors can expect relatively fast dividend growth.
Looking at the bank’s most recent 20-year dividend growth history, that isn’t hard to believe. However, dividend lovers shouldn’t expect anywhere close to 15%+ annual growth going forward.
That’s because management’s conservative payout policy of 40% to 50%, which is where the current payout ratio is sitting, means that the dividend is only likely to grow as fast as earnings.
Fortunately, thanks to the fast rate of growth from the bank’s U.S., Wholesale, and other international businesses, Toronto-Dominion expects to grow its long-term earnings (and likely its dividend) at 7% to 10% annually.
Shares of Toronto-Dominion Bank currently trade at a forward P/E multiple of 12.5, which is about in line with its long-term average, and offer a dividend yield of 3.8%, which is somewhat higher than its five-year average yield of 3.6%.
The stock doesn’t look particularly cheap compared to its historical valuation multiples, and high quality banks such as Toronto-Dominion rarely look undervalued.
Based on management’s expectations for 7-10% annual earnings growth over the medium-term, the company’s annual total return potential sits around 10-13% (3.8% yield plus 7-10% annual growth).
TD’s stock has sold off since March following reports of its aggressive sales practices, which are causing some investors to wonder if much of the firm’s impressive growth came at the expense of its clients.
If this issue is widespread enough to affect Toronto-Dominion’s long-term earnings growth rate, the stock doesn’t deserve to trade at the premium multiple it has historically enjoyed over its peers.
Given the uncertainty and the somewhat concentrated portfolio I run (holding 20 to 25 stocks), I would prefer to wait for the dust to settle unless the stock price really gets whacked and falls closer to $40 (currently $47 per share).
Closing Thoughts on Toronto-Dominion Bank
In Canada, Toronto-Dominion Bank is known as one of the most dependable dividend growth stocks you can own.
The bank’s storied history, fundamentals, and growth plans suggest its reputation is very well earned, and I suspect the ongoing recent review of its sales practices won’t change that fact.
The rise in Canadian debt levels and housing prices bears watching, especially since its banking industry hasn’t faced a crisis in more than a century, but Toronto-Dominion appears to be one of the best banks in the world.
While I don’t have any plans to buy the company for our Conservative Retirees dividend portfolio, the bank’s dividend growth track record alone makes it a worthwhile company to keep on almost any watch list.