Published by Nick McCullum on July 24th, 2017
‘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 100+ years
- And pays a 3% dividend yield.
Generally speaking, comprehensive lists of blue chip stocks can be a great source of investment opportunities. You can see the full list of blue chip stocks here.
The Toronto-Dominion Bank (TD) – or TD Bank, for short – is a Canadian financial institution that satisfies our requirements to be a blue chip stock.
And, this stock has been a darling for its investors. TD has delivered market-beating total returns over long periods of time while simultaneously performing very well during the 2007-2009 financial crisis.
This article will analyze the investment prospects of TD Bank in detail.
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), 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 which work together to serve its ~22 million customers.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 3
TD’s peer group among the large Canadian financial institutions is comprised of:
- The Royal Bank of Canada (RBC)
- The Bank of Nova Scotia (BNS)
- The Bank of Montreal (BMO)
- The Canadian Imperial Bank of Commerce (CM)
TD differentiates itself from its peers thanks to its extensive presence in the United States.
While the Canadian banking market is attractive from a number of perspectives, it is undoubtedly quite saturated, with the Big Five listed above having the majority of the market share.
TD’s exposure to the United States will be the bank’s largest driver of growth moving forward.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 5
TD’s presence in the United States is fundamentally different than the U.S. presence of many of its peers.
Since 2005, TD has been strategically investing in the retail banking industry south of the border. This began with TD’s acqusition of 51% of Banknorth in 2005, which it eventually privatized as TD Banknorth.
Since then, TD’s U.S. acquisitions have increased in magnitude and intensity. A full timeline of TD’s U.S. expansion can be seen below.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 8
Today, TD has more branches in the United States than it does in Canada. And, the company is more focused on retail than ever before.
The following diagram shows the growth of TD’s earnings over time, broken down by operating segment. It is evident than the majority of the bank’s profits are generated by the retail bank.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 11
Looking ahead, TD is likely to continue delivering satisfactory growth through its ongoing U.S. expansion efforts.
Competitive Advantage & Recession Performance
TD 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, TD is arguably the Canadian bank with the highest concentration in the United States.
Secondly, TD 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 a ‘premium’ earnings mix relative to its peers.
TD’s earnings mix during the 2016 fiscal year can be seen below.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 7
As far as financials go, TD is a highly recession-resistant institution.
During the Great Recession of 2007-2009, while many banks were experiencing a complete meltdown, TD’s only symptom was to freeze its annual dividend increases for a single year.
TD’s long-term dividend history can be seen below.
Source: TD Bank Group Second Quarter Earnings Presentation, slide 13
TD’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 can be seen below:
- 2007 adjusted earnings-per-share: CAD$2.78
- 2008 adjusted earnings-per-share: CAD$2.46 (11.5% decrease)
- 2009 adjusted earnings-per-share: CAD$1.75 (28.9% decrease)
- 2010 adjusted earnings-per-share: CAD$3.24 (85.1% increase)
TD’s earnings experienced 37% peak-to-trough decline in adjusted earnings-per-share 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 & 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-to-earnings ratios of these companies allows them to have the rare combination of high dividend yield and low payout ratio.
Case-in-point: TD is currently trading at a dividend yield of 3.6%, yet is paying out only 49% of 2016’s adjusted earnings-per-share.
The company’s valuation based on price-to-earnings is equally compelling. TD reported adjusted earnings-per-share of CAD$4.87 in fiscal 2016. Using the company’s Canadian-listed security price on the Toronto Stock Exchange of CAD$65.35, TD is trading at a price-to-earnings ratio of 13.4.
On a forward-looking basis, TD’s valuation is even more appealing.
TD aims to achieve 7%-10% growth in earnings-per-share. Applying the bottom of this growth expectation (7%) to 2016’s adjusted earnings-per-share gives a 2017 earnings estimate of CAD$5.21. Based on this estimate, TD is trading at a forward price-to-earnings 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.
TD’s current valuation is slightly above its 10-year average whether you use 2016’s earnings or a reasonable estimate of 2017’s earnings.
However, I believe the company still presents reasonable value in today’s market, and will deliver market-beating total returns moving forward composed of:
- 7%-10% earnings-per-share growth (management’s expectation, which I believe they will achieve)
- 3.6% dividend yield
For total returns of 10.6%-13.6% per year over full economic cycles for long-term investors.
The Toronto-Dominion Bank fits our two criteria to be a ‘blue chip stock’:
- 100+ Year Operating History: TD’s predecessor, the Bank of Toronto, was founded back in 1856
- 3%+ Dividend Yield: TD currently pays a dividend of 3.6%, making it an excellent stock for income investors
Further research reveals that TD has compelling growth opportunities in its United States expansion, and has historically performed better than its U.S. peers in economic downturns.
Moreover, TD’s fundamental financial statistics are attractive. The company is trading at a price-to-earnings 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 return.