US
investors can hold TD shares without incurring direct foreign exchange risk
As
a bank with significant operations in both Canada and the US, the weak Canadian
dollar could benefit TD bank.
The
Canadian central bank’s rate cuts enhance TD’s appeal
A recent (Jan. 16, 2015) article on SeekingAlpha entitled “Toronto-Dominion Bank Analysis Points Toward Growth," provided a general summary
of the advantages of TD bank as a growth story for investors considering a
Canadian bank. Rather than repeat that
discussion, this posting focuses on characteristics of TD bank that should
resonate with US investors.
However, before focusing on characteristics that
should be important to US investors, the article makes a point that should be
relevant to all investors: “TD's latest report shows profit continuing to be
made, but falling shy of analysts' expectations, which those analysts deem a
signal of stagnation. Reuters's data predicted $1.05 in earnings per adjusted
share and $1.00 per share of net income, but were disappointed when faced with
98-cent profits per share and a 91-cent per share of net income. With these
results came a 2.71% decrease in stock price that same day.”
For short-term investors, missing an estimate is
justification for selling, but often for a long-term investor it is an
opportunity to purchase a stock that is temporarily depressed because of the
short-term focus of many other investors.
I view it in the latter sense and increased my holdings of TD at 10%. Less that be interpreted as an effort to try
to time the market, the balance of this posting focuses on the other reasons
for purchasing TD bank shares. Thus, the
earnings miss just influenced the timing of an investment that was planned for
a variety of reasons, including the company's long-run prospects as indicated
by its fundamentals and portfolio considerations.
For a US investor, the most compelling reason for
considering Canadian banks remains the issue discussed in a March 5, 2014
posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.” If possible, one would want some
representative of the financial sector included in a portfolio for
diversification. Canadian banks are
subject to far less regulatory risk than US banks. Reading about and receiving notices
concerning lawsuits against you as a stockholder gets tiresome, and one should
avoid it if possible.
When addressing any investment in Canada, the US
investor has to keep exchange rates and energy prices in mind. A good illustration occurs in an article
published on January 16, 2015 in the WALL STREET JOURNAL. It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector,
but it was impossible for the article to thoroughly address that issue without
discussing the impact of oil prices on the Canadian dollar. The same is true when looking at Canadian
banks. It is how energy prices and
exchange rates relate to TD bank's business profile that makes it an appealing
investment for US investor who is choosing among Canadian banks.
The first thing to note is that foreign exchange
rates do not influence the desirability of TD bank's shares in the same way
they would many other Canadian companies.
The shares on NYSE are not ADRs. They are a special class of interlisted
securities. That is true of many
Canadian banks. You are buying US shares directly, not ADRs. So, the US investor is not exposed to foreign
exchange risk in the actual price of the stock.
For TD bank, the advantage of listing on several
exchanges is that it allows the company's shares to gain access to more
investors and increases a company's liquidity.
The shareholder is exposed to the sentiment of investors in multiple
countries. Thus, the TD bank shareholder
has exposure to a foreign stock market without the direct foreign exchange
risk. It is diversification across
markets without direct foreign exchange risk in the price of the stock.
Similarly, the US investor holding any Canadian bank
has diversified their portfolio to include exposure to a non-US economy. That is true of any international company
whether headquartered in the US or a foreign country. In the case of TD bank, that exposure is
easily quantified: 25% of the bank's retail bank earnings
come from the US, 65% come from retail banking in Canada and 10% come from
wholesale bank.
Looking at the correlation between the US and
Canadian stock market and economies, one sees that the diversification benefit
exists, but it is weak. From the portfolio
perspective, that weak diversification across stock markets and economies when
combined with the diversification benefit of being able to hold a bank stock
without the regulatory risk provides the basis for putting TD bank on one's watch
list.
What is important is how foreign exchange rates will
affect the profits of TD bank. TD bank
is the fastest-growing Canadian bank. It has a presence outside of Canada that
is as large, but not as profitable as its Canadian base. It was the American
side of business that specifically concerned analysts. While only 25% of the bank's retail earnings
come from the US, it represents a much larger portion of the bank's retail
operation (about 50%) when measured by number of branches.
That TD bank earns a lower return from its US
branches is not surprising. TD bank is
essentially exporting services into one of the most competitive banking markets
in the world. It is easy for Canadians
to overlook the fact that in the US all one needs is to have 10 bucks and a politician
in your pocket, and you can open a US bank.
That TD has been able to compete in that market and maintain overall returns
that are competitive with other Canadian banks is very much to its credit.
Like many exporters that have their production
facilities in the country where they sell the product, TD bank benefits from
the international operation through its impact on its earnings when translated
back to its native currency. In Canadian
dollars that 25% of earnings that originate from US operations will increase
without any increase in the efficiency or scope of the US operation. It is, if you will, the opposite of the
foreign currency translation that will negatively impact many US
multinationals. From the US investor’s
perspective, it is an opportunity to invest in a situation where the strength
of the US dollar benefits the holding.
Just as foreign exchange developments justify
putting TD bank on one's watch list, energy market developments also justify
giving TD bank a close look. TD bank's
footprint is far less affected by energy prices than most Canadian banks. In the US, TD branches are located in areas
that benefit from lower energy prices.
Thus, the retail customers they serve are benefiting and should be
better bank customers. Also, the bank is
not overly exposed to commercial loans to the energy sector.
TD bank has relatively limited exposure to the
current slumping oil market. It would be
a mistake to view that as just avoidance of a negative situation. In fact, it creates a very positive
environment for TD bank. The central
bank of Canada just cut interest rates which should guarantee that the
favorable foreign currency affect discussed above will grow.
At the same time, one of the concerns regarding
Canadian banks is the potential that Canada is developing a housing bubble and
a consumer debt bubble. The lower
interest rates that are the central bank’s response to the impact of energy
prices on the Canadian economy should, at least temporarily, mitigate any
impact of the perceived bubbles. However,
the US investor is aware that the bubble in the US housing market was a product
of our institutional framework. No
similar chaotic institutional pursuit of serving consumers who want to increase
their leverage seems to exist in Canada.
Lower interest rates are generally viewed as
unfavorable to banks. They pressure the
interest rate margins. However, as
discussed in a SeekingAlpha article entitled “Surprise rate cut not yet feeding through in Canada,” TD has not immediately respond by lowering its interest
rates. Until they do, the impact on
interest rate margins will not show up.
It is important to keep in mind that for 50% of TD
bank's retail operations, US interest rates are equally important. If the US central bank raises interest rates
as is expected, interest rate margins on the US portion of TD bank's operations could
improve. That improvement would occur at
the same time that a strengthening dollar is making the earnings of US
operations appear more significant in Canadian dollars. The divergence between the policies of the
central banks of Canada and the US should ensure that the benefit to TD bank
persists for a while.
In summary, TD's appeal applies to both Canadian and
US investors to the extent that it results from the interaction of its geographic
footprint and the effect of a weakening Canadian dollar. What is unique from a US investor’s
perspective is the ability to diversify across stock markets and national
economies without incurring foreign exchange risk directly. When that diversification risk is added to
the ability to avoid the regulatory risk embodied in US bank stocks, it makes
TD bank an appealing alternative. That
the impact of a strengthening dollar on TD bank's earnings could be the
opposite of the impact of the strengthening dollar on other holdings of
multinationals just adds to its appeal.
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