Sunday, January 25, 2015

The Canadian central bank’s rate cuts should put TD Bank on US investors’ watch lists.

TD has many of the characteristics of a quality dividend growth stock

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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