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Written by Dirk S. Leach

It is difficult to find safe investments with 3%+ dividend yields and solid growth prospects.

Many equities today are priced on the rich side of valuations resulting in lowered dividend yields.Low interest rates have made bonds a poor value for income seeking investors.

The benefits of investing in high quality stocks with above average yields and good growth prospects – trading at fair or better prices – are well-known to long-term investors.

What if you could quickly identify an entire group of these stocks? This article takes a look at one such group the market is overlooking:

The Canadian banking sector.

There are 3 large Canadian banks that rank as a ‘Buy’ using The 8 Rules of Dividend Investing.

This article gives an overview of the favorable investment prospects of the Canadian banking system.It also analyzes 1 of the 3 highly ranked Canadian Banks in more detail:Toronto Dominion Bank (TD).

Why Canadian Banks ?

With all the banking names in the United States, why focus on Canadian banks for potential investments? The short answer is that the Canadian banking system is recognized as number 1 in the world for financial strength and safety, has a significantly smaller fraction of non-performing loans than their EU and US peers, and Canadian banks have historically paid outsized dividends compared to their US counterparts.I covered these attributes of Canadian banks in greater detail in the first article of this series.

In addition, while Canada is not the US, it is also not all that different in its business culture, laws, regulations, and values.

Narrowing the Field

In the first article, I screened the 5 largest Canadian banks looking at 10 year compound annual growth rates for revenue, EBITDA, EPS, dividends paid, and the most recent dividend payout ratio. That list of 5 includes, the Bank of Montreal (BMO), the Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), the Royal Bank of Canada (RY), and Toronto-Dominion Bank (TD). The summary of the screening data is provided in the table below.

Source: Author

Based on that screening, I selected BNS, RY, and TD for more detailed analysis.I covered RY in detail in the first article and BNS in the second article. Today, in this last article, I’ll cover TD.

Toronto-Dominion Bank Overview

TD is Canada’s second largest bank by assets with a market capitalization of $83B in US dollars, one of the top 10 banks in North America, and is ranked 19th globally with more than 22 million customers worldwide.

TD is technically the youngest of the three banks in this series having been founded in 1955 via the merger of the Bank of Toronto and the Dominion Bank which were founded in 1855 and 1869 respectively.

Today, TD is headquartered in Toronto, Canada and offers a broad range of advice, products and services, including personal and commercial banking, wealth management and private banking, corporate banking, investment banking, and has a 30% interest in the TD Ameritrade retail brokerage.

Over the last 10 years, TD has managed to achieve steady growth of its revenue, earnings-per-share, and dividend payments while maintaining a conservative dividend payout ratio. These metrics are shown in the charts below. Readers will note that the dip in earnings-per-share and the spike in the dividend payout ratio was due to the impact of the 2009 financial crisis. TD recovered its earnings-per-share to pre-crash levels after roughly 3 years.

Source: GuruFocus

TD maintains a Common Equity Tier 1 of 10.1% (exactly the same as RY and BNS) which well exceeds the Basel III accord requirement of 6% and TD carries an AA- credit rating from Standard and Poor’s, one notch above BNS and the same credit rating as RY.

TD’s cash flow remains strong and TD recently raised its quarterly dividend to $0.55 CDN from $0.51 CDN, an increase of 7.8%, continuing its history of rewarding its share holders.

TD’s annual dividend yield is a respectable 3.9%.TD has the second highest dividend growth rate and the lowest dividend payout ratio of the three banks analyzed in this series.

The reader should note that all of the above data is based on financials reported in US dollars except where noted and is therefore impacted by the exchange rate between the Canadian dollar and the US dollar. As an example, the dividends per share chart above shows the annual dividend paid in US dollars at $1.59 based on the current exchange rate. The annual dividend paid in Canadian dollars is $2.12 TTM.

This does have implications in understanding the charts above. While the charts show that revenue, EPS and dividends have all turned and headed south over the last several quarters, that result is true only in US dollars due to the recent strength of the US dollar compared to the Canadian dollar.

The bottom line is that the reader needs to factor in the impact of the exchange rate to fully appreciate the charts above and all Canadian bank financial data quoted in US dollars. I was unable to find a comparable website to GuruFocus with data in Canadian currency but I’ve included a more complete discussion on exchange rate impacts and risks in the next section of this article.

This summary investment thesis, while brief, indicates that TD has a solid balance sheet, is growing earnings, and increasing its distributions to shareholders. For a more complete picture of TD’s financials, the reader should spend some time browsing through the most recent investor presentation.

Potential Risks to Investors

When someone tell you that an investment is a “sure thing”, my recommendation is that you run, not walk, to the nearest door. I’ve yet to find a “sure thing” in the roughly 30 years I’ve been investing.Investors should always look at the possible risks of any potential investment before committing their hard earned cash.

I covered the generic risks of investing in the Canadian banking sector in detail in the first article of the series including the risk of economic downturn and the potential risk of a Canadian housing bubble collapsing.In this article, I will only cover the risks specific to TD’s loans to the oil and gas industry and exchange rate risks.

Canadian oil producers are in no better shape than those in the US.

Both RY and TD have relatively low loan exposure in the oil and gas industry with RY having about 1.6% of its outstanding loans in the oil and gas industry and TD having less than 1% of its gross loans in the oil and gas industry. TD’s total loans in the sector are about $6.6B CDN and roughly 47% of that is with firms that carry an investment grade credit rating.

TD’s most recent investor presentation has a more detailed presentation of the bank’s oil and gas loan exposure. Readers should note that low loan exposure to the oil and gas industry is one of the primary reasons that TD has lower dividend yield than either RY or BNS.The market has judged that TD’s oil and gas loan risk is small.

The second potential risk I’ll cover is the exchange rate risk.Today, the Canadian dollar is weak compared to the US dollar. This has had a couple of impacts that should be considered by US investors looking to invest in Canadian companies. Canadian companies pay dividends in Canadian dollars. The strong US dollar has made those Canadian dividends worth less to us on the southern side of the border.

However, the strong dollar has also lowered the share price of Canadian companies for US investors. Today, our strong US dollar buys us more equity or shares of Canadian companies. So, is this a risk or a benefit?

If a US investor bought shares of TD today and the US dollar continued to strengthen relative to the Canadian dollar, the dividends paid in Canadian dollars would be worth less and the principal value of the investment could also drop.

However, if the Canadian dollar strengthens relative to the US dollar, those Canadian dollar denominated dividends will be worth more and the price of the equity would likely rise in US dollar terms. To take a look at a graphical representation of this I’ve included a chart  below.

Source:Author

From this chart one can see the impact of the strong dollar on the value of the dividends paid to US investors. While TD has continued to increase dividends paid out in Canadian dollars (the red bars), the value to US investors (the green bars) has not kept up and actually fell in 2014 and 2015.

This is due to the strong US dollar and the current exchange rate where $1 Canadian is worth only about $0.785 US. Those US investors that bought into TD in 2014 are probably not pleased with the impact from the strong US dollar as the value of their investment is down in US dollars.

However, for those US investors that are considering an investment today, the reward potential has improved due to the rise in the value of the US dollar. Today, US dollars buy more of TD than they did in 2014 and a lot more than they did in 2012. The US dollar strength relative to the Canadian dollar has been higher in the past 10 years but not by very much.

The chart below shows the value of the Canadian dollar versus the US dollar over the last 10 years. While the dollar has fallen in the last couple of months we are still close to a 10 year peak in the value of the US dollar versus the Canadian dollar.

Source:XE.COM

The question each investor has to answer to determine if the exchange rate issue is a risk or a benefit is …”Which way will future exchange rates go?”

As a result of the US Federal Reserve Open Market Committee (FOMC) finally figuring out that the global and US economies, while growing, are not sufficiently robust to warrant a series of interest rate increases, the US dollar valuation against the Canadian dollar has recently dropped. In the longer term, as the Canadian economy strengthens, I believe the Canadian dollar will strengthen relative to the greenback. So, long term, I believe the exchange rate will work in my favor as a US investor in TD.

As with most financial ratios and metrics, it is likely the USD/CAD exchange rate reverts towards its mean value.

Final Thoughts

The Canadian banking sector is strong, healthy, and conservatively managed. Of the big five Canadian banks, I believe TD stands out as having strong investment potential and a very low risk of impact from oil and gas sector loans.

TD has shown the ability to grow revenue, EPS and their dividend payments while maintaining a payout ratio lower than its four peers.

While past performance is not a guarantee of future performance, it is a good indication that the company is being managed well.

TD ranks highly using The 8 Rules of Dividend Investing thanks to its solid growth prospects, high dividend yield. and reasonable payout ratio.

Finally, I believe the potential risks of investment in TD to be low and, at least in the longer term, the exchange rate will work in favor of US investors.