In bank stocks he trusts

Why TD Dividend Growth's manager made the Big Five his top five.

Diana Cawfield 29 June, 2017 | 5:00PM

Doug Warwick, a managing director and portfolio manager with TD Asset Management Inc. in Toronto, is clearly undeterred by the downgrading of Canada's major banks by Moody's Investors Service in May. In fact, the Big Five banks are his top five recent holdings in the $7.2-billion TD Dividend Growth.

As reported this week on the TD Mutual Funds website, parent company  Toronto-Dominion Bank (TD) was the fund's top holding at 8.8%, narrowly ahead of the 8.7% weighting of  Royal Bank of Canada (RY).  Bank of Nova Scotia (BNS) was third at 7%, with  Canadian Imperial Bank of Commerce (CM) and  Bank of Montreal (BMO) at 6.7% and 6.5%, respectively. Collectively, they accounted for nearly 38% of the fully invested fund.

Why put so much stock in the fortunes of the Big Five? "The Canadian banks were always rated with about the highest ratings of banks around the world, so they were taken down a notch," says Warwick. "The important thing for me, is funding costs didn't change for the banks, so despite that downgrade, it was business as usual for the banks at no cost disadvantage."

Banks have always played a prominent role in the fund, since they've provided regular streams of dividend income and have strong records of dividend growth. Overall, the financial sector currently represents about half of the assets of Morningstar 4-star rated TD Dividend Growth, led by the big banks but also including other service providers such as life insurers.

Warwick says the downgrading of the major banks by Moody's coincided with people talking about the high level of Canadian consumer indebtedness and concerns over the hot housing market. "This is the big question and I look at it a lot," says Warwick.

But the veteran manager puts the concerns over creditworthiness of borrowers in perspective, relative to the strength of the banks. He says mortgages represent about 55% of bank lending, but probably only 20% of the profitability.

What is concerning, says Warwick, is that personal lending has probably been increasing at 5% to 7% a year for many years, which is much greater than the rate of inflation, "So obviously at some point it just goes too far," he says. "What I would like to see, and we've seen early signs of it, is personal lending flattened out and other types of lending starting to pick up."

Today's banks are significantly different and better investments than they were 30 or 40 years ago when they were lending mostly to corporate Canada, says Warwick. "What has happened," he says, "is the banks have moved into much more stable fee income and recurring income that is not nearly as cyclical as it once was."

Despite their healthy balance sheets, bank shares can go up and down in any given year with the market. "For example, in 2008," says Warwick, "the fourth quarter of 2008 was an absolute wipeout in the markets around the world, so the Canadian banks got carried down significantly in the downdraft."

Recently, Canadian stock prices fell -- including bank stocks -- when oil prices plunged. But Warwick puts the risks of loan losses in the energy sector in perspective. "If you look at the oil and gas loans by the Canadian banks," he says, "the average percentage of the loan book loaned out to that industry was about 2.5%, and it was primarily in investment grade."

Though their growing dividends are an attractive feature of the banks, this growth isn't guaranteed. In the wake of the 2008 financial crisis, says Warwick, some of the banks didn't increase their dividend for a couple of years. "The rules changed," he says, "and the world regulators thought that banks were undercapitalized and should have a lot more capital on their balance sheets. So the Canadian banks took their capital ratio from 5% to 10% and paused (the growth of) dividends for two years to do that, but they didn't cut."

Warwick says that while valuations are generally high in the Canadian equity market, Canadian financials are very cheap. He thinks that's especially true when you consider that bank-capital levels have doubled in the last eight or nine years. "They're much safer entities. You've got dividend yields between 3.5% and 4.5%, depending on the bank, and wow, you've got five-year Government of Canada bonds at under 1%." Investors receive multiples of a government bond yield with the potential for growth in the banks' dividends over time, he adds.

"The banks continue to generate 10 to 25 basis points of capital every quarter," says Warwick, "so it's just a huge stream of income that the banks seem to be able to continue to generate. I like those kinds of things for registered retirement savings plans. My parents, for example, they don't own any bonds, but they own a lot of banks."

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bank of Montreal96.86 CAD-0.03
Bank of Nova Scotia75.57 CAD0.11
Canadian Imperial Bank of Commerce111.05 CAD0.49
Royal Bank of Canada106.95 CAD0.30
The Toronto-Dominion Bank74.10 CAD0.16

About Author

Diana Cawfield

Diana Cawfield  Diana Cawfield is an award-winning writer who has been a regular Morningstar contributor since 2000. Her numerous publication credits include the Toronto StarAdvisor's Edge and Chatelaine, as well as the Canadian Securities Institute's online educational services.