After Toronto-Dominion Bank TD-T disclosed this week that it has set aside US$450-million to cover expected penalties related to probes by U.S. regulators into the bank’s anti-money-laundering practices, you could almost sense that the other shoe was about to drop.
And then it did: The U.S. Justice Department is looking at how drug traffickers used TD to launder proceeds from fentanyl sales in the United States.
If investors are looking to the stock market as a preliminary gauge for how serious this situation for the Canadian lender, they might be relieved.
The share price dipped all of 1.1 per cent – hardly a panicked response – on Wednesday, the first day of trading after investors learned about the initial provision. It fell 3.5 per cent on Friday morning, which looks more serious.
If this looks like a relatively muted response, that’s because probes into TD’s anti-money-laundering practices have been known since last year.
The share price, which has trailed most of its peers over this period, may have been reflecting a harsh outcome already, along with lingering concerns that more penalties will follow.
But the bigger concern for investors, longer term at least, is whether the once lofty valuation that TD shares once enjoyed is now a thing of the past.
The shares used to trade at a premium to other big bank stocks based on a number of valuation measures. The stability of the lender’s large retail operations and TD’s sizable footprint in the lucrative U.S. market, where branches outnumber those on TD’s home turf, drove enviable growth.
But this premium has been slipping away.
Its price-to-earnings ratio, according to Bloomberg, is now 10.1, based on estimated earnings from analysts. That puts TD in near the bottom end of Big Six banks, behind Bank of Nova Scotia and just slightly ahead of Canadian Imperial Bank of Commerce.
Its price-to-book ratio, which compares the bank’s market value to its assets minus liabilities, is 1.34. That puts TD in third spot, behind National Bank of Canada and Royal Bank of Canada.
And TD’s dividend yield, which used to be lower than most peers because of the bank’s stronger potential for boosting the quarterly payout, is now 5.3 per cent. That’s well above RBC, National Bank and Bank of Montreal, whose dividend yields are 4.3 per cent on average.
While the higher yield makes TD more attractive from an income standpoint, it offers another indication that the stock’s valuation has been downgraded by the market to a level that is ho-hum at best.
In some ways, this is good news for investors who like to pad their portfolios with beaten-up Canadian bank stocks. Buying the unpopular laggards in this sector can often lead to outsized gains, since banks have a strong tendency to rebound from tough times.
Is TD a strong candidate?
The stock is certainly on sale. Darko Mihelic, an analyst at RBC Dominion Securities, said in a note earlier this week that TD’s price-to-earnings ratio trails its 15-year average at a far larger discount to other the banks.
The suggestion here is that a lot of downside risk is already baked into TD’s share price, as investors consider the full scope of financial penalties the bank faces.
“We continue to view TD’s valuation as discounting something close to the worst-case scenario,” Mr. Mihelic said in a note.
He did not define what this scenario looks like, but some analysts have argued that financial penalties could be as high as US$2-billion. TD also faces the threat of additional regulatory scrutiny that might slow its U.S. expansion.
If the worst case is averted, Mr. Mihelic believes that the stock could significantly outperform its peers.
However, there are a couple of risks here. For one thing, the uncertainty about the penalties could drag on.
At TD’s annual general meeting in mid-April, chief executive officer Bharat Masrani, asked shareholders to be patient. If a bet on TD today requires a speedy resolution to its regulatory headaches, investors may be disappointed by a longer-than-anticipated wait.
Another risk is that while TD can probably absorb financial penalties without too much pain, it may have a harder time getting its premium valuation back.
Other Canadian banks that have encountered setbacks – Canadian Imperial Bank of Commerce (CM-T) and Bank of Nova Scotia (BNS-T), in particular – have suffered through years of discounted valuations that have weighed on share-price performance.
Both stocks continue to trail their peers with the low price-to-earnings ratios and price-to-book ratios, and they have the highest dividend yields among the Big Six.
Investors buying into the uncertainty now embroiling TD can make a tidy return if the lender becomes exceptional again. But that’s no sure thing.
David Berman