The 3 Best Dividend Growth Stocks In Canada For 2017 (And Beyond)

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Includes: CNI, ENB, TD
by: Sure Dividend

This is a guest contribution from The Financial Canadian.

Before we dig into Canada's best dividend growth stocks, I wanted to say that I was absolutely delighted to have the opportunity to write for the Sure Dividend website. I immediately knew that Ben and I had a lot in common when I read the following passage:

"Sure Dividend helps individual investors build dividend growth portfolios made of shareholder friendly businesses with strong competitive advantages trading at fair or better prices."

Now, onto the body of the post.

The Underlying Assumption

Throughout this post I will be providing investment research. However, this research is not valid without the assumption that readers will be investing with a long time horizon (meaning a minimum of three years).

"The single greatest edge an investor can have is a long-term orientation."
- Seth Klarman

Long-term systematic investing is extremely important. Investors can lose out on outstanding long-term returns by trading too often. With a short time horizon, we are subject to the whims of the market and investor psychology.

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."
- Benjamin Graham

Over the long run, however, better businesses outperform the overall market. This is especially true in the world of dividend growth investing. Reinvesting those dividend payments results in a snowball of compound earnings that can eventually grow into a substantial passive income.

This is not possible with a short time horizon, so keep that in mind as you read the rest of this post.

Criteria

This post is titled "The 3 Best Dividend Growth Stocks In Canada for 2017 (and Beyond)."

The word "Best" is ambiguous by nature, so before continuing I wanted to define the criteria by which I would be judging these stocks. Long-time Sure Dividend readers will notice that my criteria are very similar to the Eight Rules of Dividend Investing. This is no coincidence. I selected this stocks by looking for:

  1. High dividend yield
  2. Low payout ratios
  3. Strong history of dividend growth
  4. Attractive valuations based on P/E and P/B Ratios
  5. Wide economic moat and strong competitive advantage

Note that none of these criteria are completely stiff. If a stock is lacking in one category, this may be compensated for with fantastic performance in another.

Let's dig into the first stock.

Toronto-Dominion Bank

The Toronto-Dominion Bank (NYSE:TD) is a diversified financial services provider with operations in both Canada and the United States. From their website, their business is divided into three main segments:

  • Canadian Retail including TD Canada Trust, Business Banking, TD Auto Finance (Canada), TD Wealth (Canada),TD Direct Investing and TD Insurance.
  • U.S. Retail including TD Bank, America's Most Convenient Bank, TD Auto Finance (U.S.), TD Wealth (U.S.) and TD's investment in TD Ameritrade.
  • Wholesale Banking including TD Securities.

TD has a pleasant blend of both organic growth and growth through acquisition. Organically TD continues to mature in the Canadian markets, being the largest bank by assets and the second largest bank by market capitalization (behind RBC). Their acquisitions are predominantly in the U.S. Retail segment, and include the privatization of TD Banknorth, Commerce Bank N.A., and The south Financial Group, Inc to form TD Bank N.A.

Key Stats:

  • P/E Ratio: 13.11
  • P/B Ratio: 1.628
  • Dividend Yield: 3.78%
  • Payout Ratio: 43.16%

In my recent analysis of the financial performance of the "Big 5" Canadian banks over the past 3 fiscal years, the Toronto-Dominion Bank ("TD") came out on top. I was encouraged to read that Sure Dividend is a supporter of this bank as well, as Ben detailed in his September 7th post "Why TD Bank Is A Buy At Current Prices." Let's dig into why we both like this stock.

Investment Thesis

A Safe, Growing Dividend

First of all, in recent history TD has had the best dividend growth among it's peer group. More importantly, their payout ratio has been among the best in their peer group. In 2015, only the Canadian Imperial Bank of Commerce had a lower payout ratio than TD. Take a look at the data:

Click to enlarge

This low payout ratio means that TD has plenty of room to further grow their dividend. It also means that they might have sources to reinvest their money at high rates of return. The U.S. Retail Banking segment comes to mind.

A World-Class Management Team

TD's senior management team has gone through two serious changes in the past few years.

First and foremost, Bharat Masrani succeeded Ed Clark as the President & CEO of TD effective November 1, 2014. This means that the 2015 fiscal year was Masrani's first full year as CEO. Though he is new as CEO, Masrani is no newcomer to the bank. After joining the bank in 1987, he most recently served as the head of their U.S. Retail Banking segment, and the Bank's Chief Operating Officer. The bank's performance was fantastic during Masrani's first full year at the helm, as the bank set a record for adjusted earnings.

The second major change was a shakeup at the executive suite of TD, which reflects a focus on technology. These changes were announced in November of last year, and were highlighted by the departure of Tim Hockey, the former head of TD's Canadian Retail operations. Hockey has assumed the role of President and CEO of TD Ameritrade, in which TD has a 40% ownership interest. There were a few other changes, which are outlined in this helpful article from Newswire.

Both changes are positive in my opinion. TD's management team remains one of the best in the business.

A Strong Economic Moat

In Canada, banks enjoy some of the largest barriers to entry of any industry. The banking industry is dominated by the "Big 5" - TD, the Royal Bank of Canada, the Canadian Imperial Bank of Commerce, the Bank of Nova Scotia, and the Bank of Montreal.

In the US, there are many more smaller competitors, but barriers to entry are still significant. The US barriers to entry are regulatory in nature, not due to an oligopoly as in Canada.

In some senses it is advantageous that there exist smaller counter parties in US banking, as this presents acquisition opportunities for the Bank (more on that later).

Fantastic Growth Prospects In US Banking

TD's presence in the United States was initiated with their purchase of Banknorth Group Inc. in 2005, which they successfully privatized in 2007. They later purchased Commerce Bancorp and a slew of Florida banks until their operations ran across the entire Eastern seaboard of the United States. Fast forward to today, and they now have more US branches than they do in Canada.

At the present, I think there is tremendous opportunity for growth in the US retail bank for TD. Since they have been progressing through a combination of acquisitions and organic growth, the bank's penetration in their US business is not at the level of the Canadian counterpart. In an interview with the Financial Post, the Bank's CEO said:

"We're not as mature in our U.S. business as we might be in Canada, so just penetrating basic banking products for our customers would be huge progress."
- Bharat Masrani

I'm excited to see how TD is able to maximize the potential of their US operations.

Attractive Value Relative to Market

The last point I'll make about TD is on the topic of their valuation.

In terms of the bank's book value, they are attractively priced compared to their peers. Their Price-to-Book value is the second lowest in the Big 5, behind only BMO.

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Source: YCharts

This P/B valuation combined with the fact that TD is the largest Canadian bank by assets means this valuation is very promising.

Based on earnings, though, the valuation story is different. TD actually has the highest price to earnings multiple among the Big 5.

Click to enlarge

Source: Google Finance

TD is preferred over the rest of the Big 5 by many investors, and that demand explains the valuation premium. My view is that there is three main reasons why.

First of all, TD derives a large portion of their earnings from their stable Canadian Retail Banking segment. In fiscal year 2015, only 9% of their earnings came from the more volatile Wholesale Banking segment:

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Source: TD Bank 2015 Annual Report

Other banks derive a larger portion of their earnings from more volatile segments like capital markets. Investors are willing to pay a little extra for the lower earnings volatility that comes with such a high concentration in retail banking. This explains part of TD's valuation premium.

Secondly, TD has a lower portion of their loan portfolio exposed to the oil & gas industry compared to the other Canadian banks. As of July 31, 2016, TD had $4.1 billion of drawn credit exposure to the energy sector, which represents less than 1% of the Bank's overall loan portfolio. $1.4 billion of this credit was to investment-grade borrowers, and the remaining $2.7 billion was to non-investment grade borrowers. Comparing this to RBC, TD's main competitor, who has $7 billion of drawn oil & gas exposure, and it's easier to get comfortable with TD's exposure to the oil and gas industry.

Third, I believe that TD investors are willing to pay a growth premium due to the bank's successful entry into the United States banking industry. As I've mentioned before, TD now has more branches south of the border than in Canada. The Bank's earnings growth in the US is also very encouraging. In the third quarter:

  • Canadian Retail net income was $1.5 billion, down from $1.6 billion one year ago
  • US Retail net income was $788 million, up from $674 million one year ago

Source: TD Q3 Report to Shareholders

TD's Canadian Retail segment had a tough quarter due to the insurance claims from the Fort MacMurray wildfires, but this was more than made up for from growth in their US Retail bank.

Altogether, TD is a fantastic dividend growth prospect. It is also a core holding in my personal portfolio, and is complimented well by the other two companies covered in today's post.

Enbridge

Enbridge (NYSE:ENB) is an energy transportation company based in Calgary, Alberta. They are in the business of transporting energy across North America -- this includes crude oil, liquid hydrocarbons, and natural gas. Enbridge owns Canada's largest network of natural gas.

While Enbridge operates in the broader energy industry, they have been largely isolated from the downturn in energy prices due the the nature of the business they are in. They also have fantastic dividend growth prospects.

Key Stats:

  • P/E Ratio: 42.16
  • P/B Ratio: 3.854
  • Dividend Yield: 3.68%
  • Payout Ratio: 85%

Investment Thesis

Strong Future Growth Prospects Complimented by Purchase of Spectra

Enbridge has been popular in the media lately because of their decision to purchase Spectra Energy Corp. Both shares of Enbridge and shares of Spectra jumped at the news, which signals that investors were pleased.

I'll dive into the details after, but first - this photo does an exceptional job of displaying the potential benefits of the purchase:

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Source: Enbridge Investor Document

The purchase of Spectra will turn pro-forma Enbridge into Canada's fourth-largest publicly traded corporation by market capitalization:

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Source: Enbridge Investor Document

The purchase of Spectra will create an energy transportation giant that moves natural resources across North America. They will have a fantastic competitive advantage, and synergies after the purchase should result in significant savings for the pro-forma company.

The Spectra purchase effects many of the other points of my investment thesis, so that's all I'll write about it here.

A Safe and Growing Dividend

Enbridge has a fantastic history of growing their dividend over time. The growth of their dividend from $0.35 in 2001 to $1.86 in 2015 represents a cumulative annualized growth rate ("CAGR") of 12.6%.

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Source: Enbridge Investor Document

12.6% is a fantastic rate of dividend growth -- and Enbridge is poised to continue this growth in the years ahead.

One of the highlights of the proposed Spectra purchase is the impact on dividend. Enbridge management is promising an immediate 15% dividend increase when the deal closes (expected to be in the first quarter of next year), and a further 10-12% annual dividend growth through 2024. In the best-case scenario, a 15% dividend increase followed by seven years of 12% dividend increases will grow the annual Enbridge dividend to $5.39 in 2024:

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Source: Enbridge Investor Document

And since dividend yield plus dividend growth is a good proxy for total return expectations (according to Morningstar), then if the Spectra deal is closed, investors should be able to expect total returns from Enbridge exceeding 15% (yield of >3% + growth of 12%). That being said, there are a lot of variable at play here -- most notably whether the Spectra deal will actually close. Only time will tell.

I've spoken a lot here about dividend growth prospects -- but the title says "A Safe and Growing Dividend." So what about the safety of Enbridge's dividend?

Let's consider their payout ratio. Enbridge reported earnings on Friday, July 29th for the six-month period ending June 30th, with adjusted earnings per share of $1.25 for the first half of the year. To that point, Enbridge had paid two dividends of $0.53 each for a total of $1.06. This means that for the first half of this year, Enbridge has a payout ratio of 85%. Looking over the fiscal year 2015, the dividend payout ratio was identical at 85%, with $1.86 of dividends per share and $2.20 of adjusted earnings per share.

Click to enlarge

While this is much higher than I would like, I am confident in Enbridge's low-risk business model (more on that later) and I don't believe that earning volatility will ever require a dividend cut for this pipeline company.

A Very Low-Risk Business Model

As far as company's in the energy sector go, Enbridge operates a remarkably low-risk business model. This is mostly because they are in the business of energy transportation, not production or exploration. Enbridge makes money based on how much product they can move from Point A to Point B -- the market price of the product they are moving does not effect their earnings.

Enbridge also hedges against changes in interest rates and foreign exchange, further reducing the risk of investing in this company. Because of this business model, Enbridge has survived and prospered, though many of their peers in the energy industry have struggled.

As long as the deal closes, I am confident that Enbridge is one of the best dividend growth stocks in Canada.

Canadian National Railway

The Canadian National Railway Company (NYSE:CNI) is a Class I railway corporation with headquarters in Montreal, Quebec. They were incorporated as a Crown corporation in 1919 and went public through an IPO in 1995.

CN has experienced a tough year to date because of a slowdown in the Canadian economy, mostly related to the drop in demand for oil. This has reduced railway volumes, effecting CN's bottom line: their Q2 net income for this year was C$858 million compared to C$886 million a year ago. Management expects EPS to remain constant year-over-year at $4.44.

Key Stats:

  • P/E Ratio: 18.96
  • P/B Ratio: 4.33
  • Dividend Yield: 1.78%
  • Payout Ratio: 41.20%

Investment Thesis

Limited Competition

CN is the beneficiary of an extremely wide economic moat. Entrance into the railway industry requires such massive capital requirements that newcomers are rare. Railways are also subject to very strict regulatory requirements.

The North American railway industry is an oligopoly, where the market share is held almost exclusively by the Class I railways:

  • Amtrak
  • BNSF Railway (owned by Berkshire Hathaway)
  • Canadian National Railway
  • Canadian Pacific Railway
  • CSX Transportation
  • Kansas City Southern Railway
  • Norfolk Southern Railway
  • Union Pacific Railroad
  • Via Rail

Of the Canadian names in this list, the only ones that operate nation-wide are CN and Canadian Pacific Railway. This creates what is, in essence, a duopoly.

Operational Diversification

CN's operations span three major coasts - the Pacific, the Atlantics, and the Gulf of Mexico - and connects all three North American Free Trade Agreement (NAFTA) countries. CN's scope is vast.

Operationally, CN presents ample diversification. Their transportation revenue comes from seven diversified commodity groups, and in 2015 no single commodity group contributed more than 23% to overall revenue. Geographic diversification is also present - from their 2015 annual report: "18% of revenues relate to United States (U.S.) domestic traffic, 33% transborder traffic, 18% Canadian domestic traffic and 31% overseas traffic."

A Safe and Growing Dividend

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Source: Canadian National Railway Website

CN pays a quarterly dividend that they typically raise once per year in January. So far in 2016, the CN board of directors has approved quarterly dividend payments of $0.375 for Q1, Q2, and Q3, which means they are on pace to meet their $1.50 annual dividend from the chart above. At CN's current price of around $85, this equates a yield of 1.76%. Not excellent, but the focus here is on CN's dividend growth.

From 2000 to 2016 (expected), CN has raised their dividend from $0.1175 per share to $1.50 per share on a split-adjusted basis. This is a cumulative annual growth rate (OTCPK:CAGR) of 17%, which is a fantastic rate of dividend growth. While this rate is likely to slow in the future as the company matures, it is certainly promising that CN's management has a promising track record of returning cash to shareholders.

At current levels, the dividend is also very safe. Assuming that CN meets their guidance of adjusted diluted EPS of $4.44 (as stated in their second quarter earnings release) and that they do not raise their dividend again this year, they have a current dividend payout ratio of 33.8% ($1.50/$4.44). This indicates that CN has plenty of room to further raise their dividend payments, or participate in share buybacks to further return money to shareholders.

The Bottom Line

These three stocks represent some of the best dividend growth stocks in Canada right now. Put together, they should provide ample diversification since they do business in three independent industries. Keep an eye on them - buying on dips provides an even better value proposition. Click here to read more investment analysis from the Financial Canadian.