Warren Buffett always says the most important job for CEOs is asset allocation. In other words, which parts of the business to invest more, which parts to sell, and how much profit to pay investors directly, as dividends or share buybacks. This is particularly true for banks.

 

Many investors are asking us what to do with their TD bank stock. For years, TD bank had the highest price earnings multiple amongst Canadian banks. This is another way of saying investors believed they had the best management in terms of capital allocation and were prepared to pay more for the bank considered as better managed. As we have stated in earlier pieces, during the latest crisis TD bank lost this premium valuation. The main reason is that the crisis revealed them being more reliant on retail banking than presumed. In particular, their large US operations were very good at collecting deposits that were in turn used for credit card growth, which obviously does poorly in recessions.

 

So is TD bank now an opportunity or does it carry a risk? We think there are two interesting facts investors should focus on. Firstly, as of right now TD has amongst the highest levels of capital, but they have also taken the most in bad loan reserves. Secondly, they own slightly more than 10% of Charles Schwab, which will be free to sell within a year. This stake is worth roughly USD $6 billion at today’s closing price.

 

So TD has 3 choices:

1. Sell the Schwab stake and use the proceeds to diversify away from retail banking into wealth management or investment banking;
2. They could decide that the best thing to do is sell the stake and repurchase their stock since the valuation is much lower than pre-crisis;
3. They could do nothing and wait to see what the economic recovery looks like.

 

Our view is simple. As long as they choose option 1 or 2, TD bank remains a good investment with interesting upside down the road. However, if they do nothing but wait for more clarity in the economic recovery, we would sell and buy Bank of America instead. As Buffett says, it’s all about the CEO making good capital allocation decisions.