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Royal Bank of Canada vs. Toronto-Dominion Bank: Which Is the Best Investment?

Royal Bank of Canada (TSX: RY)(NYSE: RY) and Toronto-Dominion Bank (TSX: TD)(NYSE: TD) are Canada’s largest banks. They are both enjoying solid growth and earnings, but are pursuing very different strategies to get there.

Let’s take a look at Royal Bank of Canada and Toronto-Dominion Bank to see which one might be a better option for new investors.

Royal Bank of Canada

Canada’s largest bank abandoned its U.S. ambitions in 2011, after a failed attempt to build a profitable business in the highly competitive market. Royal Bank has since focused on growing its wealth management and capital markets businesses. The shift in strategy has paid off.

Royal Bank reported record Q3 2014 earnings of nearly $2.4 billion, a 4% year-over-year increase. The company’s capital markets division stole the show with a 66% surge to $641 million, representing a hefty 27% of total earnings. Wealth management earnings jumped 22%, and Royal Bank’s insurance group also stood out, with a year-over-year gain of 34%.

Investors should be careful about getting too optimistic as the company acknowledged the record capital markets results might not be repeated.

Royal Bank finished the latest quarter with a Basel III Common Equity Tier 1 (CET1) ratio of 9.5%.

One concern for investors in all of the Canadian banks is the exposure to Canadian residential mortgages. Royal Bank had $189 billion of mortgages on the books at the end of Q3, with 39% being insured. The loan-to-value ratio (LTV) for the uninsured component was 55%.

Royal Bank trades at 13.7 times earnings. The dividend yield is about 3.8%.

Toronto-Dominion Bank

TD has the best Canadian retail operation among the Big 5 banks. The company consistently wins awards for customer service excellence and has a deposit franchise that is the envy of its peers.

Toronto-Dominion is also investing heavily in its U.S. operations. With more than 1,300 branches, TD is now the 10th largest bank in the U.S.

The bank reported net income of $2.1 billion in its Q3 2014 earnings statement. Canadian retail contributed $1.4 billion, a 54% increase over the second quarter in 2013. The entire Canadian retail operation is firing on all cylinders, including a rebound in TD’s insurance operations. South of the border, TD’s U.S. division enjoyed record net income of US$518 million, a 4% year-over-year gain.

Recent results have been great, but the company might run into some headwinds in the coming quarters. Management told analysts on the conference call that TD is forecasting higher credit losses and is facing heavy competition for assets in the U.S. Net interest margins are expected to shrink as a result.

TD is still well capitalized although its CET1 capital ratio of 9.3% is at the lower end compared to the other banks. About 63% of TD’s $231 billion mortgage portfolio was insured as of the end of Q3. On the uninsured portion, the LTV ratio was 61%.

Toronto-Dominion Bank trades at 13.6 times earnings. The dividend yield is about 3.6%.

The bottom line

Both banks are solid long-term holdings, but I would lean toward Toronto-Dominion right now. Royal Bank has a higher percentage of uninsured mortgages on its books, and the heavy reliance on capital markets revenues is also a bit concerning, given the potential earnings volatility in those activities.

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Canadian banks are considered must-have investments. After all, they're very stable, well capitalized, and face limited competition. That said, there are concerns for the banks and their investors. In this FREE report, we cover everything you need to know about Canada's Big 5 -- whether you're already an investor or are considering buying shares. Simply click here to receive your special FREE report, “What Every Bank Shareholder MUST Know."

Fool contributor Andrew Walker has no position in any stocks mentioned.

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