Would Warren Buffett Buy Toronto-Dominion Bank?

Followers of Warren Buffett know he has been a heavy investor in financial stocks, with four of his 11 largest holdings in the sector. His largest position by a wide margin is in American banker Wells Fargo & Co (NYSE: WFC).

Why is Wells Fargo Buffett’s largest holding? Because of its simple, customer-driven, low-cost, low-risk approach to banking. This is an approach that has paid handsomely, with Wells Fargo posting a 3,880% total return since 1990.

In Canada, there is one bank that bears many uncanny similarities to Wells-Fargo, and that’s Toronto-Dominion Bank (TSX: TD)(NYSE: TD). Here’s why TD Bank is a Buffett-quality pick.

TD focuses on old-fashioned, customer-driven retail banking

In a 2009 interview regarding Buffett’s investment in Wells Fargo, he commented that one reason he favors the company is because it has a large and enduring relationship with a huge customer base, and even brings a retail mindset into banking, referring to their branches as “retail-stores”.

Sound familiar? TD Bank adopts the same approach, even down to the language of referring to its branches as stores. TD Bank currently has a huge customer base of 22 million, exceeding Royal Bank of Canada’s customer base of 16 million, despite having a smaller market capitalization.

Currently, TD receives over 90% of its revenue from its American and Canadian retail operations, and only 10% from its wholesale division. This is in contrast to Royal Bank, which earns attains about 27% of its revenue from its capital markets division.

Focusing old-fashioned banking businesses such as mortgage lending, credit cards, and wealth management, produces low-risk, stable, but highly profitable earnings. This is in contrast to other banks that focus more on investment banking and trading, which can produce high returns, but can also be very volatile and tied to favorable economic conditions.

Royal Bank, for example, posted record results from its capital markets division in Q3 2014, with earnings rising 66%. CEO Dick Mackay, however, was quick to note that such strong results were unlikely to be repeated, and were tied to favorable economic conditions.

TD Bank, on the other hand, also posted record $2.1 billion earnings, but these earnings were driven by strong performance from TD’s retail segment, which grew 54% from 2013 thanks largely to excellent loan and deposit growth. This is income driven by an enduring relationship with a large customer base, and through the simple yet profitable business of receiving cheap deposits and lending them out at higher rates.

The result? Like Wells Fargo, TD has outperformed its peers over the past year, while at the same time posting the least share price volatility, a direct result of its strategy.

Like Wells Fargo, TD Bank has solid net-interest margins and low costs

What else does Buffett look for in bank stocks? According to Buffett, the key is low-cost deposits, and earning the highest possible spread on assets. In Canada, TD meets both of these criteria better than its major competitors.

TD Bank currently has a net-interest margin of 2.98%. Although this is slightly lower than Wells Fargo’s margin of 3.06%, it exceeds the margins of both Royal Bank and The Bank of Nova Scotia, which have margins of 2.73% and 2.07% respectively.

Why does TD have a higher net-interest margin? The key is that it has a huge proportion of low-cost demand and notice deposits compared to peers. These are chequing and savings accounts which cost very little, but which the bank can then loan out at much higher rates. In fact, TD Bank currently has the highest percentage of demand and notice deposits to loans out of all the big six Canadian banks.

In Q4 2014, TD Bank had 65% of its total deposits as demand and notice deposits, and only 35% in more expensive term-deposits like GICs. This contrasts with Royal Bank for example, which only has 49% of total deposits as demand and notice deposits.

With a low-cost, customer-focused approach to banking, TD Bank certainly passes the Buffett quality test.

With the recent slide in oil prices and pull back in bank stock prices, now is an excellent time to consider moving away from energy stocks towards the banking sector. The question is, what to buy? Its absolutely essential to know the risks, strengths, and future prospects of each of the top banks so you can make the most profitable choice.

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Fool contributor Adam Mancini has no position in any stocks mentioned.

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