Watch for a pullback before buying the TSX's top-performing financial stock this year

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Stocks surged higher after the U.S. Federal Reserve announced its decision to leave rates unchanged on Wednesday. Resource stocks, in particular, rallied as the U.S. dollar weakened. However, discussed below is another beneficiary of the rising investor sentiment and positive market momentum, a financial stock that pays a healthy dividend, TMX Group Ltd. (X-TSX).

The company

Toronto-based TMX Group provides services such as exchange listings, trading, clearing and settlements for its marketplaces, notably the Toronto Stock Exchange and the TSX Venture Exchange.

Key features of the investment thesis are as follows:

• Industry leadership. TMX Group is a leading operator in Canadian capital markets.
• Strength in the S&P/TSX composite index. Canadian equity markets are outperforming major global markets. The S&P/TSX composite index has a price return of 13 per cent year-to-date, and the S&P/TSX Venture composite index has soared 54 per cent so far this year. Positive market momentum translates into strengthening investor sentiment, which in turn helps drive trading volume. In addition, it fosters a favourable environment for initial public offerings, another revenue driver for the company.
• Activity in the third quarter was promising. In August, there were 43 financings on the Toronto Stock Exchange, compared to 23 in the same month last year. In July, there were 66 financings, up from 57 in July, 2015. Activity was similarly robust on the TSX Venture Exchange. In terms of trading activity, as of the end of August, trading volume for all TMX equity marketplaces was up 10 per cent year-over-year.
• Focus on improving profitability. Last week, management announced plans to cut approximately 115 jobs, targeting annualized savings of between $8-million and $10-million by the end of 2016, and additional annualized savings of between $3-million and $5-million by the end of 2017. Cost savings may also be realized from the integration of the Canadian Depository for Securities Ltd. with the Canadian Derivatives Clearing Corp.
• Record financial results. In August, the company reported record second-quarter revenue and earnings per share. Revenue grew 9 per cent year-over-year to $194.6-million. Adjusted earnings per share came in at $1.23, up 32 per cent compared to the same period last year.
• Revenue diversification. The company’s revenues are spread across multiple asset classes such as equities, fixed income and derivatives.

Potential challenges to be aware of:

• Competition heats up. In February, Nasdaq announced it had completed the acquisition of Chi-X Canada, which offers an alternative trading system. Nasdaq has yet to provide specific details on its strategic plans.
• Potential fee changes. Potential regulatory changes to market data fees could have negative implications for TMX if its fees were reduced or capped.

Dividend policy

The company pays its shareholders a quarterly dividend of 40 cents per share, or $1.60 on a yearly basis. This equates to an annualized dividend yield of approximately 2.7 per cent. The dividend appears sustainable with room to expand.

Valuation

According to Bloomberg, the stock is trading at an enterprise value-to-EBITDA multiple of just over 10 times the 2017 consensus estimate, which is above its historical three-year average multiple of 9.2 times. (EBITDA represents enterprise value-to-earnings before interest, taxes, depreciation and amortization.)

Analysts' recommendations

Analysts have been very cautious on this stock throughout this year. Last week, one analyst lifted his recommendation to a "buy" from a "hold," making him the sole analyst with a "buy." There are four with "hold" recommendations and one "sell."

According to Bloomberg, the one-year average target price is $63.60, suggesting the share price has approximately 6 per cent of upside potential. Target prices range from a low of $55 to a high of $69.

The consensus EBITDA estimate is $370-million in 2016, and anticipated to rise more than 6 per cent to $394-million in 2017. The consensus EPS estimate is $4.30 in 2016, and forecast to climb 8 per cent to $4.65 in 2017.

Analysts have been revising their forecasts higher in recent months given the better-than-expected financial results reported over the past two quarters. At the beginning of March, the consensus EBITDA estimate was $342-million for 2016 and $375-million for 2017, and the EPS estimate was $3.63 for 2016 and $4.08 for 2017.

Insider transaction activity

On Aug. 23, Luc Bertrand, a director, purchased 170,000 shares at an average price of $56.88 a share.

Chart watch

Year-to-date, TMX Group is the top-performing stock in the financial sector of the S&P/TSX composite index with a price return of 68 per cent.

There is initial overhead resistance between $60 and $62. There is initial downside support at $55, and failing that, between $48.50, which is near its 200-day moving average, and $50.

The bottom line

I rarely believe in chasing a stock, even if it's a great company, as there is typically volatility in the markets that will often give you a better buying opportunity. On Sept. 21, when I heard about the cost-cutting measures, it signalled a buying opportunity in my mind. However, since then the share price has jumped nearly 6 per cent.

So now, I suggest readers put this stock on their radar screen and watch for a pullback on days when there is market weakness.

As always, I strongly encourage readers to consult a financial adviser, and to do their own proper due diligence before taking any investment action.

The author does not personally own shares in the security mentioned in this story.