Investment strategies as tax reforms evolve
The Trump administration’s plans to slash corporate taxes and make other business-friendly changes to the nation’s tax laws have helped lift U.S. stocks in recent weeks. And depending on which changes, if any, ultimately end up in signed into law, more companies could see bigger gains.
“The market is still not pricing in a lot for tax reform, and for good reason,” said Parag Thatte, a market strategist at Deutsche Bank.
Even with a way to go to a final tax package, strategists and fund managers have identified some investment angles for investors looking to trade on the prospect of a more business-friendly tax policy: Tax reform should benefit many smaller companies, as well as multinationals with a lot of profits parked overseas. Interest rates could rise, favoring financial institutions.
Under the administration’s tax plan, the first major overhaul of the tax code in three decades, corporations would see their top tax rate cut from 35% to 20%. For a period of five years, companies could further reduce how much they pay by immediately writing off their investments. The plan also would impose a new, lower tax on overseas corporate profits and create a new tax structure for overseas business operations of U.S. companies.
Given those details, some companies are likely to reap bigger benefits should the proposal become law. Small-cap companies, for example, are expected to get a healthier boost from the proposed cut to the corporate tax rate than most large-cap companies. That’s because small-cap companies tend to pay a higher tax rate now than largecap firms.
Consider that the gap between the tax rates paid by the companies with the highest tax rate and the lowest is at a 30-year high, according to Deutsche Bank.
“The last time we had that gap being so high, we got tax reform in 1986,” Thatte said. “Following the tax reform in 1986, the high-tax paying companies at that time did outperform the low-tax paying ones for the next two years or so.”
Thatte recommends that investors looking to bet on the tax reform favor companies in the Russell 2000 index of smallcap stocks over S&P 500 companies. The Russell has gained about 1.6% since the plan was unveiled, compared with a 1.2% gain in the S&P 500 index.
Should tax reform pass, it’s also a good bet that interest rates will move higher, which will benefit banks and other financial companies, Thatte added.
He also favors value stocks over growth-oriented stocks.
“We are looking for that envelope kind of strategy that does well, even if tax reform does not happen,” Thatte said. “But if tax reform does happen, they get an even larger boost.”
Among top 50 Russell 2000 companies that stand to benefit the most from a tax cut are Skywest, Vectrus and KapStone Paper and Packaging, according to Deutsche Bank. Some S&P 500 companies that are paying higher average tax rates, and would benefit from a tax cut, are Hilton Worldwide Holdings, Charter Communications and Dollar Tree.
The White House’s tax reform proposal also includes a provision to encourage multinational companies to bring back, or repatriate, cash that they’ve kept overseas. All told, there’s more than $1 trillion in cash held abroad by S&P 500 companies, according to Deutsche Bank.
The last time the government did this, in 2004, companies were given a tax “holiday” on overseas profits that let them bring money back into the U.S. at a discount to the 35% tax rate. Most of the $300 billion that companies repatriated went toward share buybacks.
What does that mean for investors? It could mean some multinational companies that elect to bring back cash held overseas could use some of it for buybacks or increase their dividends to investors.