Tax Reform Effect on Stocks
January 18 2018 - What We Know and Don’t Know About Tax Reform’s Effect on Stocks By Dr. Van Tharp Trading Education Institute
The strong push up in the U.S. stock markets has everything to do with the market narrative. The narrative is the overarching theme that is the most prevalent driver of the long-term stock price trend.
I know that I sound like a broken record. I hear you saying, “D.R. — you’ve talked to us about the market narrative so many times…”
I do it for these reasons:
It keeps us on the right side of the market.
We don’t have to be smarter than everyone else and call the top.
We don’t have to sit on the sideline waiting for our market topping call to take effect.
We just follow the price action by understanding the prevailing narrative that is driving traders’ and investors’ actions.
If we have a clear understanding of the market narrative, we can avoid anticipating the top and just ride the momentum until the top shows itself.
Since early November of 2016, the Trump Growth Narrative has been the prevailing market driver. The three legs of this growth narrative are still — and have been since our original discussions — reduced taxes, regulatory reform, and infrastructure spending.
And right now, the most important driver out of this three-legged stool is the recently passed tax reform. I believe that the effects of tax reform have not yet been fully priced in by the markets. Here’s why.
The most basic fundamental analysis of a stock’s value would be that the current price should reflect the net present value of all future cash flows produced by the company.
Given that definition, when cash flow has a step-change increase (in this case from reduced tax expense), a stock’s price must, over time, increase to take into account all of the future tax benefits.
And until companies start reporting actual earnings under the new tax regime, we won’t know the all the nuances of the tax benefits sectors and individual stocks will enjoy.
Because of this uncertainty, the market has not yet fully been able to price in or “discount” the effects of reduced tax expenses.
So what do we do about that?
Let’s look at the three areas of the tax reform that I believe will have the biggest impact on stock prices:
Companies with most or all of the tax revenue coming from the U.S.
Companies that require large capital expenditures.
Companies with large cash hoards overseas.
Let’s look at these individually, and then zoom in on some companies that I have my eye on in each category.
High Percentage of Tax Revenue from the U.S.
This one is pretty straightforward once you realize that companies by and large get taxed for their sales in the country where the sales are made. Corporate tax rates haven’t changed significantly in other countries. But they sure have in the U.S.
Since the tax reform only impacts sales that happen in the U.S., countries who get most or all of their revenue inside this country stand to benefit the most because of the drop of the top tax rate from 35% to 21%.
I was surprised to find 292 stocks out the largest 1000 U.S. stocks have all or almost all of their revenue coming purely from the U.S.
That makes for some pretty bountiful hunting. Look for banks and healthcare companies to make up a large part of those 292 companies.
Capital Spending Becomes an Expense Sooner
How a company gets to expense the cost of property — from real estate to equipment to even software has always been a complex accounting issue.
In somewhat of an oversimplification: If you put in a new piece of manufacturing equipment with an IRS imposed 20-year lifespan, you could only write that expenditure off in equal increments over 20 years.
With the generous early expensing provisions of tax reform, companies that would benefit include:
Transportation companies (airlines, trucking and rail are favorites).
Telecom (building out and maintaining networks require high levels of capital)
Large national car dealers
Bringing the Cash Back Home
Companies with large overseas businesses won’t benefit as much from the domestic tax breaks, but those that have managed to accumulate cash overseas get a chance to repatriate that cash at a reduced rate that ranges from 8 to 15.5%.
The companies will then be able to return that cash to shareholders through dividends or share buybacks or better yet, invest the low-tax-rate capital in business growth opportunities. While we know Apple (AAPL) has the single largest overseas cash hoard, there are other companies that have as much as a percentage of market cap and include tech companies like Microsoft and Cisco as well as chip makers like Qualcomm. Biotech firms also tend to have large overseas cash holdings.
The market narrative is a powerful tool to keep us heading in the right direction. And with a strong market mover in tax reform, we have the opportunity to profit on many stocks as they realize the benefits of this growth-oriented tax plan.
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