The Republican-led tax cut has been an amazing gift to investors.
Analysts at Goldman Sachs think 2018 S&P 500 earnings will grow 14%, with more than a third of that coming from tax reform. That’s in the process of getting priced in to stock prices, and it helps explain the market’s strength so far this year.
Since tax reform passed, “much of the rally has been analysts doing forecasts for 2018 and adjusting the tax rate,” says Charles Mulford, an accounting professor at the Georgia Institute of Technology who runs the Georgia Tech Financial Analysis Lab.
There’s good reason for the rally. Theoretically, at least, the market value of a company should increase by the dollar amount of tax saved multiplied by the company’s price-to-earnings ratio, says Albert Meyer, a money manager at Bastiat Capital, which is up 177% since its April 2006 inception compared with 104% for the S&P 500 SPX, +0.44%
This is another way of saying that as earnings increase by the amount of tax saved, either the P/E ratio has to go down or the stock price has to go up. This won’t always be the case, but it is a good rule of thumb.
Let’s take Home Depot Inc. HD, +1.51% as an example. The retailer paid $4.3 billion in 2016 taxes at an effective tax rate of 36%. At 21%, Home Depot would have paid $2.5 billion, saving $1.8 billion. Multiply Home Depot’s P/E of 27 by that $1.8 billion in extra earnings, and you get a $48.6 billion increase in market capitalization. That boosts Home Depot’s value to $282 billion from $233 billion, a 21% increase in the value of the company, and presumably its stock, though some of this is undoubtedly priced in already.
Here are four basic rules to follow if you want to hunt for tax cut beneficiaries on your own — to avoid the pitfalls and get the most traction. I’ve also included a few dozen companies that appear to be some of the biggest potential beneficiaries. Special thanks to S&P Global Market Intelligence for assistance with screening databases to come up with the numbers to do this.
Rule No. 1: Check the effective tax rates
The rallying cry for corporate tax cuts was that U.S. business taxes were among the highest in the world. This was only a half-truth. The dirty little secret among U.S. companies is that, because clever tax lawyers exploit a raft of deductions, many companies pay no tax at all. Or at least rates well below the current 21%. Obviously, they aren’t going to benefit from a tax cut to 21% from 35%. Big picture, the effective tax rate for the S&P 500 was 26% last year, far below the 35% tax rate at the time, notes Abby Cohen of Goldman Sachs.
A lot of companies pay no taxes because they make no money. Obviously, you can scratch them off your list of tax-cut beneficiaries. Many of those are in energy and biotechnology, including Hess Corp. HES, -2.28% Halliburton Co. HAL, +1.24% ConocoPhillips COP, -0.02% Alnylam Pharmaceuticals Inc. ALNY, +0.68% and Juno Therapeutics Inc. JUNO, -4.99% Early-stage companies like Tesla Inc. TSLA, +1.58% are in the same boat.
But even companies reporting lots of net income can have low tax rates. They’re not going to benefit from lower tax rates. These include Alphabet Inc. GOOGL, +0.66% GOOG, +0.68% with an effective tax rate of 19.3%, Facebook Inc. FB, +0.83% (18.4%) and Boeing Co. BA, -0.71% (12.1%).
In contrast, companies with lots of net income and also effective tax rates well above the new 21% level include: Wells Fargo & Co. WFC, +0.42% with an effective tax rate of 31.4%, Walt Disney Co. DIS, +0.15% (32%), Comcast (CMCSA) CMCSA, +1.55% (37%), Fastenal FAST, +0.85% (36.8%), Dollar General Corp. DG, +0.94% (36%) and American Express Co. AXP, -1.83% (33%). You can find the effective tax rate in a company’s annual 10-K report.
Rule No. 2: Go domestic
Companies that pay all or most of their tax abroad won’t benefit from the U.S. tax cut. So take those off your tax-boost shopping list. Caterpillar Inc. CAT, +1.40% has a relatively high effective rate of around 30%. But it’s all on foreign profits. The same goes for Philip Morris International Inc. PM, +3.66% Aflac Inc. AFL, +0.44% pays a large percentage of its tax abroad, so it fits the bill, too.
In contrast, companies that do stand to benefit because they have tax rates well above 21% on mostly domestic profits, while they report little to no foreign taxes, include: CVS Health Corp. CVS, +0.64% with a tax rate of 38.4%, United Parcel Service Inc. UPS, -0.38% (33%), Lowe’s Cos. LOW, +3.54% (40.5%), TJX Cos. TJX, +2.12% (38%), Southwest Airlines Co. LUV, -0.02% (36.7%), Altria Group Inc. MO, +1.56% (34.8%), Aetna Inc. AET, +1.25% Visa Inc. V, -0.33% (42.7%), Campbell Soup Co. CPB, +2.46% (31.4%), Comcast (37%), Capital One Financial Corp. COF, +0.94% (31.3%) and Verizon Communications Inc. VZ, +0.70% (35.2%).
Rule No. 3: Avoid companies with high debt
They’re not going to benefit as much from the tax cuts, because the new rules limit deductions for interest paid. Companies can only deduct interest expenses of up to 30% of earnings before interest, taxes, depreciation and amortization. This will take a sizable bite out of earnings. Congress’ Joint Committee on Taxation estimates that the change will raise about $171 billion in tax revenue over 10 years. Further restrictions on interest deductions starting in 2022 will raise another $307 billion over 10 years.
Companies with high tax rates that have a lot of debt include: J.C. Penney Co. JCP, +1.53% Avis Budget Group Inc. CAR, +5.61% Eastman Kodak Co. KODK, -1.48% Ford Motor Co. F, -0.58% Pitney Bowes Inc. PBI, +1.04% Sinclair Broadcast Group Inc. SBGI, -0.25% Sequential Brands Group Inc. SQBG, -2.27% and Townsquare Media Inc. TSQ, +1.96%
Rule No. 4: Go small
The sweet spot for companies getting a boost from the tax cut are small- and mid-cap companies, which I’ll define as businesses with a market cap of between $500 million and $5 billion. There are two reasons why. First, they typically can’t afford the army of tax lawyers hired by large-cap companies. So they tend to pay higher taxes. Next, those companies are less researched and noticed by others. So any benefit from the tax cut may be less priced in.
To find some of the better potential winners here, I cut out any names that are losing money or don’t pay taxes. Next, I avoided the ones with high debt, and those paying a substantial amount of tax to foreign countries. I also avoided names that look expensive either on a P/E or price-to-book basis.
Names that look like big winners under the tax cut because they clear all these hurdles and pay high effective tax rates include: Evercore Inc. EVR, +2.17% with a tax rate of 44.5%, MYR Group Inc. MYRG, +1.61% (44%), Primoris Services Corp. PRIM, +0.61% (43%), Kforce Inc. KFRC, +2.11% (41%), ePlus Inc. PLUS, +2.13% (41%), Meridian Bioscience Inc. VIVO, +1.34% (40.8%), Scholastic Corp. SCHL, +0.79% (40.3%), Heritage Insurance Holdings Inc. HRTG, -0.05% (40%), Houlihan Lokey Inc. HLI, +0.50% (39.3%), DSW Inc. DSW, +3.08% (38.8%), Marriott Vacations Worldwide Corp. VAC, +2.51% (38.4%), Beacon Roofing Supply Inc. BECN, +0.08% (38.3%), On Assignment Inc. ASGN, +1.48% (38.2%), Shoe Carnival Inc. SCVL, +0.95% (37.7%), American Eagle Outfitters Inc. AEO, +2.33% (36.6%), Ethan Allen Interiors Inc. ETH, +2.62% (36.5%), Urban Outfitters Inc. URBN, +2.90% (35.5%), Winnebago Industries Inc. WGO, +1.15% (34.3%), Waddell & Reed Financial Inc. WDR, +1.06% (33.9%) and Encore Wire Corp. WIRE, +1.56% (33.4%).
Companies excluded as direct beneficiaries of the tax cut still stand to gain. Presumably, the companies that do benefit will invest some of their newfound cash flow, creating economic growth. And the lower rates will encourage more foreign investment in the U.S. Plus, the boost to stocks may reduce unfunded pension liabilities at governments around the country, potentially lowering the tax burden.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested HES, COP, ALNY, JUNO, GOOGL, FB, BA, WFC, DIS, FAST, DG, AXP, CAT, PM, LUV, HRTG and VAC in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.