3 Winners From Tax Reform

A joint committee from the House and Senate has agreed on a reconciled tax proposal that combines the two packages from each chamber.

While stocks have jumped more than 5% since mid-November in anticipation of the new tax package, a look at individual industries shows there may still be time to position ahead of the companies that stand to disproportionately benefit.

Besides lowering the overall corporate tax rate, the bill includes several other key proposals that could drive corporate earnings for 2018 and beyond.

That means some industries and even specific companies could see an even bigger boost.

In fact, three components of the new tax deal caught my eye as particularly beneficial, and I’m using them to rebalance my own portfolio.

​Broad Changes In The New Tax Bill
The broadest change in the new tax package is the reduction in the corporate tax rate from 35% to 21% starting next year. Companies would pay a 15.5% rate on foreign income held as cash or an 8% rate on income invested in property or equipment.

Owners of pass-through businesses will be allowed to deduct 20% from their business income before paying taxes at their personal rates.

For individuals, the bill keeps the seven tax brackets but lowers the rates and income limits in each. The package also nearly doubles the standard deduction for individuals to $12,000 though it eliminates the $4,050 personal exemption.

The tax package simplifies corporate taxes by repealing the alternative minimum tax (AMT), though it only increases the limits on the individual AMT.

As intended, the tax package does limit or eliminate some loopholes and deductions, but enough remain that it won’t be an even playing field for all companies. That means looking deeper into the tax bill for the components that could be used to create outsized profits for particular companies.

Three Places To Look For Tax-Reform Winners
Before looking to individual components of the tax bill, understand that picking winners from the change in rates means looking first for companies with positive earnings. A company would have to be profitable to benefit from the lower corporate rate because companies with no income won’t pay income taxes anyway.

One of the largest changes to the new system will be how overseas income is taxed. The current rate of 35% due when income is repatriated will be replaced by a 15.5% rate on all profit made outside the United States and an 8% rate on cash held in property or equipment.

This will mean an immediate tax bill for companies with overseas cash but will also free the money up to be brought back and distributed as dividends, used for share buybacks or invested in growth.

Technology companies look to benefit the most from the new rules. Among the 25 companies in the S&P 500 with the most overseas cash, 10 are from the tech sector with a total of nearly $600 billion, followed by consumer retail with six companies and a total of over $100 billion in foreign cash.

Capital spending by companies will be immediately deductible, freeing them from having to spread the expense over decades as depreciation. This could shield billions of income from taxes for industries with high levels of capital expenditures like telecom and transportation. Look for U.S.-focused transportation companies with older fleets that need to be updated like Spirit Airlines (Nasdaq: SAVE) and Schneider National (NYSE: SNDR).

The change only relates to equipment purchased from September 2017 through January 2023, after which the percentage that can be immediately deducted is phased out, so watch for a wave of spending by these companies over the next several years. This could drive a boom in orders for heavy equipment manufacturers.

Industries with most of their sales from within the United States tend to pay the highest average effective rate. According to data from the Stern School for Business at NYU, the four industries with the highest average tax rate are retail (38.6%), healthcare support services (38.2%), wireless telecom (37.7%) and trucking (37.5%).

Retailers could benefit on both the top- and bottom-line in the tax reform. Consumers could find more cash in their pocket after a doubling of the standard deduction, spurring consumer spending, and the lower corporate tax rate could drive higher earnings for this heavily-taxed sector.

Retail has lagged the S&P 500 with the SPDR S&P Retail ETF (NYSE: XRT) up just 1.2% this year versus 19.5% for the broader index. Companies in the fund trade for 15.9 times trailing earnings compared to a multiple of 25 times for the S&P 500.

Two Losers To Avoid
The benefits of the new tax package don’t come without a cost.

Healthcare companies may benefit from lower rates and other components, but the repeal in the individual mandate that everyone buy health insurance could hit top-line revenue. Fewer people with health insurance could mean fewer seek health care and that hospitals must once again provide treatment to uninsured.

The tax bill could also be a mixed bag for companies with a high amount of debt and low earnings. Currently, companies are able to deduct all interest expense from operating earnings before calculating taxes. The new bill would cap the amount of interest that can be deducted at 30% of earnings before interest, taxes, depreciation and amortization (EBITDA).

Risks To Consider: Tax reform will be a strong tailwind for companies, but it won’t be the only factor determining stock prices. Invest in best-of-breed companies with strong fundamentals.

Action To Take: Take advantage of the coming momentum in some companies provided relief by tax reform. Look for companies with large amounts of overseas cash, high levels of capital spending and/or a U.S.-centric business model with a high effective tax rate.

— Joseph Hogue

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Source: Street Authority