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For Lasting Tax Cut Benefits, Look to Earnings Quality

Even before the corporate tax rate was cut from 35% to 21% late last year, the stock market anticipated it. In the fourth quarter, the top 25% of companies with the highest tax rate outperformed the bottom 25% of companies with the lowest tax rate by 5%. 

Entering 2018, the tax cut story is likely to get more complicated. While lower taxes should be positive for corporate competitiveness, we believe that for some industries, the earnings bump from lower tax rates may not be sustainable. Mike Wilson, chief U.S. equity strategist for Morgan Stanley & Co., argues that overall earnings quality is apt to deteriorate this year and investors are overly optimistic about the impact of tax benefits today.

Investors should consider the durability of this tax benefit, rather than its size. We think high quality companies with effective competitive barriers are more likely to be lasting beneficiaries of tax reform. From this perspective, we look to industries like pharmaceuticals and biotechnology, aerospace and defense, and payment networks as potentially having lasting benefits. 

Seeking Quality

The shake-out has already started to occur. Lower quality companies are generally more likely to lose the benefits of the tax cut due to competitive forces that drive them to make price, wage, or investment choices that may prevent much of the tax savings from hitting the bottom line. This may cause the earnings growth of many presumed “tax winners” to disappoint this year.

Consider banks and retailers. As the tax bill neared completion, analysts predicted that both would be big beneficiaries given their largely domestic footprints and above average tax rates. Indeed, in 2017’s fourth quarter, as the broad market gained 7%, retailers were up 14% and banks, 10%. However, these sectors have competitive business models, making it less likely that they retain the entire tax benefit. 

Industry Dynamics Matter

We took a look at sectors that may not have initially benefitted from the fourth quarter tax rally because they did not seem to benefit as much from lower taxes as companies with higher tax rates. However over time, some of these companies with strong competitive positions might actually keep more of their respective tax benefit than their high tax rate peers, as the tax savings are less likely to be “competed away.”  When taxes are cut for these higher quality companies, there is usually less pressure on margins and returns, potentially allowing them to keep most of the tax-cut-related earnings benefits.

To assess quality, we studied metrics such as operating margins and return on capital, both of which tend to be strong for high quality companies, with advantages like high barriers to entry, leading market share, and economies of scale. Typically, companies that have a unique product or offering have greater pricing power, which boosts operating margins and allows for more efficient operations, which drives return on capital. 

In our research, we highlighted three sectors that benefit from tax cuts and have these kinds of advantages: 

  • Pharma/biotech companies tend to have drug patents which give them monopoly-like power to drive price and market share gains. Also, some have large overseas cash balances that can be repatriated and put to use in the U.S.
  • Payment companies draw most of their value from networks that are nearly impossible to be replicated due to their sheer size and reach, allowing for greater returns on capital and higher margins.
  • Aerospace/defense companies are generally domestic and typically enjoy high barriers to entry, given their strong market share and long-term contracts. 

These industries, which weren’t in the top quartile of highest tax-paying companies last year, did not participate as much in the initial “tax trade” late last year as the first quartile. But as the market realizes the durability of their tax benefits, they may be set to outperform a basket of formerly highest-taxpaying (but lower-quality) companies.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

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