Small caps could win big on tax cuts

March 6, 2018 11:00 AM

Now that the hotly debated tax reform bill is a reality, potential winners of a corporate tax move to 21% from 35% are starting to emerge, but exactly how long those benefits will last is being questioned. 

Large Caps: It goes without saying that the country’s most highly taxed companies will greatly benefit under the new reform, specifically those with large portions of cash overseas that have a history of profitability. Apple (AAPL), the biggest taxpayer in the world, has come under fire for keeping more than 90% of its cash balances overseas in order to take advantage of lower foreign tax rates. Now they will be able to repatriate billions back to the United States with less of a penalty. Big tech in general also will be a winner for this reason. 

However, that benefit won’t be recognized immediately due to a one-time repatriation tax between 8% to 15%. Big banks started lowering Q4 2017 expectations as a result, with the likes of Goldman Sachs (GS) saying it would knock $5 billion off of its bottom line in the final quarter. After that, it should be clear skies ahead in 2018 for the banks. Earlier last year, Morgan Stanley (MS) estimated that a cut in the corporate tax would result in double-digit quarterly earnings-per-share growth for all major U.S. banks.

As an industry, retailers may receive the largest lift from tax reform. According to the National Retail Federation, retailers see very little benefit from the deductions and credits that historically have lowered taxes for other industries, and as a result, they end up paying one the highest effective tax rates of any group.

Small Caps: While the blue chips have the advantage of size, smaller names tend to be more domestically focused, and therefore may not have to bother themselves with a large one-time repatriation tax and can take greater advantage of measures meant to improve U.S. companies. These businesses are also seen as a better value during a time when large cap valuations are rather rich. 

“Tax cut winners” shows how the most highly taxed small caps (S&P 600) have outpaced their mid (S&P 400) and large cap (S&P 500) counterparts since tax reform was first mentioned, as investors expect a huge boost. 

International companies 

It’s not only U.S. companies that are set to gain, but international companies will see an increase in post-tax earnings from the United States. Europe’s two largest oil companies, Royal Dutch Shell (RDS) and British Petroleum (BP), recently reported that their U.S. deferred tax assets and liabilities were being revalued as a result of the new tax rate. But similar to their U.S. counterparts, a lofty one-time non-cash charge will be realized for the fourth quarter of 2017.

While there is no doubt that a lower tax rate will equal larger profits for U.S. corporations, there is some debate about how long that benefit will last. Strategists at Bank of America Merrill Lynch recently argued that the new tax law would likely only be helpful in 2018, and may infringe on earnings growth thereafter. They argue that higher profits and more favorable tax laws would increase competition and therefore eat into margins, especially at a time when a number of industries (retail especially) are facing heightened instances of disruption. Another reason is that the Federal Reserve could speed up interest-rate normalization to a pace for which the economy is not ready.

The big question is whether tax reform is baked into current prices, as many companies are updating 2018 guidance based on the 21% rate, helping to bolster an already lofty earnings growth expectation for the year. In just the last three months, the 2018 earnings-per-share estimate for constituents of the S&P 500 has moved to 12.1% from 9.8%. If these predictions start coming to fruition, stocks may follow suit; if investors don’t feel they’re already overheating.    

About the Author

Christine Short is a senior vice president at Estimize. An expert in corporate earnings, she produces content highlighting Estimize data. Prior to Estimize, Christine held positions at Thomson Reuters and S&P Capital IQ. @Estimize