A recent report from Goldman Sachs Group Inc. (GS) predicts that enactment of federal tax reform in 2018 now has a likelihood of 65%. Categories of stocks that are emerging as the potential winners include, per Goldman: high tax rate stocks; value stocks; cyclical stocks; small-cap stocks; and firms with strong balance sheets. Goldman's analysis was presented in a detailed October 3 report entitled "Progress toward tax reform creates earnings upside and gives new life to Trump trades."
High Tax Rate Stocks
Another Goldman report presents a basket of 50 S&P 500 companies with a ten-year median tax rate of 38%, well above the 30% median for the S&P as a whole. These are potentially the biggest winners from tax rate reductions (see the next two sections), and were presented in the September 29 edition of Goldman's U.S. Weekly Kickstart report.
The companies in this basket with the highest ten-year median tax rates are: Marathon Oil Corp. (MRO), 57%; oil producer ConocoPhillips Co. (COP), 49%; Goodyear Tire & Rubber Co. (GT) 46%; metal products manufacturer Arconic Inc. (ARNC), 47%; social media company Facebook Inc. (FB), 40%; electric and gas utility Public Service Enterprise Group (PEG), 40%; water utility American Water Works (AMW), 39%; pharmacy chain CVS Health Corp. (CVS), 39%; managed healthcare company Centene Corp. (CNC), 39%; and options exchange operator CBOE Holdings Inc. (CBOE), 39%.
The White House proposes bringing the statutory federal income tax rate on corporations down from 35% to 20%, and Goldman estimates that state and local corporate income taxes add another 4% on average. They calculate that the median S&P 500 company pays a 27% effective combined federal, state, and local income tax rate. The White House proposal, in dropping the combined statutory rate from 39% to 24%, would shift the U.S. from having the highest rate among the advanced economies of the OECD to a position near the average.
The biggest driver of the difference between the combined statutory rate (39%) and the median S&P 500 company's effective rate (27%) are foreign earnings held abroad, Goldman reports. Currently, S&P 500 companies repatriate only about 30% of their overseas profits for the simple reasons that foreign tax rates are typically much lower than U.S. rates, and that repatriated profits would be subject to the higher U.S. rates.
The most likely scenario, in Goldman's opinion, is that the federal rate will fall to 25% in the final version of the bill. Additionally, Goldman expects the adoption of a territorial tax system in which the overseas profits of U.S. corporations will be taxed at a federal rate of 10%, whether or not they are repatriated. The White House proposes no tax liability at all on overseas profits.
Anticipating these changes, Goldman indicates that its respective baskets of stocks with the highest effective taxes and the biggest overseas cash balances have outperformed in recent weeks. (For more, see also: 5 Stocks That May WIn Big From Tax Reform.)
Direct Earnings Benefit
Goldman currently forecasts 2018 EPS of $139 for the S&P 500. If the statutory federal drops to 25% while foreign earnings are taxed at 10%, Goldman projects a $9 increase to $148, a boost of 7%. Given their existing forecast of 5% EPS growth from 2018 to 2019, and a forward P/E of 17.1, this leads Goldman to project a 2018 closing value of about 2,650 for the S&P 500, a gain of 4.4% from Wednesday's close.
A matter for debate raised by Goldman is whether competitive pressures will cause some of the benefits of tax reduction to be passed along to consumers in the form of lower prices. On the other hand, they note that increased industrial concentration and the rise of "superstar" firms with pricing power means that most of the tax benefits indeed will flow to corporate earnings.
Spurring Economic Growth
Goldman's economists estimate that each additional percentage point of GDP growth in the U.S. adds three percentage points to the growth of S&P 500 EPS. At current levels, that translates into about $4 of extra EPS. Nonetheless, Goldman projects that tax reform will add only about 0.2 percentage points to GDP growth in the first year, or less than $1 of additional EPS. Additionally, they warn that the positive impact can be muted if this fiscal stimulus leads to higher inflation, and thus increased tightening by the Federal Reserve, producing higher interest rates that weigh on equity valuations.
Value and Cyclical Stocks
As the enactment of tax reform has gotten more likely in the minds of analysts and investors, Goldman sees increased projections for economic growth, inflation, and interest rates. This, in turn, has prompted investors to rotate out of growth and defensive stocks, and into value and cyclical companies, leading to enhanced relative performance for the latter two. While Goldman does not anticipate enactment of accelerated expensing or depreciation of capital expenditures, they note that any move in this direction would be of particular benefit to industrials and other cyclical stocks.
Small-cap stocks, such as those represented in the Russell 2000 Index (RUT), derive a larger percentage of their revenues from domestic sources than do large caps in the S&P 500, 80% vs. 71%, on average, per Goldman. As a result, small caps are more sensitive to changes in U.S. tax policy and economic growth. Only 69% of Russell 2000 companies have positive pre-tax income, but among these the effective combined tax rate is 33%, versus 27% for the S&P 500. Better yet, Goldman's basket of stocks with the greatest exposure to small and medium business has outperformed both the Russell and the S&P, and should benefit further, in Goldman's opinion, if tax reform and deregulation spur small and medium business activity.
Strong Balance Sheets
The White House proposal suggests limitations on the deductibility of interest expense, as a partial offset to the revenue loss associated with lower tax rates. Anticipating this, Goldman notes that companies with strong balance sheets (i.e., relatively low levels of debt and interest expense) have been outperforming those with greater leverage.