By: Jeff Pollock
November 27, 2017

Tax reform has advanced to the US Senate where a vote could take place as early as Thursday. With the 2018 election one year away, Republicans will be eager to boast a legislative achievement to their constituents. However, as of this writing, nine Republican Senators have yet to commit their support. Carrying only a slim 52-48 majority, the GOP cannot afford to lose more than two votes and pass its bill through the Senate.

Cutting corporate taxes from today’s 35% to 20% would jolt the S&P 500’s earnings by 8% in 2018. The question is whether a tax cut is already priced in to today’s stock valuations?

We compared the Russell 2000 index against the S&P 500. The Russell 2000 is comprised of two thousand small cap companies that operate mostly in the US. Their weighted average tax rate is 31%. The more global S&P 500 includes five hundred stocks, which generate one-third their revenues internationally. Its weighted-average tax rate is 24%, 700 basis points below the Russell 2000.

While the more heavily taxed Russell 2000 initially outperformed the S&P 500 by as much as 10%, its gap dropped around March 2017 to where it sits today below 5%. Recall that on March 24, the Republicans withdrew their scheduled vote to repeal Obamacare in the House of Representatives due to its lack of support. Since then, the market has been skeptical that tax reform can be achieved.

Vestcap’s Investment Committee believes the bull market has further room to run despite the gains already achieved. In the twelve months following Ronald Reagan’s 1986 tax cut, the S&P 500 rallied 39%. Furthermore, according to UBS, the top 20 companies that will benefit most from a tax cut currently trade at an 8% discount to the overall S&P 500. This collection of data suggests that the market has not yet priced in the full benefit of a corporate tax cut.

Several of the securities owned in client portfolios are pure-play investments in the US that pay close to a 35% corporate tax rate. Along with lower rates, these securities will generate significantly higher profits. In 2018, we expect to see continued upside to their stock prices.

 

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