Miller/Howard Investments
Miller/Howard Podcast
How might tax reform impact equity investments?
Gregory Powell, Portfolio Manager

How will a lower corporate tax rate impact the stock market? Since the bill was forged in congress, stock prices have taken a big step forward, leading most investors to argue that the tax bill has been fully priced in.

That could be true, but there's a lot more to this story.

Cutting the US tax rate to 21% will increase profitability, but the impact will be spread unevenly across firms. Many companies such as Johnson & Johnson already pay a rate well below the new rate due to their extensive foreign operations. With the new law, Johnson and Johnson will pay lower rates on their US earnings but taxes on their offshore income could actually go up.

No doubt J&J's corporate tax experts will work overtime, but it will be hard for their overall rate to go down by much given the low starting point.

In contrast, US-focused corporations typically have paid high rates and could benefit significantly. The question is whether they will be able to keep the cut.

Several Companies such as AT&T, Comcast, and Wells Fargo have instituted employee bonuses and higher minimum wages in response to the tax bill. We view these statements as political rather than economic.

The real question is whether competition will allow companies to keep the tax cut. Industries such as retail, regional banking and health insurance are touted in the press as big winners because they currently pay tax rates nearing 40%. In the short term they will benefit but over the longer term, competition will force prices down. It's not that the companies want to give the money back. It's simply how a competitive economy works.

A simple analogy is what happens to gasoline prices when the price of oil drops. Your local service station would love to keep retail prices high and for a time they do. But competition is relentless at forcing prices down. Especially in situations where all market players have their cost reduced at the same time.

Some firms however, should benefit permanently. Those best positioned currently pay tax rates well above 21% and compete largely against companies that are unaffected by the US tax law.

As an example, Lyondell uses low-cost US natural gas to make chemicals sold in global markets. Prices are set by foreign companies who are unaffected by the US tax law. Lyondell's tax savings should drop to the bottom line because the tax law will have no impact on global chemical prices.

As a second example, Texas Instruments is also well-positioned to keep its tax cuts. The tech sector is notorious for moving manufacturing abroad in order to reduce taxes. Unlike virtually all of its competitors, Texas Instruments makes most of its semiconductor chips here in the United States, not abroad. Tax rates for its competitors will be unchanged. Chip prices should be unaffected, allowing TI to expand its after-tax margins.

Holding onto tax gains means more than a one-time step up in earnings. Those with permanent gains can reinvest in their businesses and compound earnings year after year. Over the long-term the ability to grow dividends is critical to achieving the magic of compounding. Lower tax rates, combined with a strong economy should give us a healthy dose of dividend increases in the coming year. For a select few companies, lower tax rates could lead to higher growth of both income and dividends for many years to come.


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