New Tax Regime: Bigger Threat Than Coronavirus?

How to position your equity investments

Favorable drivers for the market remain in place… The S&P 500 topped 4,000 before the Good Friday holiday, marking a new all-time high and representing a 7% YTD gain. We attribute this performance to four factors. One, the innovative nature of U.S. corporations and their inherent ability to grow (without which the other stuff wouldn’t matter much). Two, ultra-low interest rates and the promise that rates will remain low. Three, government stimulus. And four, momentum.

…Notice that we did not cite expectations for the economy to “reopen” among our list of favorable market factors.   The media and analysts continue to talk about economic recovery as a positive driver for many businesses, the stock market, and the economy overall. It is a positive. However, in our opinion, this was fully reflected into professional investor expectations months ago. If you are buying stocks today because Covid19 is going away, you’re too late.

…but if we’re looking forward, we see a cause for concern.   Government spending is a stimulus to economic activity. Biden’s $2 Trillion infrastructure plan, unveiled last week, promises to be a boon to select companies, their employees and the economy in general. Unfortunately, the dark side of the plan is that it will be paid for by raising tax rates on corporations.  

Why Higher Tax Rates on Corporations Matter

This is very simple. Higher tax rates mean lower earnings. Higher tax rates also reduce a company’s economic return. A business’ economic return (how much value it creates for shareholders) determines in part what multiple it should trade relative to earnings. A lower return equals a lower multiple. Thus, higher tax rates for corporations will result in lower earnings (the “E”) and also justify a lower earnings multiple (how you get to the “P” in the price to earnings ratio (“P/E”)). All else being equal, it seems clear that raising corporate tax rates would drive stock prices lower. 

Unfortunately, Higher Tax Rates for Individuals are Also on Tap

You might believe that a lower stock market is not that relevant to the overall economy. Therefore, higher corporate tax rates and lower equity prices might not seem like something to worry about. You might also believe that funneling the tax proceeds into a much-needed infrastructure plan is a favorable offset. We agree that this spending will serve as an offset and a is positive for economic activity. The trick is in quantifying this benefit relative to the negative of higher taxes.

Regardless of the net impact, following the $2 trillion infrastructure tax-and-spend plan is likely to be a change to the individual income tax brackets. Specifics are not available but we believe it’s safe to assume that rates will be going up. This could include higher federal tax rates, higher rates on capital gains or investment income, reduced deductions, and various higher transfer taxes on estates.  

Why Higher Tax Rates on Individuals Matter

Think of higher taxes as the opposite of stimulus. If sending money to individuals boosts economic activity (the data over the past year with three cash distributions clearly shows this to be the case) then taking money away via higher tax rates will have the oppositive impact. Progressives might argue that the lower income families getting the stimulus payments had a very high propensity to spend. On the other hand, taking money away from higher income families that might otherwise save the funds would hurt the economy to a lesser degree. There is some truth to this, but it does not remove the reality that higher taxes on individuals equals lower spending.

The Double Whammy of Lower Equity Prices and Higher Tax Rates

Consumer spending is 2/3 of U.S. economic activity. It is difficult for the economy to grow if consumer spending contracts. The single most important factor in determining consumer spending is employment and wages. Consequently, “closing” the economy due to Covid19, which threw millions out of work, plunged the U.S. directly into economic contraction and recession. 

Subsequently, both administrations have followed the same strategy which essentially amounted to throwing money at the consumer and economy while playing time for a vaccine. This has worked. Things are looking much better and the crisis is fading into the past. Unfortunately, the new proposals being considered would essentially reverse a key component of the previous strategy by effectively reducing spending power and taking money away from consumers. What will be the positive offsets?   

The Ironic Beneficiaries of These Policies are…

How you should position your investments in an environment of higher taxes and lower spending: 

If recent “reopening gains” reverse and spending contracts, the companies that will benefit the most from these challenges are large established businesses with strong balance sheets that are able to consolidate share. We’re talking about Microsoft (MSFT), Amazon (AMZN), Google (GOOGL) and the like. In other words, the same big tech names that are frequently pilloried by politicians and the media. We would continue to own this group. There are two other categories of stocks we’d own. The second are innovative fast-growing companies (if the shares can be bought at reasonable valuations). The third are stocks where the equity is being priced well below the assets and expected future cash flows of the business (value stocks). 

Stocks we’d avoid: Over the past 9 to 12 months, many of the best performing stocks have been businesses that were threatened with extinction by Covid19 but didn’t die. Aside from the companies were able to use Covid19 to transform their business models, these names are now trading at prices that are no longer attractive. We would also continue to avoid slow-growth legacy businesses, smaller companies with no particular competitive advantage and debt on their balance sheets, and unprofitable speculative names. In short, our investment strategy is unchanged whether the economy is off to the races or whether a giant tax-raise-induced recession is looming. When you think about it, this is the best strategy when it is not really possible to predict the future, which it isn’t.  

Selection from our Model Portfolio: Facebook (FB) The Master Manipulator

You generally want to own management teams that understand how equity markets work: One of our favorite long-term holdings remains Facebook (FB). We see FB’s value as primarily stemming from its trove of user information across its Facebook, Instagram and WhatsApp platforms and its ability to monetize this over time, mostly via advertising. However, not everyone is happy about how FB makes its money. Apple (AAPL), which wants to be perceived as the “good-guy” in the loose confederation of tech conglomerates controlling the digital world, last June announced changes to its operating platform that would give users more control over information shared with app developers, including Facebook. Mark Zuckerberg started whining loudly about this in January, calling it a “risk” to Facebook’s business. But was it? Never in our view. Consider: If Apple’s changes make it harder for app developers to gather user data, then the value of user data will increase. Since Facebook has more data than nearly all other companies (most of it provided willingly by users), Apple’s operating system changes can only make FB’s cache of information even more valuable while simultaneously hurting the ability of smaller competitors to gather equivalent data. Never mind. The media fell into Zuckerberg’s trap, talking up the risk to FB and leading to a few months of underperformance for FB stock (see chart below). This further had the effect of encouraging Apple to proceed. Then, in mid-March, in a “shocking” about-face, Zuckerberg changed his tune and suggested that the new Apple operating system changes would actually benefit FB. Shares have since been on a tear and we remain very optimistic on the company’s future. Well played, Zuck.  

Do you already have enough ETFs and mutual funds? Do you have idle cash earning near-zero or negative interest rates in bank deposits? Would you like to learn more about how we invest in the markets on behalf of our clients? Please click here to request a copy of our client brochure. 

Yours,

John Zolidis

President & Founder

Quo Vadis Capital, Inc.

John.zolidis@quovadiscapital.com

www.quovadiscapital.com

Mr. Zolidis started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford.  He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients.  He also managed money in a buy-side role at a long-short equity fund over 2013-2014.  He was named in the Wall Street Journal’s Best on the Street list in 2005.  Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017 and works from New York and Paris, France.

general Disclosures:

Quo Vadis Capital, Inc. (“Quo Vadis”) is an independent research provider offering research and consulting services. The research products are for institutional investors only. 

The price target, if any, contained in this report represents the analyst’s application of a formula to certain metrics derived from actual and estimated future performance of the company. Analysts may use various formulas tailored to the facts and circumstances surrounding a specific company to arrive at the price target. Various risk factors may impede the company’s securities from achieving the analyst’s price target, such as an unfavorable macroeconomic environment, a failure of the company to perform as expected, the departure of key personnel or other events or circumstances that cannot be reasonably anticipated at the time the price target is calculated. Quo Vadis may change the price target on this company without notice. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources Quo Vadis believes to be reliable; however, Quo Vadis does not guarantee its accuracy and does not purport to be complete. Opinion is as of the date of the report unless labeled otherwise and is subject to change without notice. Updates may be provided based on developments and events and as otherwise appropriate. Updates may be restricted based on regulatory requirements or other considerations. Consequently, there should be no assumption that updates will be made. Quo Vadis disclaims any warranty of any kind, whether express or implied, as to any matter whatsoever relating to this research report and any analysis, discussion or trade ideas contained herein. This research report is provided on an "as is" basis for use at your own risk, and neither Quo Vadis nor its affiliates are liable for any damages or injury resulting from use of this information. This report should not be construed as advice designed to meet the particular investment needs of any investor or as an offer or solicitation to buy or sell the securities or financial instruments mentioned herein. This report is provided for information purposes only and does not represent an offer or solicitation in any jurisdiction where such offer would be prohibited. Commentary regarding the future direction of financial markets is illustrative and is not intended to predict actual results, which may differ substantially from the opinions expressed herein. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

The analyst who is the author of this report has positions in Amazon (AZMN), Apple (AAPL), Facebook (FB), Google (GOOGL) and Mircosoft (MSFT). Quo Vadis prohibits analysts from trading in a way that is inconsistent with opinions expressed in reports [subject to exceptions for unanticipated significant changes in the personal financial circumstances of the analyst].

Permission is hereby granted to reproduce or redistribute this report. Please cite Quo Vadis Capital, Inc. in any reproduction.

SEC Reg AC Certification:

All of the views expressed in this research report accurately reflect the research analyst's personal views about any and all of the subject securities or issuers. No part of the research analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in the subject company of this research report.