U.S. equity markets rose sharply in the fourth quarter following the surprise election of businessman Donald Trump. Small-cap companies outperformed large-cap companies by a large measure as key portions of Trump’s economic plan including lowering corporate taxes, reducing regulation, and denouncing the benefits of globalization are likely to benefit small-cap companies given their higher exposure to U.S. markets. From a sector standpoint, financial stocks were the top performers on the prospects of reduced regulation. Industrial stocks also moved higher and energy companies delivered strong performance on higher oil and natural gas prices. Consumer staples, real estate,and utilities all underperformed as rising interest rates and a risk-on mentality caused investors to exit these prior safe-havens. Interest rates moved higher as the Fed raised rates and higher inflation expectations hurt bonds. Oil prices advanced past $50/barrel while gold prices fell.
Although a portion of the post-election rally can be attributed to market expectations for decreased regulation and increased fiscal spending, in our view the majority of the market rally is due to the expectation that the corporate tax rate will be reduced. As we originally suggested in the Q4 2015 quarterly letter, a decrease in the corporate tax rate from 35% to 15% would result in a 31% increase in after-tax earnings (for a profitable company paying the full corporate tax rate). Such a reduction would result in an immediate increase in corporate earnings that would otherwise take years to develop. CNBC recently reported that the effective tax rate for companies in the Russell 2000 is 32% while the effective tax rate for large-cap companies in the S&P 500 is 26%. The difference in tax rates can be at least partly attributed to the jurisdiction where revenues are generated. Large-cap companies generate over 40% of their revenues outside of the United States (where corporate tax rates are lower) compared to small-cap companies that generate just over 20% of their revenues internationally. Thus, a reduction in the U.S. corporate tax rate is likely to provide a larger benefit to the after-tax earnings of small-cap companies and this is effectively what we have seen since the election. While we tend to shy away from making predictions on the legislative process, we expect the U.S. corporate tax rate will be reduced to a range of 20-25%, although the timing and duration of such a move remains uncertain. A reduction to the corporate tax rate presents a number of other key considerations for investors. While after-tax valuation metrics such as price/earnings ratios should remain relatively consistent on a forward basis, ratios that measure profitability before taxes (such as Enterprise Value / EBITDA) are likely to expand. In addition, companies with significant deferred tax liabilities are likely to benefit compared to companies with deferred tax assets (especially those with built-up net operating losses). Finally, a reduction in the tax rate reduces the incentive mentioned earlier for corporations to issue debt financing as the tax deduction related to interest rate payments will decrease.