Two New Strategies for a Changing Tax Regime
Ever since the election, investors have celebrated the anticipated tax reforms of Donald Trump, sending U.S. markets higher, in particular small-cap companies that are deemed to benefit from a two-pronged focus:
First, Trump wants to “Make America Great Again,” and small-cap companies have more revenue from the U.S.
Second, because these small-cap companies have more revenue from the U.S., they stand to benefit disproportionately from tax cuts because they pay more U.S. taxes and they have less ability to capitalize on opening offices in locations around the world with lower tax rates.
We published an initial sensitivity analysis to look at how various assumptions on tax rates might impact the earnings growth and ultimate market valuations across a market cap-weighted index set of the S&P 500, S&P MidCap 400, and S&P SmallCap 600—along with WisdomTree Indexes.
New Forward-Looking Price-to-Earnings (P/E) Ratio Analysis
We have continued to update our original analysis to also include domestic WisdomTree Indexes. Instead of looking at trailing 12-month P/E ratios, which are biased higher due to losses primarily in the energy sector, the analysis in this table is based on current estimates for this year’s earnings, which we do not believe include any impact from tax changes yet.1 Of course, analyst estimates tend to be optimistic, but this gives us one way of looking at valuation not biased by losses in the energy sector.
New Indexes Geared Toward Revenue Location: Well-Positioned for Tax Reforms
Moreover, WisdomTree recently simplified the methodology of two Indexes that had screened based on revenue location—Indexes that were focused on the U.S. domestic economy and U.S. multinationals but previously had a more complex weighting methodology that incorporated the correlation of each stock to the U.S. dollar. While that methodology had appeal to us, the primary purpose was more about creating baskets of U.S.-focused stocks and U.S. multinationals. The new weighting methodology emphasizes a valuation sensitivity in addition to the revenue location screen/factor.
In many ways, these Indexes are particularly relevant for today’s markets and tax changes on the horizon. Many of the tax reform proposals are geared to impact stocks determined by whether they are U.S.-economy focused or more multinational based. Even prior to the election, we thought revenue location was an important factor for long-run trends based on changes in the U.S. dollar impacting global revenue differently than U.S. revenue. But with tax reforms lowering U.S. effective tax rates, this will also be an important factor in the short run, as it will be the critical factor in explaining how much relative earnings growth results from corporate tax cuts that are planned.
Lowering Tax Rates = Big Earnings Growth in Companies with More U.S. Revenue
The more earnings (and taxes paid) that come from the U.S., the greater the earnings growth should be from a tax cut, as by and large, the companies with revenue across the world already have lower effective tax rates.
Some highlights of this tax analysis:
- Reasonable Valuations: On a forward-looking P/E basis, broad market indexes like the S&P 500 actually appear reasonably priced, with P/E ratios that can be somewhere around 16 to 17 times earnings with a tax rate between 15% and 25%. This tax cut, along with good expected earnings growth this year, could meaningfully help valuations.
- Small-Cap Benefits: Small caps, because they have a higher percentage of revenue already in the U.S., consistently saw better earnings growth under the tax cut scenarios.
- Earnings Weight Lowers P/E Ratios: Yet for those worried about valuations, WisdomTree’s earnings-weighted approach helps lower starting P/E ratios, even before potential tax cuts. When people say the mid- and small-cap spaces look expensive, we point to analysis from the table below that shows our mid- and small-cap earnings Indexes are expected to have P/E ratios that range from 13.6 to 15.6 times earnings with expected P/E ratios and further tax cuts.
- New Domestic Economy Index Brings Greatest Earnings Growth from Tax Cut: The newly positioned WisdomTree U.S. Domestic Economy Index had a weighted average of 97% of taxes paid coming from the U.S.—a full 27 percentage points more than the S&P 500, which had only 70% of taxes paid from the U.S. As a result, compared to all the Indexes on here, this set of stocks had the greatest increase in earnings from a tax cut—whether new rates are assumed to be 15% or 25%. Because this basket also includes an earnings-weighted element, the P/E ratios are expected to be 13.5 to 15.1 times earnings under rates of 15% to 25%. This is a fairly reasonably priced basket of U.S.-oriented stocks, in our view.
- New Multinational Index Benefits Less: The Index with the least pickup in earnings from a lower tax rate looks at companies where revenue is found abroad. This Index had the lowest percentage of taxes paid to the U.S.—less than 50%. As a result, the relative earnings growth compared to other indexes was significantly lower—about one-third of the earnings growth of the U.S. Domestic Economy Index. Yet due to the modified earnings-weighted approach of this index that also includes tilts toward companies with more revenue abroad, the P/E ratio of this Index is fairly similar to the S&P 500 P/E ratio, with a slight discount. These companies may be the ones where we see higher dividend and buyback growth if they are allowed to bring cash back from abroad at lower repatriation rates.
The analysis presented herein will be a work in progress for us. As more details about Trump’s policy become clear, we plan to update this scenario analysis on better models to help clients understand where the market valuations might be impacted most by tax reform. Our newly positioned Indexes, particularly the U.S. Domestic Economy Index, could be quite interesting beneficiaries of changed policies.
Summary of Potential Tax Cut Impact Across Indexes
For definitions of indexes in the chart, visit our glossary.
1Our precise calculations estimate an effective tax rate for each index and a new method for calculating this starting effective tax rate when companies have losses resulting in a lower starting effective tax rate and thus smaller improvement in earnings growth with new tax policy scenarios.
Jeremy Schwartz has served as our Global Chief Investment Officer since November 2021 and leads WisdomTree’s investment strategy team in the construction of WisdomTree’s equity Indexes, quantitative active strategies and multi-asset Model Portfolios. Jeremy joined WisdomTree in May 2005 as a Senior Analyst, adding Deputy Director of Research to his responsibilities in February 2007. He served as Director of Research from October 2008 to October 2018 and as Global Head of Research from November 2018 to November 2021. Before joining WisdomTree, he was a head research assistant for Professor Jeremy Siegel and, in 2022, became his co-author on the sixth edition of the book Stocks for the Long Run. Jeremy is also co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” He received his B.S. in economics from The Wharton School of the University of Pennsylvania and hosts the Wharton Business Radio program Behind the Markets on SiriusXM 132. Jeremy is a member of the CFA Society of Philadelphia.