One of the most widely accepted principles of investing is that the intrinsic, or fundamental, value of an investment equals the present value of all future after-tax earnings to the owners of that investment. Simple math shows that a lower tax rate leads to higher after-tax earnings, in turn creating a higher intrinsic business value. Said more eloquently by Warren Buffett when commenting on the Tax Cut and Jobs Act, which permanently lowered the U.S. federal corporate tax rate to 21% beginning this year: “You had this major change in the silent stockholder, the U.S. government, in American business, who has been content with 35%, and now instead of getting a 35% interest in the earnings, they get 21%, and that makes the remaining stock more valuable.” Lower tax rates will boost earnings and make owners’ claims on those earnings worth more, all else being equal.
But all else is not equal. We, as relatively passive shareholders, rely on company management teams and boards to decide how to invest or distribute our companies’ earnings—a process known as capital allocation. Skilled managers’ capital allocation decisions often lead to increases in future earnings per share, and therefore intrinsic business value. Due to the lower corporate rate as well as two other provisions of the new tax code which involve the treatment of overseas earnings and capital investments, companies will have more earnings to put to work. What they do with the extra cash will be a significant driver of the future intrinsic value of our investments.
"Due to the lower corporate rate as well as two other provisions of the new tax code which involve the treatment of overseas earnings and capital investments, companies will have more earnings to put to work."
Aside from the U.S. corporate rate, “repatriation” was addressed in the final version of the bill. Prior to the new legislation, U.S. companies doing business internationally had to pay a top tax rate to bring those earnings home. This created an incentive to keep or reinvest those earnings overseas. The new law mandates a one-time tax of 8% to 15.5% on past foreign earnings, after which those earnings may be repatriated tax-free or at a potentially lower rate than would be levied in the U.S. As a result, companies have more capital to allocate either at home or abroad. The effect is more pronounced among technology and healthcare companies, which often earn an outsized portion of their profits outside the U.S. Apple, for example, is said to have plans to repatriate almost $200 billion this year.
In addition to repatriation, certain methods of accelerated depreciation made it into the new law. This will allow companies to write off capital investments in certain long-lived assets over shorter periods of time—in many cases during the year in which the assets were purchased—instead of spreading the tax benefit over many years. The resulting lower tax bill will put more after-tax earnings in the hands of company management in the near term. The effect is particularly notable among industrial companies, which tend to rely on expensive long-term assets to generate profits. In turn, it may also boost demand for goods produced by companies that sell such long-term assets. For instance, Clifford Swan Research recently spoke to a company that plans to purchase more airplanes in the near term from a major U.S. aircraft manufacturer because of the new law.
"...Clifford Swan Research recently spoke to a company that plans to purchase more airplanes in the near term from a major U.S. aircraft manufacturer because of the new law."
There are several ways company management can put excess earnings to work to increase intrinsic value for shareholders. First, a company can attempt to grow and generate higher future earnings. Growth might involve building new stores or factories, hiring more employees, or buying another company. As increased spending on growth initiatives would work its way through American businesses in a number of ways, many proponents of the tax bill tout its potential to stimulate the economy. Ford, CVS, and AT&T, for example, say they plan to invest for growth. Next, a company can reduce debt, ensuring that shareholders have a greater claim on future earnings. Exxon Mobil, for instance, has expressed an intention to pay down debt post tax reform. Finally, a company may use excess earnings to pay dividends, repurchase stock, or simply save for future opportunities. The effect of repurchases is that a greater proportion of earnings will accrue to you, the remaining shareholders, increasing the intrinsic value of the shares you own. Apple, Cisco, Wells Fargo, Pepsi, Amgen, and Alphabet are all planning to use excess earnings to buy back significant amounts of their own stock.
Strong management teams behave like fiduciaries when it comes to allocating owners’ earnings to produce the maximum benefit. If attractive growth opportunities exist, a significant portion of excess earnings should be allocated toward them. If opportunities to grow earnings and intrinsic value for shareholders are more plentiful via share repurchases, then it makes sense to buy back more stock. A company “investing in itself” may simply be good corporate stewardship. In either case, tax reform gives management more dry powder to create value.
"Strong management teams behave like fiduciaries when it comes to allocating owners’ earnings to produce the maximum benefit."
There are two important caveats that deserve attention. The first is about the likelihood that corporate tax cuts will remain permanent. The second focuses on what happens if excess earnings are not put to good use. Both have the potential to impact the intrinsic value of your investments.
It is conceivable that corporations will be asked to share more of the federal tax burden under certain circumstances. Since World War II, tax receipts as a percent of GDP have been a consistent 15-20%. Corporate tax receipts as a percent of GDP, however, have declined from approximately 5% to less than 2% during this time. Should government debt and deficits become a problem, particularly given the country’s bourgeoning entitlement and demographic situation, corporations may be asked to share more of the burden via higher taxes. That request may garner more political support if the recent act’s potential to drive economic growth does not come to fruition.
Further, there is no guarantee that excess earnings will be spent prudently. Like the lottery winner that goes broke, or the progeny that drives the family business into the ground, corporate history is littered with bad mergers and acquisitions, failed growth initiatives, and share repurchases that left companies without enough cash at inopportune times.
"Ultimately, it is up to company management to grow per-share earnings and create intrinsic value for owners. Though tax reform should be beneficial at the margin, the stakes have been raised."
Ultimately, it is up to company management to grow per-share earnings and create intrinsic value for owners. Though tax reform should be beneficial at the margin, the stakes have been raised. The act will only amplify the difference between good and bad management. Fortunately, our active approach at Clifford Swan allows us to invest in companies we have identified as having the strongest management teams, who will now have more earnings to put to work, and who we believe can create tremendous value investing those earnings. Our approach allows you, as shareholders, to overweight the skills of these leaders instead of taking your chances on the entire S&P 500 Index. We believe choosing wisely is the best way to create long-term value.
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