It's been a trying year for Americans, and an exceptionally volatile one for the investment community. The coronavirus disease 2019 (COVID-19) pandemic has completely upended societal norms.
Meanwhile, Election Day is right around the corner. In 13 days, people across the country will head to their local voting booths; many have already mailed in their ballots. The results will determine whether incumbent Republican Donald Trump will receive a second term or if Democratic Party challenger Joe Biden will become the 46th President of the United States.
If Biden wins in November, expect corporate taxes to increase
According to polls (which haven't always proved prophetic), Biden has a comfortable lead both nationally and in key swing states. If these surveys are correct and Biden wins, he'll be able to implement some of his core campaign proposals. Americans and investors thus could face big changes come 2021 or 2022.
Biden's chief promised change is a reversal of a handful of tax cuts implemented by President Trump in the Tax Cuts and Jobs Act.
The TCJA was the most sweeping overhaul of the U.S. tax code in decades. It lowered the individual tax rate for a majority of Americans or widened the income range applicable to a respective marginal tax bracket. Additionally, the corporate tax rate was slashed from 35% to 21% on the idea that lowering it would fuel business expansion, hiring, and wage growth.
Biden's proposal would see the peak marginal corporate tax rate increase from 21% to 28%, erasing half of the cut passed along by President Trump. Also, the peak individual tax rate would be moved back to 39.6% from its current 37%.
There's no argument on Wall Street that a corporate tax hike would lower operating earnings for the S&P 500. A recent analysis from Goldman Sachs estimates that Biden's tax hike would reduce S&P 500 earnings by about 12% in 2021.
It's not all bad news if Biden's tax hike becomes law
But I have news for investors: Even if Biden wins and this tax increase comes to fruition, there are three sectors that can still thrive.
One sector that's capable of completely shrugging off Joe Biden's tax proposal is real estate -- specifically, real estate investment trusts. In exchange for avoiding normal corporate income tax rates, REITs distribute 90% of their earnings in the form of dividends to shareholders. Therefore, REITs are going to avoid direct liability from changes to the U.S. tax code.
I'd strongly suggest keeping an eye on mortgage REITs. Although this part of the industry is well off the map for most investors, it could be a surprising winner during a Biden presidency. Annaly Capital Management (NYSE:NLY) in particular could thrive.
Mortgage REITs like Annaly borrow money at short-term lending rates and acquire assets (i.e., mortgage-backed securities) that have higher long-term yields. The difference between this higher long-term yield and lower short-term lending rate is known as the net interest margin. The higher the NIM, the more money Annaly can make.
With Joe Biden more likely to spend aggressively to bring the U.S. economy out of the pandemic-induced recession, and the Federal Reserve willing to go to whatever lengths necessary to support financial markets, it's my belief that Annaly Capital's NIM will steadily expand over the coming four years.
Another sector that can thrive if Biden's tax increase becomes law is utilities. Unlike REITs, electric, natural gas, and water utilities aren't going to get a free pass. However, since most utilities are regulated, they'll have more than enough justification to request price hikes from state public utility commissions to offset their increase in tax-related expenses.
A good example of a utility stock that can excel during a Biden presidency is American Water Works (NYSE:AWK). As the name implies, American Water Works operates as a water and wastewater utility provider in many U.S. states. Though it can't simply pass along rate hikes at will, being regulated means the company avoids being exposed to potentially volatile wholesale pricing. In other words, this is a very predictable, cash-flow-friendly business model.
A higher corporate tax rate shouldn't stand in the way of American Water Works making bolt-on acquisitions, which are expected to contribute roughly 1% to 2% of the company's estimated compound annual earnings growth rate of 7% to 10% through 2024.
With regulated investments comprising the bulk of the company's growth potential through 2024, American Water Works should have little trouble justifying, and eventually getting approval for, rate hikes.
Healthcare is a third sector that can excel even if Biden increases corporate tax rates to 28%.
To be clear, not all healthcare stocks will be winners if Biden's tax plan becomes law. However, healthcare companies that offer exceptional pricing power will be able to pass along higher costs to patients and insurers, much in the same way that utilities are likely to increase rates on their customers. What this suggests is that low-margin healthcare stocks (e.g., pharmacy chains) could see earnings decline, whereas the majority of drug and device makers would be largely unfazed.
For instance, Big Pharma company Bristol Myers Squibb (NYSE:BMY)can continue to grow its earnings even with a higher corporate tax rate. In Nov. 2019, Bristol acquired drugmaker Celgene, whose prized cancer drug Revlimid offers some of the strongest pricing power among pharmaceuticals in the world. Between 2010 and 2017, the list price of Revlimid nearly doubled, and it's continued to increase well above and beyond the rate of inflation ever since. This pricing power, along with Revlimid's increased demand and duration of use, should be a positive for Bristol Myers Squibb.
Although the category isn't wholly immune to a tax hike like the REITs, most healthcare stocks should benefit from stronger pricing power.