Institutional money managers say the proposed capital gains tax cut could extend and broaden the bull market, pushing small-capitalization stocks to move out of the doldrums to new higher levels.
Even before Congress and the White House reached a compromise, many portfolio managers had been devising strategies to take advantage of a potential tax cut.
Loomis, Sayles & Co., for example, which has $3 billion under management, has been buying more high-growth emerging companies in the last year and a half, in expectations of a cut, said Scott Pape, vice president in Chicago.
"We have increased our exposure to those companies with a higher return from capital appreciation to 30% of the portfolio from 15%, because we think they offer much more attractive valuations relative to their growth rate, compared to large-cap companies such as Coca Cola Co. and General Electric Co.
"That sector has been fully exploited," he said.
He prefers high-growth stocks such as SunAmerica Corp., The Charles Schwab Corp. and Transamerica Corp and also favors such fast growing sectors as consumer healthcare and technology.
But with the likely prospects of a cut, State Street Research and Management, Boston, with $44 billion under management, would be quite comfortable with its current high exposure to stocks, as long as interest rates and inflation remain intact, said deputy chief investment officer Jim Weiss.
Even though many Wall Street experts had been predicting a cut in the capital gains tax could lead to a huge sell-off in stocks, now they're saying that is less likely, because of the way the tax cut will be implemented.
Gains on investments sold after May 7 and before July 29, 1997, will be taxed at a top capital gains rate of 20%, as long as they were held for at least a year; investments sold on or after July 29 and held more than 18 months will be taxed a maximum rate of 20%; those on investments held between 12 and 18 months will be taxed a maximum rate of 28%; and those held less than a year will be taxed at the same rate as ordinary income.
Mr. Weiss predicted the cuts could propel the stock market to rise another 25% over three years. "Investors look at after-tax returns, so once the tax rate is lowered, they can get the same return from a higher level of pricing, which should lead to a higher level in the stock market."
Small-cap stocks also are expected to appreciate. They have historically performed better after tax cuts, said Peter Anderson, senior vice president at Federated Investors, Pittsburgh, which has $80 billion under management. That scenario is likely to be repeated, he said, because those companies are taxed less than the stocks that make up the Dow Jones industrials and Standard & Poor's 500 Stock Index, which get dividend income.
The cuts ultimately could affect corporate dividend policy, but dividend yields are already at an all-time low, Mr. Anderson said. "It's possible that some of those companies will lower their payouts or offer more stock buybacks," he said.
Mr. Pape of Loomis, Sayles will continue to focus on the smaller high growth businesses, he said. "The cuts should lead to greater investment in those companies whose earnings growth is more dynamic, which in turn should help those stocks and broaden the market rally. The small caps weren't doing well until early May, when the legislation was first drafted, calling for a capital gains cut on assets sold after May 7."
His portfolios are overweighted in financial supermarket stocks, which stand to benefit from the capital gains cuts, because they will encourage a higher rate of savings and investment.
While money managers are applauding the tax cuts, those committed to value strategies say it could make life rougher.
Donald Yacktman, chief investment officer at Yacktman Asset Management Co., Chicago, which has $1.6 billion under management, said he's happy to participate in the stock market's phenomenal rise, but expects it will translate into higher valuations.
"Since our approach is to buy growth stocks that are selling at a discount to the market, few bargains have been showing up lately. We could wind up with more cash."
Currently his portfolio holds 22% cash, 78% stocks.
If there are any losers as a result of the cuts, it could be the annuity business, said Mr. Weiss of State Street Research. "Since they offer the chance to defer taxes, there will be less incentive to go into them if taxes are reduced. But the damage there will be minimal."