By Joseph Hogue, CFA
With even Warren Buffett calling for a minimum 30% income tax on the wealthy, the picture looks increasingly bleak for capital gains going into next year. In fact, it seems that two outcomes exist for taxes on capital gains and interest income in 2013. If no deal is reached between the President and Congress, everyone will see their taxes go up on investment returns. If the President gets his way, those households earning above $250,000 will pay significantly higher taxes on interest and 23.8% on capital gains.
Either outcome means large money managers may start positioning their portfolios, taking their capital gains this year and reassessing the value in dividend-paying stocks. The most likely targets of selling could be those stocks with significant gains this year but with tenuous growth or value into next year. Investors may want to reassess their holdings for companies whose share prices have overreached their fundamental value.
Looking at my own portfolio, I began with a simple comparison of returns, price multiples and profitability. Those stocks seeing higher returns could be natural targets as the market looks to collect capital gains in the weeks to come, but this would not be sufficient reason enough to sell out of a strong company with strong prospects.
I also looked for companies with a lower return on equity, a key measure of management effectiveness, and high price multiples relative to peers. Some high-fliers in the market have soared past reasonable valuations on strong sentiment for growth or a niche. These growth stocks are often the first to be sold when investors look to safety or simply to take profits off the table.
Telecom, Technology and Housing
Three sectors have enjoyed strong gains this year and may be good candidates for profit-taking. Telecoms have ridden the surge in demand for smartphones and dividend-payers but investors seem to be overlooking continued losses. Technology has outperformed the general market since the recession and some names are pricing in supernormal growth that may not materialize, while some names in housing seem to have priced in a V-shaped recovery in the sector.
Sprint Nextel (NYSE:S) has jumped 141% this year on investor hopes that the company will eventually return to profitability. Strong smartphone sales are expected to result in a loss of just $0.79 next year versus a loss of $1.46 per share in fiscal 2012. While this would be a good start, the company is not expected to show positive earnings until 2015. The company's return on equity is -40.0%, lower than 82% of peers in the industry, though its gross margin of 41.2% is about average for the industry. While the company recently announced that it would use part of the $3.1 billion from its Softbank sale to improve its wireless coverage and rollout a new LTE network, the shares may be a candidate for profit-taking on valuation.
Shares of KB Home (NYSE:KBH) have fully enjoyed the rally in homebuilders with a 111% gain since January. The company is expected to return to profitability next year with earnings of $0.13 per share versus a loss of $0.81 per share this year. While the rebound in housing should keep the company a going concern, the estimate for earnings next year still brings the stock's valuation to 110 times earnings. The company's current return on equity is -2.0%, lower than 67% of peers in the industry. While few doubt the resilience of the housing recovery, shares of homebuilders could stagnate as earnings catch up to hefty valuations. This outlook makes the shares easy targets for selling to lock-in returns.
I am probably more bullish on the housing recovery than most, as evidenced by a recent article highlighting the growing imbalance in supply-demand dynamics. Instead of neglecting the sector, I recommend shifting to stocks with cheaper valuation and stronger fundamentals. Shares of home improvement retailer Lowe's (NYSE:LOW) trade for a much more reasonable 21.2 times trailing earnings and pay a 2.0% dividend yield. The shares have lagged peers with an increase of only 37% over the last year. The company has a strong 12.8% return on equity, higher than 63% of peers, and is expected to increase earnings by 19.8% to $2.06 per share in the next fiscal year. While the shares have not performed as well as others in the industry, the company should be able to grow revenue consistently as the housing picture continues to improve.
LinkedIn (NYSE:LNKD) is basically Facebook (NASDAQ:FB) for professionals so it has surprised me that the company's shares have climbed 68% this year compared to the stunning drop in the larger rival. While earnings at the $11.7 billion business-networking site are expected to jump 77% next year to $1.28 from $0.72 this year, the shares still trade for 84 times forward earnings. The company's return on equity of 2.8% is above the industry average and the operating margin of 4.8% is better than 71% of peers, but any weakness in earnings or margins could send the shares sharply lower. I use the site myself and am generally positive on the long-term outlook but think the shares could face selling pressure on valuation relative to peers.
Shares of Facebook have improved dramatically over the past weeks but are still down 32% since the IPO. Even after the 30% jump over the last three weeks, the shares still trade for 42 times forward earnings, relatively cheap compared to LinkedIn. The company announced a new jobs application to rival LinkedIn that partners with Monster Worldwide (NYSE:MWW) and BranchOut Incorporated. The recent stock appreciation is sure to slow but the company is a good long-term bet on growth as management monetizes more than one billion active users.
A third scenario?
The most optimistic out there will say that I have neglected the scenario where Washington decides to postpone increases for taxes on all income earners. While this has happened twice in the past, I do not think it is a likely outcome this time. The President has a fairly strong hand after the election and campaigned primarily on having higher income earners paying more. Even if an agreement comes to postpone taxes on all earners, the President would put it off to the 11th hour and the market may have already corrected on fears of a fiscal cliff. By the time a deal is reached, those stocks with the most to lose will have fallen sharply. While no one could pretend to know how the fiscal cliff negotiations will unfold, investors would do well to protect themselves from those stocks that could see increased volatility on sentiment.