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Recently, The New York Times reported that General Electric (NYSE:GE) is keeping its tax rate low by exploiting the loopholes in the tax code that it helped to create in the first place. GE’s effective tax rate was 7.4% in 2010. Effective tax rate is calculated by using accounting taxes rather than cash taxes. In 2010 GE paid $2.67 Billion in cash for taxes, but its accounting taxes were only $1.05 Billion.

We believe investors should invest in stocks with high effective tax rates rather than low effective tax rates. These companies are usually more profitable. They also don’t effectively exploit the tax loopholes, but if they do, it will probably boost their stock prices significantly.

In order to display how this strategy works, we compiled a list of 30 Dow components and ranked them based on their annual effective tax rates in 2010. Here's how the top and bottom halves performed in 2010:

HIGHER EFFECTIVE TAX RATES

Effective Tax Rate 2010

2010 Return

EXXON

XOM

40.7%

9.78%

MERCK

MRK

40.6%

2.79%

CHEVRON

CVX

40.3%

22.21%

HOME DEPOT

HD

36.7%

24.46%

WALT DISNEY

DIS

34.9%

17.55%

WAL-MART

WMT

32.2%

3.17%

AMERICAN EXPRESS

AXP

32.0%

7.70%

KRAFT FOODS

KFT

31.5%

20.20%

MC DONALD'S

MCD

29.3%

26.55%

INTEL

INTC

28.6%

6.19%

UNITED TECHNOLOGIES

UTX

27.9%

15.86%

3M

MMM

27.7%

6.93%

ALCOA

AA

27.0%

-3.78%

BOEING

BA

26.5%

23.67%

CATERPILLAR

CAT

25.8%

67.36%

AVERAGE

16.71%


LOWER EFFECTIVE TAX RATES

Effective Tax Rate 2010

2010 Return

TRAVELERS

TRV

25.3%

14.56%

IBM

IBM

24.8%

14.03%

MICROSOFT

MSFT

24.1%

-6.63%

JOHNSON&JOHNSON

JNJ

21.3%

-0.70%

PROCTER & GAMBLE

PG

21.1%

9.21%

HEWLETT-PACKARD

HPQ

20.5%

-17.65%

VERIZON

VZ

19.4%

14.13%

DUPONT

DD

17.8%

53.01%

JPMORGAN CHASE

JPM

16.8%

2.28%

COCA COLA

KO

16.7%

18.47%

CISCO SYSTEMS

CSCO

15.6%

-15.50%

PFIZER

PFE

11.9%

0.22%

GENERAL ELECTRIC

GE

7.4%

23.93%

AT&T

T

-6.4%

10.81%

BANK OF AMERICA

BAC

-69.2%

-11.16%

AVERAGE

7.27%

DOW JONES INDUSTRIAL

DJI

-

11.02%

The first group of 15 stocks with higher annual effective tax rates returned 16.71% in 2010, beating the DJI by 5.6 percentage points. On the other hand, the second group of 15 stocks with lower annual effective tax rates underperformed the market, returning only 7.27%. Only AA in the first group brought negative returns to its investors, while five stocks (MSFT, JNJ, HPQ, CSCO, BAC) of the second group had a negative performance in 2010. The best performing Dow component was Caterpillar. Ken Fisher was the largest holder of CAT among prominent investors. Phill Gross’ Adage Capital and Jim Simons’ Renaissance were among the hedge funds with CAT investments.

We think investors can beat the market by focusing on companies with high effective tax rates. We will compile another list and check the performances of these Dow stocks at the end of second quarter.

Disclosure: I am long T, MSFT.

Source: Investing in Stocks With High Taxes