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Stock Watch

How to Cash In on Corporate Tax Cuts

Investors can expect higher earnings and more generous dividends.

Illustration by Owen Weiss

Stocks have been rising for months on hopes that tax cuts will fuel a surge in corporate profits and dividend increases. But you haven’t missed the rally—it should last well into 2018, especially for the parts of the market that may benefit the most.

See Also: 9 High-Yield Dividend Stocks to Buy On the Dip

One way to cash in is with shares of small and midsize firms. Such companies tend to pay taxes at higher effective rates than large multinationals (based on actual taxes paid), so those com­panies stand to save more from lower tax rates.

You can invest in this area with exchange-traded funds such as iShares Core S&P Small-Cap (symbol IJR, $80) and iShares Core S&P Mid-Cap (IJH, $196), a member of the Kiplinger ETF 20. Among individual stocks, consider domestic retailers Target (TGT, $77) and Ulta Beauty (ULTA, $237). Tax cuts should lift profits for both firms by at least 18% in 2018, and the stocks still look like good values, says brokerage and investment firm UBS.

New corporate tax breaks are also good news for dividend investors. Big companies are likely to repatriate large amounts of cash held abroad, partly because they can now pay tax on the money at reduced rates.Some of it will go for acquisitions and stock buybacks (which can increase earnings per share by reducing the amount of outstanding stock). But many firms will probably use some overseas cash—estimated at $1 trillion—to increase dividend payouts more than they would have without the tax changes.

Big drugmakers and technology companies have stockpiled a lot of cash abroad, making them good candidates to increase dividends. Johnson & Johnson (JNJ, $146)—one of our favorite dividend-paying stocks—could tap its estimated $41 billion in overseas cash to bolster its payout. The stock now yields 2.3%. Google parent Alphabet (GOOGL, $1,131), Apple (AAPL, $177) and Microsoft (MSFT, $90) have also amassed huge cash hoards overseas. With their businesses thriving, money they repatriate may lead to steeper dividend hikes.

But the tax overhaul is not all good news for cor­porate America. The new levy on foreign cash and profits will sting initially as companies start paying tax on those gains, potentially hurting their bottom lines in the short term. Apple, for instance, says it plans to repatriate much of its overseas cash—estimated at $252 billion—and reinvest some of it in the U.S. But the firm says it will pay $38 billion in taxes on that cash. Other firms, including banks such as Citigroup and Goldman Sachs, are taking big hits to their earnings as a result of the new repatriation tax, too.

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And some parts of the market aren’t compelling regardless of tax cuts. Util­ities should get a big tax break from new rules that allow companies to deduct 100% of their spending for the next five years on capital equipment, such as factories and machinery. But utility stocks could face pressure in a market that favors faster-growing companies and those that thrive in an accelerating economy.

Banks and other financial stocks look appealing. Tax cuts could boost bank sector earnings by 10%, adding to an already healthy outlook for profits and dividends. Consider Financial Select Sector SPDR ETF (XLF, $29), also a member of the Kiplinger ETF 20, or, if you prefer individual stocks, JP Morgan Chase (JPM, $113) and M&T Bank (MTB, $179). Like utilities, industrial companies could get a boost from the rule allowing firms to deduct capital expenditures, accelerating demand for machinery and equipment. FedEx (FDX, $272) recently raised its earnings forecast for 2018 to account for the expected tax savings. We also like Fidelity MSCI Industrials Index (FIDU, $41), a fund we are adding to the Kip ETF 20.

See Also: The 10 Best Stocks for GOP Tax Reform