I will keep politics aside as I dont like to muddy my thinking with that. The government announced a tax reduction recently from 33% to around 25%. The market has responded positively to this announcement. I will not get into the macro impact of this decision as it is too complicated for me due to the second and higher order effects.
I will use a functional equivalent to understand the impact on our portfolio positions. Think of this tax cut as similar to a permanent drop in the input cost. The impact of such a drop will not be the same across all companies. I would like to bucket it in three groups
Group 1: Companies with a strong competitive position and high growth prospects which allows them to deploy all their profits into future growth
Group 2: Companies with a strong competitive position which will enable it to retain the extra profits. However due to lower growth prospects, the company may return some of it to shareholders via dividends
Group 3: Companies with weak competitive position where most of the extra profits will be competed away.
The net impact
The drop in tax rate will create the most value for shareholders in group 1 companies. We are already seeing the evidence of that. Its quite possible that the market is under-appreciating the long-term benefits of compounding in such cases.
Group 2 companies will see an increase in fair value, but due to the absence of compounding of retained profits (as they are not able to re-invest their current profits fully), this increase is much lesser than that of Group 1.
Group 3 companies which account for almost 80%+ of all the companies would see an increase in fair value only if the demand for the industry improves as a result of price reduction and an improvement in GDP growth. It is difficult to estimate this increase as this will take time for this change to flow through the economy and there are other factors which would play an equally important role
I am not raising the valuation for our positions even though we hold a few in group 1 and group 2. I would like to see this effect flow through before I do that.
I think there is a problem with your Group 1 companies. By your definition, these are companies who are in strong competitive position and high growth trajectory and therefore deploy all of their profits into future growth. Agreed. But these companies are entitled to lot of exemptions and deductions, like RIL and many such companies and due to this, their even current tax liability is roughly between 22 to 25% (including all surcharge and cess) even after taking into account MAT implication. The revised base rate of 22% (with applicable surcharge and cess) is for those companies/assesses who opt for no exemption/deduction. Whereas earlier 30% (with applicable surcharge and cess) was with all allowable exemption/deduction.
Please highlight your comments on this.