Wall Street’s New Trend: How to Play Tax Inversion Mergers

Source: Thinkstock

Source: Thinkstock

A new trend is developing on Wall Street. American companies are looking to merge with overseas companies in order to move corporate headquarters to reduce corporate tax rates. With America’s corporate tax rate sitting at a punitive 35 percent and with several European countries boasting low corporate tax rates — sometimes half of this level or lower — this is a very attractive move for American companies.

For instance, a company that earns $1 million before taxes earns $650,000 after taxes. If we put a 15 price-to-earnings multiple on this figure, the company’s valuation is $9.75 million. But if the company moves to Ireland — a popular tax inversion jurisdiction where the corporate tax rate is just 12.5 percent — the compay’s earnings jump to $875,000 and the same 15 price-to-earnings multiple brings the stock’s valuation up to $13.1 million: a whopping 35 percent higher! Not only that but the company now has $225,000 to invest, this means that it can grow faster. No wonder companies want to do this.

Covidien (NYSE:COV) was the latest acquisition target, but now we are seeing that AbbVie (NYSE:ABBV) – an American pharmaceutical company — is interested in acquiring Shire (NASDAQ:SHPG) — another Irish company. We are also seeing interest in Walgreens (NYSE:WAG), which wants to buy Alliance Boots — a European drugstore chain. While the President and the Treasury Department are sabre-rattling, the fact remains that remaining incorporated in the United States makes little sense so long as taxes are so high, especially since there is a loophole for corporations to renounce their “citizenships.”

With this in mind, investors should consider acting. We have already seen Irish companies — especially Irish drug companies — soar on the tax inversion possibilities. Even before Shire was so close to a deal with AbbVie, the stock had been soaring. In fact, it is up over 80 percent year-to-date. But I think another place for investors to look is in Asia, and another sector to consider is the financial sector. Countries such as Singapore and Hong Kong have incredibly low corporate tax rates — 17 percent and 16.5 percent, respectively. Furthermore, these are places where several large Asian banking institutions are headquartered. American banking institutions who are looking for ways to create value (and this is difficult in the banking sector in this day and age) may begin to look for acquisition targets in these regions.

So how do you play this possibility? The easiest way is to simply look at country ETFs such as the iShares Singapore ETF (EWS) or the iShares Hong Kong ETF (EWH). While I think the opportunities are in the banking sector, both of these funds have very heavy allocations to financials. This takes the guess-work out of picking which companies are the most likely takeout candidates. Investors should note that these funds are also relatively attractive from an investment standpoint more generally, in part due to these countries’ low corporate tax rates.

Before researching these opportunities investors should be aware of the risks of international investing. While there are great opportunities abroad, we need to keep in mind that securities regulations are different in different countries. Investors also need to be aware of the possibility that the U.S. government will be successful in stopping these mergers. But with this in mind, we should also be aware of the fact that the U.S. has a very high corporate tax rate, and this makes investing in U.S. companies relatively unattractive — at least from this standpoint — and that investors should look seriously consider a country’s corporate tax rate when making an investment decision.

Disclosure: Ben Kramer-Miller has no position in any of the stocks or funds mentioned in this article.

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