In a non-registered account, when you a sell a security that has declined in value, you realize a capital loss. You can use these to offset any capital gains you’ve incurred in the current year, which can reduce your tax bill. Moreover, unused losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains.

Tax loss selling is not a foreign concept to most investors; however, the impact this selling can have on securities of different market capitalizations is less known. Unlike large-cap stocks, the markets for which are dominated by large institutional investors and are usually very liquid, small-cap stocks can be less liquid and dominated by retail investors who typically all pay taxes at the same time of year. This leads to herd-like behaviour in the months leading up to year-end where consistent selling pressure on smaller (and often poor performing) names that are already thin traders leads to unwarranted declines.

The “January effect” refers to the general increase in (small) stock prices during the month of January, with the phenomenon rooted in tax-loss selling and window dressing. Retail investors who sell a small-cap stock at a loss in December for example, are likely to redeploy capital in January, perhaps even in the same stock or risk category, resulting in returns to those areas that were initially effected by tax-loss selling in December. Window dressing occurs when institutional managers sell big losers or winners to make their fund look ‘clean’ or look like they hold/have held no bad investments in the past. Think of it as being similar to Spring-cleaning.

With that, we are using this months 5i Filter to present stocks with market-caps greater than $100MM that are experiencing a quarter to date price change of -15.0% or worse but also have revenue growth estimates for next year greater than +15.0%. These names are likely candidates for tax-loss selling; yet offer good growth prospects going into the New Year. Looking at the list, Concordia Healthcare is a name that jumps out at us as a company that could offer potential in the New Year. It is a company we have recently added to the growth portfolio at 5i Research and a write-up we have done on the situation can be found here. Likely not surprising to readers, there are a few energy and materials names on the list as well. We would expect the tax-loss selling impact on these to be less severe as there has likey already been plenty of losses booked on these names. Within materials, it seems like the sector has seen losses for multiple years and at this point there may be very little embedded capital losses for investors to take advantage of.

Source: Thomson Reuters

So what can you expect this year from tax-loss selling and how can you best position yourself? First, the effect tends to be strongest following years in which the market experienced big losses. With the S&P/TSX down roughly -9% YTD on the heels of low oil prices and a healthcare sell-off led by Valeant, there should be no shortage of candidates. As year end tax-loss selling is traditionally concentrated in the very smallest companies whose trading is most sensitive to slight changes in investor behavior, do not be alarmed if December prices pullback on a lack of fundamental news. Instead, this may be an opportunity to add to such positions with the prospect of larger returns in January.

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