Investing in tax inversions: What's the next target?

Even as President Obama labels them "unpatriotic," companies are rushing to take advantage of a loophole that lets them significantly lower their tax bill. The maneuver, called a tax inversion, allows firms to buy a foreign competitor, relocate their headquarters to that jurisdiction and sidestep the 35 percent top federal corporate tax rate in the United States, the highest of any industrialized nation.

In fact, activity has reached a fevered pitch: In 2014 so far, there have been nine deals either completed or announced. Compare that to just two in 2010 and 2011 and six in 2013.

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Hospira, a drug maker and device manufacturer, is rumored to be a bidder for the medical-nutrition unit of France's Danone for $5 billion, which would give it the opportunity to take advantage of France's lower tax rate, but no deal has been confirmed.

What's behind this flurry of activity? First off, stock-market highs encourage M&A activity in general, especially when acquirers use their inflated stock to finance the purchase. The cost ends up being significantly lower than cash deals. Next, companies have wrung as much efficiency as they can from operations. Now they're looking at other ways to drive bottom- line growth. Tax savings flow directly to profits.

Finally, tax inversions beget tax inversions. The more prevalent the maneuver becomes in one industry, the more likely other players will follow suit. That's why we're seeing so many deals in health care, for example.

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Shareholders don't seem to share President Obama's opinion that tax inversions are wrong. In fact, 12 months after a tax-inversion deal, two-thirds of the companies involved in those deals outpaced the S&P 500 by an average of 13 percentage points, according to research from Empirical Research Partners; after three years, they're ahead of the index by 22 percentage points.

Holger Leue | Look | Getty Images

Motif Investing has just launched a Tax Inversion Target motif: a 25-stock tradable index of potential tax-inversion targets domiciled in tax havens.

We believe that investing in the acquisition targets is a better approach than the acquirers since they benefit from both the tax savings and takeover. The stocks in the motif are concentrated in areas of the world that offer a favorable tax rate, but also enough economic activity that better justifies the mergers themselves. That's why it's weighted more heavily to Europe than say Bermuda and the Caymans, which have no corporate tax.

Read MoreLew pushes Congress to crack down on tax inversions

Also, we've put an emphasis on sectors which have experienced a lot of activity recently like health care and oil & gas; and on sectors we think are likely to in the future such as technology.

Companies in this motif include:

  • InterContinental Hotels
  • ARM Holdings
  • TE Connectivity
  • Logitech

The motif (see the full list of stocks) is very new and so has limited return history: it's one-month return is 1.3 percent versus 1 percent for the S&P.

To be sure, there are risks to this motif. The biggest is that President Obama is able to change the tax code to make inversions impossible. Or public opinion sours on them and companies are pressured against inversions. Take Walgreens, the drug store giant. It was set to move its headquarters to Switzerland following its acquisition of Alliance Boots, but pulled those plans because of the public sentiment. Its stock got hammered. Finally, it's hard to predict mergers with any degree of certainty — why we prefer investing in a portfolio of stocks instead of betting on individual names.

I'll let you debate the ethics of tax inversions. In the meantime, there seems to be no slowdown in companies' appetite for tax savings or for investors' desire for the profits that come with them.

Commentary by Hardeep Walia, who co-founded Motif Investing to create an intuitive way to invest conceptually. He spent more than six years at Microsoft, where he was general manager of the company's enterprise services business, and prior to that was a director of corporate development and strategy, helping to oversee Microsoft's investments and acquisitions. He started his career at The Boston Consulting Group. Follow him on Twitter @hardeepw.

This story has been updated to reflect that Hospira is rumored to be a bidder for the medical-nutrition unit of Danone, which would give it an opportunity to take advantage of France's lower tax rate, but no deal has been confirmed.

Perrigo is not one of the stocks in Motif Investing's tax-inversion motif.

The proposed merger between Omnicom and Publicis of the Netherlands was called off.