The dominance of the so-called “Magnificent Seven” stocks — the major tech companies that fueled the equity market’s growth in 2023-2024 — appears to be coming to an end. The main reason, according to Mark Sherlock, who runs a U.S. small- and mid-cap fund at Federated Hermes in London, is overinflated expectations around large-cap stocks. He has identified four companies that investors should consider as alternatives to Big Tech names. These companies vary in size but share a key feature — “the power of low expectations.”
Details
Sherlock, who manages the Federated Hermes U.S. SMID Fund, notes that most large caps are now facing incredibly high expectations about future earnings, as reported by Barron’s. As a result, bigger returns may come from investing in smaller companies in the S&P 500 or Russell 2500 indexes — those that can “harness the power of low expectations,” as Sherlock puts it.
Power Integrations
Power Integrations, with a market capitalization of $3.6 billion, specializes in high-voltage power conversion units for city lights and electric cars. The stock has performed poorly over the past few years, Sherlock points out: It is down more than 40% since the summer of 2021. However, it may be poised for a turnaround as businesses look to become more energy efficient. Power Integrations saw its revenue for the second quarter of 2024 fall 14% year over year but rise 16% quarter over quarter. It is guiding for further growth in the third quarter.
According to MarketWatch, five out of the seven analysts covering Power Integrations recommend buying the stock, while two have it as a “hold.” Their average price target is $78.50 per share, implying 23% upside versus the last closing price.
Martin Marietta
Martin Marietta, with a market capitalization of $33.3 billion, runs rock mines that produce materials to build roads. Its stock has risen more than 27% since the start of the year, with further upside of 15%, based on the average target price of the 23 analysts who cover the company, according to MarketWatch. Sixteen of them rate it a “buy,” six a “hold,” and only one a “sell.”
Last week, the investment bank Jefferies reduced its target price for Martin Marietta from $650 to $635 per share while restating its “buy” call. The target price cut was said to reflect “near-term headwinds,” such as wet weather and a weaker start to the residential construction season. Nevertheless, Jefferies remains upbeat on the 2025 outlook thanks to expected Fed rate cuts, which could spark a rally for lagging companies.
Trex Co.
Trex Co., with a market capitalization of $7 billion, makes decking and railing materials. Its stock is down more than 22% this year. After a surge in home improvement spending during the pandemic, demand has since cooled; however, Sherlock expects a rebound in the near future.
According to MarketWatch, out of the 19 analysts covering Trex, seven have “buy” ratings, 11 have “hold” recommendations, and one has a “sell” call. Their average price target of $77.30 suggests 20% upside versus the last closing price.
Fortune Brands
Fortune Brands, with a market capitalization of $10.2 billion, makes home and security products ranging from padlocks to faucets. Over the last 12 months, its shares have climbed more than 44%. Sherlock believes the rally has more room to run thanks to an anticipated rise in consumer spending on home improvement.
MarketWatch data shows that six analysts recommend buying Fortune Brands, 12 suggest holding it, and one advises selling it. Their average target price is $88.50, about the same as the closing price on Friday, October 11.
Context
- After a rough few years, small-cap stocks may be undervalued, Sherlock believes. Certain sectors, such as real estate, appear to have already “effectively been through a recession.”
- Smaller firms are driven primarily by domestic economic conditions, whereas larger companies often depend on international sales, says Sherlock. If you are betting on U.S. economic growth, small-cap stocks are the better bet.
- Sherlock looks for companies with strong cash flows and solid barriers to protect them from competition, and tends to hold them for around five years.
