As The Magnificent 7 Stumble, Pivot to These 3 Growth Stocks

August 01, 2024 at 07:00 AM EDT

Enphase Energy, Inc. logo is displayed on a smartphone screen — Stock Editorial Photography

The S&P 500 and Nasdaq Composite have delivered impressive returns for investors this year. However, a recent pullback in mega-cap growth stocks, particularly the most popular known as the Magnificent Seven, is causing some investors to reconsider their strategies. This shift in market dynamics presents a compelling opportunity to explore alternative growth stocks in sectors poised for long-term expansion. This pullback, coupled with a noticeable change in investor sentiment, could signal a broader market rotation away from the dominance of mega-cap technology companies.

The Decline of the Tech Giants

Four of the seven companies comprising the Magnificent Seven - NVIDIA (NASDAQ: NVDA), Tesla (NASDAQ: TSLA), Meta (NASDAQ: META), and Google’s parent company Alphabet (NASDAQ: GOOG) - have entered correction territory, characterized by a decline of more than 10% from their recent peaks. This trend comes during a time of growing investor concern about the high valuations of these companies and uncertainty surrounding the timeline for returns on significant investments in artificial intelligence (AI).

Recent sector declines exemplify a sentiment shift despite some tech companies reporting solid earnings. Investors are apprehensive about the substantial AI-related expenditures by certain tech companies, questioning the timeline for returns on these investments. For example, Alphabet's earnings report revealed capital expenditure in the last quarter reached $13 billion, almost double that of a year ago. This trend of increasing AI investment is apparent across many of the Magnificent Seven tech companies, prompting investors to demand more clarity regarding the productivity gains and expected returns from these expenditures.

The current earnings season reveals a heightened sensitivity to companies that fail to meet expectations. Tesla’s stock price experienced a 12% share price drop after reporting slower sales growth and lower-than-anticipated profits, partly attributed to increased AI spending. Research data further evidences this trend, showing that companies missing earnings expectations are experiencing more significant share price declines than the five-year average. Concurrently, companies exceeding expectations are not seeing corresponding share price gains.

The recent performance of these mega-cap tech stocks and investor rotation into smaller companies that may benefit from interest rate cuts suggests a potential shift in market leadership. This presents a compelling opportunity for investors to diversify their portfolios and explore alternative growth stocks with solid fundamentals in sectors poised for long-term expansion.

Three Growth Stocks for a Shifting Market

As investors look beyond the Magnificent Seven, companies like Rocket Lab (NASDAQ: RKLB), Hexcel (NYSE: HXL), and Enphase Energy (NASDAQ: ENPH) offer compelling investment opportunities in the rapidly growing space, aerospace, and solar energy sectors.

Rocket Lab: Reaching for the Stars

Rocket Lab stock is uniquely positioned to benefit from the burgeoning space economy, projected to reach $1.8 trillion by 2035. The company's Electron rocket currently holds the distinction of being the second most frequently launched U.S. rocket. Its impressive track record reflects this success, deploying over 190 satellites across 50 launches.

Rocket Lab’s Electron rocket is designed to place small satellites into low Earth orbit, a segment experiencing high demand. Evidence of this strong demand is seen in the company’s growing backlog, which surged from $494 million at the end of the first quarter of 2023 to $1.1 billion at the end of the first quarter of 2024.

To capitalize on the growing space market further, Rocket Lab is developing the Neutron rocket capable of undertaking deep-space missions and human spaceflight. This ambitious project requires substantial capital investment, and while it delays the path to profitability, it positions Rocket Lab for significant long-term growth.

Hexcel: Soaring Above Near-Term Turbulence

Despite Hexcel's earnings report indicating a recent downgrade in its full-year 2024 revenue, earnings, and cash flow guidance, the company maintains its appeal as a strong growth candidate. This confidence stems from the long-term prospects of its core business, which specializes in producing advanced graphite composites primarily employed in commercial aerospace, representing 60% of its sales.

Hexcel's recent guidance downgrade can be attributed to well-documented delivery delays from Boeing (NYSE: BA) and Airbus (OTCMKTS: EADSY), key customers in the commercial aerospace market. While this presents a near-term headwind, it's essential to recognize that these are delivery pushouts, not cancellations. Boeing and Airbus are committed to ramping up delivery rates to fulfill their multiyear backlogs.

The long-term growth of the commercial aerospace market, coupled with the ongoing trend of increasing composite content on newer aircraft, strongly favors Hexcel. Management remains optimistic, forecasting overall sales to grow by 10% to 12% annually from 2024 to 2026, with commercial aerospace sales projected to grow at an even faster rate of 12% to 16% during the same period. Furthermore, management anticipates generating at least $800 million in free cash flow over the next few years, further bolstering Hexcel's investment case.

Enphase Energy: A Shining Light in a Challenging Industry

While the solar energy industry faces significant headwinds, including bankruptcies and layoffs, Enphase Energy’s earnings demonstrate resilience and a quick recovery potential. Despite the Invesco Solar ETF (NYSEARCA: TAN), which tracks the industry, hitting a four-year low, Enphase's stock price is rebounding from its 52-week low, showcasing its relative strength.

The company recently reported second-quarter earnings that missed Enphase’s analyst community expectations. However, the company provided strong third-quarter guidance, signaling a potential turnaround. This positive outlook is based on the company's anticipation of increased revenue from the California market and other key regions.

The company's robust financial position further supports its case for recovery. Enphase exited the second quarter with $1.65 billion in cash, equivalents, and marketable securities, significantly exceeding its long-term debt of $1.2 billion. Importantly, Enphase continues to generate positive free cash flow, including $117.4 million in the most recent quarter.

Diversification and Risk: A Balanced Approach

Diversifying away from mega-cap tech stocks and investing in companies like Rocket Lab, Hexcel, and Enphase, which operate in sectors with distinct growth drivers, can be a strategic approach to mitigating risk and potentially enhancing returns. However, it is crucial to acknowledge the inherent risks associated with growth stock investing. These companies often exhibit higher volatility, may experience fluctuations in earnings performance, and may take longer to achieve profitability.

As the market terrain changes, investors must remain adaptable and seek out opportunities in sectors poised for long-term growth. The recent pullback in the Magnificent Seven and the increasing investor focus on value and diversification suggest a potential shift in market leadership. Companies like Rocket Lab, Hexcel, and Enphase, with their strong fundamentals and compelling growth narratives, offer investors a chance to participate in the expansion of exciting new industries. Investors must conduct thorough research, consider their individual risk tolerance, and stay informed about market trends and company performance to make well-informed investment decisions.