For the past three years, the debate on Wall Street has revolved around whether investors are better off chasing the Magnificent Seven stocks or if they should get into defensive stocks for a crash that is yet to fully materialize. Small-cap stocks have been mostly ignored, and that trend has continued so far into this year as well.

That said, the Magnificent 7’s momentum is cooling off. Year-to-date, Roundhill Magnificent Seven ETF (BATS:MAGS) is down 4%, whereas the S&P 500 has turned positive at 1.23%. According to Wells Fargo, the Mag 7 companies will see slower earnings growth in the coming years as they mature, and that should also translate over into their stock performance.

Small-cap stocks are now worth looking into before Wall Street dives deeper into the market for more growth in the coming years. Not only that, penny stocks and small-cap stocks in general have done very well during a rate cut cycle. Goldman Sachs expects three rate cuts in the next 18 months, so now could be a good time to buy. Here are three that can outpace the big caps:

Applied Energetics (AERG)

Applied Energetics (OTCMKTS:AERG) is also a solid buy-the-dip opportunity if you’re hunting for penny stocks in the defense industry with high growth. I’m mainly interested here after the “Golden Dome” announcement by President Donald Trump on Tuesday. His announcement about the missile defense program will include “new defense companies,” and would specifically include lasers.

Even if Applied Energetics does not land a direct contract with the government, there is tremendous potential for it to land contracts from other government contractors. This company specializes heavily in laser-based defense technology. AERG stock is up almost 72% year-to-date now, but I see massive upside potential from here if it lands contracts in the coming quarters.

This is a $175 billion project over the next three years. This company would need a very “small” contract from that project to win big. 0.2% of the 3-year budget is $350 million, and it is worth more than this company’s $266.4 million market cap. The Golden Dome may cost as much as $831 billion over two decades.

$25 billion of it is being included in a Republican “reconciliation” spending bill already.

PDF Solutions (PDFS)

PDF Solutions (NASDAQ:PDFS) is a data science company that helps with semiconductor manufacturing. During the chip manufacturing process, a lot of data is needed, and PDF Solutions sells software to help chip makers sift through it to find patterns, identify bottlenecks (areas where production slows down), and pinpoint why some chips might be failing. It also collects and organizes data for them. It also has its own specialized test chips.

The company has seen slower growth in the past few years, and the stock declined 63.4% from its August peak to its trough. PDFS stock has been climbing up since then, and I think a much stronger recovery could be ahead.

This company’s revenues may have slowed down, but it is now a profitable company. It had lots of cash and little debt on its balance sheet, though it recently acquired secureWISE for $130 million. Even then, it has $54 million in cash vs. $73 million in debt, and the acquisition will boost the business significantly.

EPS growth is expected to be just 1.8% this year, but it is expected to accelerate to 30.4% next year. On the other hand, sales growth is expected to be 21% this year and 18.4% next year. EPS forecast trends have gone up in the past month, and the company is seeing solid tailwinds from continued strength in the chip industry.

The average price target of $31 implies almost 60% upside.

Aehr Test Systems (AEHR)

Aehr Test Systems (NASDAQ:AEHR) sells test systems for burning-in and testing integrated circuits. It has historically derived most of its revenue from the automotive sector and has been subject to the cyclicality that comes from it. However, the company has been moving more and more towards AI, robotics, and high-performance computing.

The stock is down 83.4% from its highs in 2023, even as things keep looking better. The EV industry could be bottoming out. Tesla (NASDAQ: TSLA) in particular may not have the best fundamentals, but since Aehr Test Systems mainly sells in Asia (87.7% of revenue), it can benefit significantly from the continuous EV boom there.

As you’d expect, the trade war with China also dragged down AEHR stock, but the de-escalation in recent weeks has led to a 31.9% recovery off recent lows. That recovery should continue, since the financials are solid.

You’re paying 47 times earnings now, but EPS is expected to improve significantly in the coming years. The 3-year revenue growth of 46.7% has been better than 95% of companies in the semiconductor industry.

Aehr is also sitting on $29 million of cash vs. $6 million of debt. Q3 FY 2025 revenue grew 142% and beat estimates by 3%. Aehr also reported an increase in bookings, so it could be on the cusp of turning a corner, especially as AI and the trend towards miniaturization, vertical stacking boost sales.

The consensus price target at $25 implies 179.6% upside for this small-cap stock.

— Omor IE

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Source: Money Morning