The outlook for software stocks quickly turned dire this week as investors envisioned a world in which Anthropic’s Claude AI assistant rendered entire enterprises and IT departments useless.
The iShares Expanded Technology Software Sector ETF (IGV) fell 19% from January 26th to February 5th, breaking the bottom for the sector.
But Morningstar says the fears are largely overblown and that the explosion of unregulated selling represents a prime buying opportunity.
Dan Romanoff, senior equity analyst at Morningstar, said while the mid-week sell-off remains strong, “We see little evidence that a bear market is developing. Retention rates and other software metrics look solid. In short, we acknowledge the risk, but we think the concerns are overstated.”
He continued: “We do not believe that enterprise software customers will influence the way they code their internal solutions in a way that threatens the application vendor’s model all together.” “While there may be pressure on seating capacity, there is no evidence that this is happening and automation is not a new trend.”
Software stocks rose on Friday, with IGV up 3% and Nasdaq up more than 2%.
With such a dramatic decline, Romanov said there are opportunities across the software sector. He singled out two shabby stocks in particular that he thinks have “significant upside potential”: Microsoft (MSFT) and ServiceNow (NOW).
Shares of Microsoft and ServiceNow are down 17% and 35%, respectively, since the beginning of the year.
Romanoff has a “fair value estimate” for Microsoft stock of $600, implying a 50% upside, and $200 for ServiceNow, implying a 100% upside.
Still, he warned of instability: “The software landscape is not for the faint of heart at this point.”
Despite concerns that AI will undermine the software industry, Romanoff said investors may be overvaluing the new technology and companies have publicly stated that many still view AI with skepticism.
“Despite the hype, AI products are not generating significant revenue for software vendors because executives fear hallucinations and rogue agents,” Romanoff said. “This is supported by public software companies’ disclosures, which typically show that AI solutions account for around 2% of their revenue (or ARR). It is also supported by OpenAI’s revenue, which is heavily skewed towards consumer subscriptions.”
He also drew historical parallels with past automation cases that did not cause major disruptions to the labor market.
“It’s possible that there will be seat pressure at some point in the future, but given the emphasis on automation in Salesforce’s innovative CRM approach 25 years ago, sales reps never felt that way,” Romanoff said. “We can also note the continued increase in employee numbers across the sector. Again, it is certainly possible that these concerns could manifest more directly, but they have not occurred at this time.”
