3 Software Stocks to Buy on the Dip—and 2 to Avoid

Software Selloff: Analysis of Buy & Avoid Opportunities

Key Concepts:

• Uniform Accounting: A method of financial analysis that adjusts for distortions in Generally Accepted Accounting Principles (GAAP) to provide a clearer picture of a company’s true earnings and profitability.
• Switching Costs: The costs (time, money, effort) a customer incurs when changing from one product or service to another. High switching costs create a “moat” around a business.
• AI Disruption: The potential for Artificial Intelligence to render existing business models obsolete.
• System of Record: The primary data source for a particular piece of information, often critical for business operations.
• Return on Assets (ROA): A profitability ratio that measures how efficiently a company uses its assets to generate earnings.
• Uniform PE (Price-to-Earnings Ratio): PE ratio calculated using earnings adjusted via uniform accounting.
• SAS (Software as a Service) Apocalypse/Magdon: A recent downturn in the software sector driven by concerns about AI disruption and valuation corrections.

I. The Current Software Landscape & Historical Parallels

The software sector is currently experiencing a significant selloff, dubbed the “SAS apocalypse” or “SAS magdon.” This downturn mirrors a similar situation in 2023 with semiconductor companies following the emergence of DeepSeek from China, which initially raised concerns about drastically reduced development costs. However, despite initial fears, semiconductor companies rebounded strongly, achieving all-time highs. The speakers argue that a similar separation of “wheat from chaff” is occurring in the software space – some companies will thrive, while others will struggle. The key is identifying those with durable competitive advantages.

A crucial point raised is the tendency for investors to forget past market cycles. The DeepSeek example serves as a reminder that initial panic often subsides, and strong companies can recover quickly.

II. Timeline for Recovery & Historical Context

Joel Litman draws parallels to the dot-com boom of the late 1990s, noting that during that period, the NASDAQ experienced multiple declines exceeding 10%, but recoveries typically occurred within a few quarters. He believes a similar timeframe applies to the current software downturn, predicting a recovery within quarters, not years. This optimistic outlook is based on the belief that many software companies are fundamentally healthier and trading at lower valuations than during the dot-com bubble, particularly when assessed using uniform accounting.

III. Stocks to Buy: Detailed Analysis

A. Microsoft (MSFT)

• Rationale: Microsoft is considered a “slam dunk” buy due to its high switching costs, its position as a “system of record” for many businesses, and its proactive integration of AI. It’s not merely a software company but an AI-centric business.
• Valuation: Currently trading at a 20x uniform PE ratio, which is attractive given its dominance and AI potential. The market is pricing in only 6% annual earnings growth, while Altimmetry Research estimates potential growth exceeding 14% using uniform accounting.
• Key Metrics: High switching costs, system of record status, aggressive AI integration.
• Time Horizon: Recovery expected within a quarter or two as Azure demand and overall business performance continue to be strong.

B. AppLovin (APP)

• Rationale: AppLovin, a mobile app advertising marketplace, has been unfairly punished due to concerns about AI-powered ad platforms. The speakers argue that AppLovin’s superior data, deep integration with the mobile ecosystem, and existing AI capabilities provide a strong competitive advantage.
• Valuation: Down over 30% recently, now trading at a 22x PE ratio with projected 64%+ annual earnings growth. The market is only pricing in 20% growth.
• Key Metrics: Better data than competitors, deep integration with mobile app ecosystem, existing AI capabilities.
• Time Horizon: Potential for a quick turnaround as the market recognizes the strength of its marketplace and the limited threat from AI alternatives.

C. Intuit (INTU)

• Rationale: Intuit (TurboTax, QuickBooks) benefits from high switching costs and a strong ecosystem of integrated services. Concerns about AI-powered tax and accounting software are overstated, as users are unlikely to entrust sensitive financial data to unproven AI solutions.
• Valuation: Down over 40%, trading at a 16x uniform PE ratio despite a 10%+ annual earnings growth rate.
• Key Metrics: High switching costs, integrated ecosystem, established brand trust.
• Competitive Edge: The extensive integration of its products and the difficulty of migrating financial data to alternative platforms.

IV. Stocks to Avoid: Detailed Analysis

A. HubSpot (HUBS)

• Rationale: HubSpot primarily serves small and medium-sized businesses (SMBs), which are more likely to switch platforms if costs become prohibitive or better alternatives emerge. It lacks the proprietary data and strong switching costs of larger CRM providers.
• Valuation: Despite a 35-40% price decline, the stock remains expensive at 65-70x earnings (using uniform accounting).
• Key Weakness: Serves a customer base prone to switching, lacks proprietary data or unique advantages.

B. DocuSign (DOCU)

• Rationale: DocuSign’s e-signature technology is easily replicable and can be readily integrated into other platforms. There’s no compelling reason for it to remain an independent entity.
• Valuation: Trading at 65-70x earnings (using uniform accounting) despite its limited competitive advantages.
• Key Weakness: Easily replicable technology, lack of proprietary data, and limited switching costs.

V. The Importance of Uniform Accounting

Throughout the discussion, the speakers emphasize the value of uniform accounting in accurately assessing a company’s financial health. GAAP accounting can distort earnings due to the treatment of R&D expenses, stock options, and acquisitions. Uniform accounting adjusts for these distortions, providing a more realistic picture of profitability and growth potential.

VI. Conclusion

The software selloff presents opportunities for discerning investors. By focusing on companies with strong fundamentals, high switching costs, and durable competitive advantages – particularly those leveraging AI effectively – investors can potentially capitalize on the current downturn. However, it’s crucial to avoid companies with easily replicable technology, weak customer loyalty, and inflated valuations. Utilizing a rigorous analytical approach, such as uniform accounting, is essential for identifying the true winners and losers in this evolving landscape. The speakers advocate for a contrarian approach, focusing on overlooked opportunities while avoiding the hype surrounding potentially overvalued AI plays.