Investors are paying less and less for software earnings these days, says Jim Cramer

Key Concepts

• Software Sell-Off: A significant downturn in the stock prices of software companies driven by fears of disruption from Artificial Intelligence (AI).
• AI Disruption: The perceived threat of AI replacing or reducing the need for certain software solutions, particularly those priced “per seat.”
• Hardware vs. Software: A market shift favoring companies that produce tangible hardware or serve industries benefiting from technology spending, while software companies face headwinds.
• Price-to-Earnings (P/E) Multiple Contraction: A decrease in the valuation investors are willing to pay for each dollar of a company’s earnings, indicating increased risk aversion.
• ETF Impact: The influence of Exchange Traded Funds (ETFs), specifically those designed to short software stocks, on individual stock performance.
• Client vs. Purveyor: A distinction between companies that use technology (clients – winners) and those that provide it (purveyors – losers, currently).

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Market Reaction to AI: A Software Sector Crisis

Today’s market saw a substantial decline, with the Dow Jones Industrial Average falling 167 points (0.84%) and the NASDAQ Composite dropping 1.43%. This downturn was overwhelmingly concentrated in the software sector, fueled by growing anxieties surrounding the impact of Artificial Intelligence (AI). Jim Cramer characterizes the market sentiment as a collective decision to “throw away” software stocks and anything connected to them.

The recent earnings reports from high-quality enterprise software companies like Salesforce, ServiceNow, and Adobe, despite being positive, were met with significant stock declines. This indicates that the market is looking beyond current performance and anticipating future disruption. The core concern is that AI can either replace existing software or reduce its user base, impacting the revenue model of many cloud-based software companies which typically charge “per seat” – a fee for each user.

The Anthropic Catalyst & Panic Selling

While concerns about AI have been brewing, the market’s recent sharp reaction was reportedly triggered by news regarding Anthropic, an AI service focused on business applications. Anthropic has developed programs automating legal work, demonstrating a potential for AI to displace jobs traditionally requiring human expertise. Although adoption by law firms is still limited, this development resonated with investors, signaling a credible threat of widespread layoffs and justifying the investment in AI automation. Cramer refers to this as “the straw that broke the camel’s back.”

The market response has largely been characterized as “panic selling” of software stocks, coupled with buying of companies that benefit from software spending – such as Procter & Gamble, FedEx, and Union Pacific. Investors are actively utilizing ETFs like the iShares Expanded Tech Software Sector ETF (IGV) to short the software sector, exacerbating the downward pressure.

Specific Stock Performance & ETF Influence

The impact of the IGV ETF is particularly highlighted. Stocks within the ETF, with the exception of Palantir (which reported strong earnings), experienced significant losses:

• Microsoft: Down 3%
• Salesforce: Down 7%
• Oracle: Down 3%
• Intuit: Down 11%
• AppLovin: Down 4%
• Adobe: Down 7%
• Palo Alto Networks: Down 5%
• CrowdStrike: Down almost 4%
• ServiceNow: Down 7%

Cramer criticizes the inclusion of cybersecurity company CrowdStrike within the IGV ETF, arguing it doesn’t belong in the enterprise software category and is being unfairly penalized. He attributes this misclassification to the “faceless people” managing the ETF, prioritizing profit over accurate categorization.

Two Competing Strategies

Cramer presents two contrasting investment strategies:

1. Exploit the Sale: Capitalize on the downturn by purchasing fundamentally strong software stocks that have been unfairly dragged down by the ETF’s broad-based selling. He cites his purchase of CrowdStrike for the charitable trust as an example.
2. Ride the Trend: Focus on companies with substantial software spending, anticipating that they will benefit from cost savings and efficiency gains through technology adoption. Examples include Alcoa and Wells Fargo, which recently hired a technologist from Amazon Web Services.

He notes that, currently, there haven’t been significant downward revisions to earnings estimates for these software companies; the primary driver of the decline is a shrinking Price-to-Earnings (P/E) multiple – investors are willing to pay less for each dollar of earnings due to increased uncertainty. He acknowledges the difficulty in predicting how low these P/E multiples could go.

Private Equity & Future IPOs

The sell-off also extends to private equity-backed software companies, hindering their prospects for initial public offerings (IPOs). Cramer believes the “window” for these companies to go public is now closed, as investors are wary of adding more software stocks to their portfolios. He also questions the understanding of the business models of many of these private companies, even among their own employees.

Call to Action & Market Outlook

Cramer advises against attempting to “jump in front of a speeding freight train” – meaning, trying to predict the bottom of the software sell-off. He emphasizes that while logic suggests the downturn should be contained within the software sector, the market is not always logical. He concludes by stating that “great stocks will prevail if they’re backed by great companies.”

The segment concludes with previews of upcoming interviews with CEOs from NVIDIA, Tezos Systems, Chipotle, and Merck, promising further insights into the evolving technology landscape.

Quote: “The clients win, the purveyors lose. Hardware companies triumph. Software companies shrivel up and die.” – Jim Cramer, outlining the current market dynamic.

Technical Terms

• Per Seat: A software licensing model where users are charged a fee for each individual accessing the software.
• P/E Multiple (Price-to-Earnings Multiple): A valuation ratio comparing a company’s stock price to its earnings per share, indicating how much investors are willing to pay for each dollar of earnings.
• ETF (Exchange Traded Fund): An investment fund traded on stock exchanges, often designed to track a specific index, sector, or investment strategy.
• Shorting: A trading strategy where investors borrow shares and sell them, hoping to buy them back at a lower price in the future, profiting from the decline.
• B2B (Business-to-Business): A business model where companies sell products or services to other businesses.