Software stocks are selling off. Here's how to play them.

Key Concepts

• AI Disruption in Software: The central theme revolves around the potential impact of Artificial Intelligence (AI), particularly Large Language Models (LLMs) like those from OpenAI and Anthropic, on the software industry.
• Terminal Value Risk: The idea that investor valuations are factoring in a long-term decline for software companies due to AI, even if current growth remains strong.
• TAM Expansion: The belief that AI will ultimately increase the Total Addressable Market (TAM) for software by enabling new capabilities and efficiencies.
• Innovation as Quality: The emphasis on a company’s ability to innovate and integrate AI effectively, rather than simply its size, as the key indicator of future success.
• LLMs (Large Language Models): Powerful AI models capable of understanding and generating human-like text, driving the development of AI agents and tools.
• AI SKUs: Specific AI-powered features or products offered by software companies.

Software Sector Response to AI: An Analysis of Current Trends & Opportunities

The discussion centers on the recent market reaction to advancements in Artificial Intelligence (AI), specifically the concerns surrounding its potential to disrupt the software industry. Dan Eizer of Wedbush has termed the situation a “software Armageddon,” prompting a debate on whether the market’s response is justified or an overreaction.

The Core Concerns & Counterarguments

The primary concern is twofold: firstly, the emergence of tools like Claude and Cursor allow companies to build custom AI agents, potentially reducing the need for traditional software solutions (like CRMs). Secondly, core functionality currently offered by software companies may be subsumed directly into platforms like OpenAI and Anthropic. This has led to a decline in valuations, reflecting what Rishi calls “terminal value risk” – investors pricing in a long-term decline in growth.

However, Rishi argues that the narrative of AI “killing” software is inaccurate and that the current pullback represents a significant buying opportunity. He emphasizes that while AI is transformative, it’s not a zero-sum game. He draws parallels to the early days of Amazon Web Services (AWS), where announcements of new AWS services initially depressed software stock prices, but ultimately, companies like Datadog, MongoDB, and Snowflake continued to thrive. He posits that AI will expand the Total Addressable Market (TAM) for software, enabling new efficiencies and capabilities, and ultimately leading to increased spending on software, potentially funded through Operational Expenditure (OPEX) savings.

Examining Recent Earnings & Market Signals

Despite the pessimistic narrative, Rishi points out that actual financial numbers from major software companies like Microsoft and ServiceNow have not declined during the recent earnings season. In fact, they have increased. This discrepancy between market sentiment and actual performance suggests that the current downturn is driven by investor fears about long-term growth prospects rather than immediate financial struggles. The market is, in effect, assuming these companies will experience a 5% perpetual decline, which Rishi deems “highly, highly unlikely.”

The Importance of Productization & Innovation

Rishi stresses that the value of LLMs and AI technology hinges on their successful “productization” at the application level. He argues that a single company cannot master all aspects of a vertical market (e.g., sales, marketing, finance, industry-specific needs). This highlights the continued importance of specialized software providers. He emphasizes that innovation is the key differentiator – companies that can effectively build AI-powered features (AI SKUs) and demonstrate customer value will be best positioned to succeed.

Case Studies & Specific Company Analysis

The discussion focuses on several specific companies to illustrate these points:

• HubSpot: Down approximately 70% over the past year due to concerns about its focus on Small and Medium-sized Businesses (SMBs) and seat-based pricing. Rishi believes HubSpot’s unified platform, combining sales, marketing, service, commerce, and operations on a single data layer, provides a strong foundation for AI integration and presents a compelling buying opportunity. He notes their early focus on agent marketplaces.
• MongoDB: Down around 20% this year. Rishi highlights its flexibility as a non-relational database, making it ideal for building new AI applications, particularly those leveraging unstructured data. He points to Cursor, Relevance AI, and Anthropic as existing MongoDB customers, indicating strong demand from leading AI companies.
• Intuit (TurboTax & QuickBooks): Down around 30% this year. Rishi believes Intuit has significant opportunities to embed AI into its products, disrupting traditional tax preparation and accounting services. He envisions AI agents assisting with tasks like book closing and potentially reducing the need for external accountants.

Narrative Shifts & Investor Strategy

The conversation acknowledges the volatility of market narratives. Just a year ago, AI was viewed as a massive tailwind for software; now, the narrative has reversed. Rishi advises investors to build a “shopping list” of potentially undervalued companies and wait for evidence of successful AI integration and customer adoption before making investment decisions. He emphasizes the importance of looking for companies that can demonstrate increased customer engagement and spending as a result of their AI offerings.

Notable Quotes

• Rishi: “This idea that AI is the death of software is absolutely wrong.”
• Rishi: “Numbers aren't coming down. Numbers are actually going up.”
• Rishi: “Quality doesn't mean size. Quality means innovation.”
• Rishi: “It’s not a zero-sum game. And all of this is actually TAM expansive.”

Conclusion

The discussion concludes that while the concerns surrounding AI’s impact on the software sector are valid, the market’s reaction has been largely overblown. The key to navigating this period lies in identifying companies that are not only embracing AI but also demonstrating a clear path to monetization and increased customer value. Innovation, rather than size, will be the defining factor in determining long-term success. The current downturn presents a potential buying opportunity for investors willing to focus on quality and future growth potential.