Is AI-Generated Rally In Software Stocks For Real?

Software growth stocks are once again in favor amid buzz over artificial intelligence. Management commentary on generative AI product roadmaps on company earnings calls has been as critical as financial results for many software stocks.

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Heading into 2023, the big issue for software firms was striking a balance between sales growth and operating margin improvement amid worries over inflation and Federal Reserve rate hikes.

After tumbling more than a third in 2022, the iShares Expanded Tech-Software ETF (IGV) — comprised of many of the major enterprise software players —  gained nearly 35% in the first half of 2023. The S&P 500, meanwhile, has advanced 16% in 2023.

Buzz around AI stocks has surged since startup OpenAI launched ChatGPT in November. Microsoft (MSFT) is OpenAI’s biggest investor. OpenAI is a leader in generative AI technology.

Among AI stocks, C3.ai (AI) shot up 226% in the first half of 2023. Palantir (PLTR) jumped 139%.

Further, IBD’s enterprise software group ranks a solid No. 25 out of 197 industry groups that IBD tracks.

Software Growth Stocks: Where The Winners Are

Meanwhile, MongoDB (MDB), Dynatrace (DT), Shopify (SHOP) and HubSpot (HUBS) are on the IBD Leaderboard. Leaderboard is IBD’s curated list of leading stocks that stand out on technical and fundamental metrics.

The IBD 50 roster of growth stocks features seven software companies. They include Monday.com (MNDY), Salesforce (CRM), Dynatrace, ServiceNow (NOW), MongoDB, Workday (WDAY), and HubSpot. Datadog (DDOG) and JFrog (FROG) recently fell off the IBD 50.

Despite rebounding valuations, some analysts expect a pickup in acquisitions.

“During the first half of the year, software M&A was somewhat quieter than we had expected at the end of 2022 as we watched dry powder steadily build and investors mostly sit on the sidelines during a stretch of volatility,” said Truist analyst Terry Tillman in a report.

He added: “With the recent pickup in deal making, along with artificial intelligence continuing to dominant headlines, we believe we could be at the cusp of an accelerating M&A cycle as financial sponsors with well over a trillion dollars in buyout dry powder look to deploy capital. Strategic buyers will begin to seize the opportunity to add new, AI-enabled capabilities to their existing platforms.”

Software Stocks: In AI, Data Is King

Investors should monitor the IBD Stock of the Day, which gives readers a close look at a company’s technical and fundamental performance. Salesforce, Palantir and Dynatrace have been featured recently as the IBD Stock of the Day.

Then, there’s Adobe (ADBE), which has made several AI announcements.

In AI, data is king. To get the most out of AI software, companies need to build up “big data” holdings that are the foundation of large language models, or LLMs. Generative AI creates text and images based on patterns in training data.

The rise of generative AI could benefit big data cloud-computing management platforms such as Snowflake (SNOW) and privately held Databricks. Snowflake and Databricks are racing to integrate AI technology into their cloud platforms.

Database vendor Oracle (ORCL) also is getting a boost. Oracle is moving fast to add AI tools to its cloud platform.

‘Seat’-Based Business Models In Jeopardy

As software companies integrate generative AI tools into products, their customers will spend more on software, a Goldman Sachs report said. Generative AI will add an incremental $150 billion to the current global software market of $685 billion, Goldman Sachs predicted.

Still, the emergence of generative AI and more intelligent chatbots could pose a threat to some software companies. Some software stocks in the customer service and call center markets have traded down in 2023.

Companies that sell software based on users, or seats, might in in trouble long-term, Jefferies analyst Brent Thill said in a report.

“As AI enhances productivity, companies will restrain headcount growth while increasing consumption of chatbots and AI generated queries,” Thill said. “We believe companies will be forced to switch to consumption-based models or a hybrid approach rather than just seat-based pricing to offset computing costs from AI queries.”

Aside from the AI boom, more cost-cutting looms for software companies. Amid the shakeout in software growth stocks, some analysts have steered away from companies with higher exposure to stock-based compensation.

Private equity firms have been active in buying public software companies. A consortium led by Hellman & Friedman and Permira acquired Zendesk in late November. And private equity firm Thoma Bravo bought Coupa Software in February.

Software Stocks: Big Years

While software growth stocks underperformed in 2022, they’ve notched some big years in the past.

In 2020, the IGV software index soared nearly 52% vs. the S&P 500’s gain of 16.3%. Software stocks also outperformed in 2019 and 2018.

Software companies remain one of the sectors that offers the best revenue growth in technology. Increased corporate spending on cloud computing, digital transformation, big data analytics and artificial intelligence all drive revenue growth for software stocks.

In the long run, low-code programming tools could boost use of artificial intelligence and cloud native applications.

Software container technology also is making it easier to develop cloud applications.

How Recurring Revenue Drives Growth

Further, software stocks with the highest percentage of subscription-based, recurring revenue stand out. They’re known as software-as-a-service, or SaaS, stocks.

Salesforce has been a leader in software-as-a-service.

The customers of SaaS companies purchase renewable subscriptions, rather than one-time software licenses. Further, customers receive automatic software updates via the web.

When deciding whether the time is right to buy software stocks, Relative Strength Ratings are important. They’re available at IBD Stock Checkup.

Also, investors should look for software stocks with Composite Ratings above 90. IBD’s Composite Rating looks at technical and fundamental factors. Those factors include relative price performance, earnings growth and return on equity.

Further, cloud computing, digital transformation and artificial intelligence projects should remain corporate priorities, analysts say.

IBD groups software companies as enterprise software stocks as well as in vertical markets such as financial and medical. Also, some software companies belong to product groups, such as database software and computer security.

Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.

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