The sell-off in software stocks is creating wonderful investment opportunities

The stocks of software companies have been clobbered so far this year...

This has been primarily due to fears that artificial intelligence ("AI") will displace their products for a large number of customers.

Many stocks in the sector have been cut in half or more. The average software stock, as measured by the iShares Expanded Tech-Software Sector Fund (IGV), is down 20.6% year to date.

You can see this in the chart below:

But my team and I at Stansberry Research think the sell-off is overdone...

After carefully analyzing the entire sector, we just recommended our favorite stock in the latest issue of our flagship newsletter, Stansberry's Investment Advisory. We wrote:

Its stock has been cut in half over the past year. As we'll explain today, this company is already wildly profitable, and its software helps customers incorporate AI into their businesses.

Between its collapsing share price and the tailwinds for its business, this stock could easily triple over the next five years. Shares have begun to recover over the past few days, but we're not too late to grab massive gains.

You have to be a subscriber to access the idea and our full analysis. (If you're not already subscribed, you can do so by clicking here.)

My editors gave me permission to share our overview of the sector. Here's a summary of how AI has been affecting software stocks:

Investors fear that AI will make software companies and their expensive licenses obsolete. Mass selling has wiped out more than $1 trillion in market cap in software stocks this year alone. In finance, folks are calling it the "SaaSpocalypse"... named after the Software as a Service ("SaaS") business model.

There are two main fears that have driven panic selling in the sector:

The first is that "vibe coders" will soon take down the biggest software giants. Vibe coding means telling AI what you want in plain language and then letting it generate the code for you. If anyone with a computer can create their own software, nobody will need to buy it from a company.

But the threat isn't just from vibe coders. It's also from "agentic AI."

Agentic AI handles entire multistep tasks from a single prompt, such as "onboard John Smith," "request approval," "review new contracts," or "prepare presentation for Q4 meeting."

It's true that AI could displace junior software engineers who mainly work in the developmental phase. But with that comes increased productivity and lower costs:

Coding is just one small portion of software development. Software follows an entire life cycle... from planning and requirements analysis, to design and architecture, to development (writing code), to deploying and maintaining the finished product...

The development phase is where AI is having the most impact. AI is good at automating mundane, labor-intensive code-writing. With AI, you no longer need armies of software engineers writing code. AI can do it much faster and cheaper...

Some analysts estimate that AI will make software-engineering teams 30% to 50% more productive. Software companies can use AI to help them bring new, improved products to the market much faster, while lowering development costs.

And AI won't fully replace experienced engineers. It will only free them up to do higher-level tasks. And they'll be the ones using AI the most effectively.

Overall, we think AI is a good thing for software companies, as it "expands markets and creates new ways to profit for companies that adapt":

If AI cuts the cost of software, companies won't stop using it. They'll embed it in more processes. It likely means more software, more deeply embedded, with AI doing the grunt work.

This "AI transition" will be painful for some software companies. Not all will survive. Some will die quick deaths. Others will see their businesses slowly fade away. But still others will do better than ever.

... Mr. Market hasn't bothered to figure out which is which. The software firms that will soar to new heights have sold off alongside the losers.

In the issue, we also highlighted why companies aren't likely to rip out mission-critical software in favor of AI:

Dharmesh Shah, co-founder and chief technology officer of SaaS company HubSpot... said it would be "silly" to try and replace the 100-plus SaaS applications that HubSpot uses when he can just buy them. As he asked, "What are you going to do when the 20-something genius that vibe coded it over a weekend leaves the company?"

Major companies choose big software vendors with established reputations because they can trust them. They want someone they can rely on.

No less important, they want someone to blame when things go wrong. In the business world, folks call this "one throat to choke."

If you're an executive who cheaps out by developing software internally or switching to an unknown startup, you'll shoulder the blame if things go wrong. You'd rather deal with a big company with deep pockets... round-the-clock customer service... proven data security... and the staying power to still be in business in five years.

In short, the death of software has been greatly exaggerated.

We even think "AI will do what SaaS did for the software market 20 years ago... grow the software pie. It will make software available to far more companies and embed it deeply into more business processes."

However, that doesn't mean every software company will survive this shift:

New SaaS competitors put many perpetual-model software companies out of business.

To know which companies will survive this AI transition, you need to know what specific traits make a software business hard for AI to replace.

Most investors have no ability to distinguish between the software winners and losers. So they sell first and ask questions later.

This has created a tremendous opportunity for investors who understand enterprise software and where the industry is headed...

My team has a combined 25 years of experience working at software companies, and Investment Advisory has been recommending SaaS stocks since 2019.

We've developed a proprietary framework for evaluating software companies – including their resilience against AI:

In researching today's issue, we started by evaluating all 258 publicly traded software companies against 12 criteria. These included things like whether software is a "system of record" that controls proprietary customer data, has embedded workflows and can "talk" to other software programs, has high switching costs, and is a platform rather than simply a user interface.

Companies most resistant to the AI threat will have many of these traits.

Large SaaS platforms that have proprietary customer data, years of usage patterns, and embedded workflows will survive. Companies that make nothing more than a slick user interface or a fancy dashboard are toast.

Simple applications can be swapped out. Other types of software are so embedded, they're like connective tissue – very hard to replicate and replace.

With the help of AI, we scored each company on all 12 criteria on a scale of 1 (highly vulnerable to AI substitution) to 10 (structurally resistant).

We weighted the 12 factors by importance. We then took the weighted average of the grades to rank which companies are most durable... and which are most at risk. The higher the score, the more resilient the company is. The lower the score, the more vulnerable.

In the issue, we shared a list of the 20 software companies with the highest score – meaning they're the least vulnerable to the threat of AI.

Only Investment Advisory subscribers can access this list. But I can tell you that this month's stock pick is on it, of course.

Another of our portfolio holdings, Microsoft (MSFT), is also on the list. That's no surprise. Nearly every business on the planet uses its Office suite of productivity software programs. And its cloud business is essential to run AI models like ChatGPT.

Our model portfolio also includes software maker Adobe (ADBE), about which I wrote most recently in Friday's e-mail, where I concluded:

Overall, the company continues to grow nicely and retains mouthwatering economic characteristics: 89% gross margins, 30% after-tax profit margins, robust free cash flow and share repurchases, etc.

And the stock is downright cheap. At around $248 with full-year [earnings per share] estimates of $23.49, the stock has a price-to-earnings ratio of only 10.6 times. I think it should trade at double that...

At the other end of the spectrum, here are some of the software stocks that scored the worst, which we shared in the Investment Advisory issue:

... storage-software maker Dropbox (DBX)... video platform Rumble (RUM)... legal software provider LegalZoom (LZ)... advertising-technology firm AppLovin (APP)... and language-learning software maker Duolingo (DUOL).

These companies' software tools are applications, not platforms. They're either easy to replicate or are nice-to-have tools that aren't deeply embedded in customers' systems.

AI can come up with cheaper ways to teach you Spanish... But it's not going to make businesses cancel their Excel licenses.

Tomorrow, I'll analyze another company in the sector about which I've written previously – Salesforce (CRM). So stay tuned!

Again, only subscribers have access to our full analysis of the sector and our favorite software stock. Click here to become an Investment Advisory subscriber.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.