Some investors see buying opportunities among oversold software stocks.Adam Smigielski/iStockPhoto / Getty Images
Spooked by disruption from artificial intelligence, software companies’ stock prices plummeted last month as investors worried that they’re facing an existential threat.
Some investors see software-as-a-service companies, in particular, being “disintermediated” as AI agents step in between apps and human workers to write code and perform other functions, thereby reducing software sales.
Others see AI as overhyped and warn that a bubble will eventually pop amid excess spending and circular deal-making, leaving software incumbents awash in free cash flow once again.
After all, past innovations such as the cloud and mobile computing, far from crushing legacy tech, made the market larger for companies such as Microsoft Corp. MSFT-Q, SAP SE and Oracle Corp. ORCL-N.
Whatever the eventual fate of software companies, there may be tactical trade opportunities in this out-of-favour sector, both in the U.S. and in Canada.
Craig Basinger, chief market strategist at Toronto-based Purpose Investments Inc., says AI is a bubble and markets are overreacting to short-term developments.
“The longer-term risks [in software] are real, but the speed of the drop is assuming too much disruption in the near term,” he says.
With U.S. software companies trading at multiples of approximately 23 times forward earnings, “that’s roughly the overall market multiple for a much higher-growth part of the market,” he adds.
Mr. Basinger has been buying iShares Expanded Tech-Software Sector ETF IGV-A, which focuses on large-cap U.S.-based software companies.
“We go to the U.S. for sectors that just aren’t very well represented or well diversified here, although we do have some good-quality technology companies in Canada, such as Shopify Inc. SHOP-T, Constellation Software Inc. CSU-T and Open Text Corp. OTEX-T, and this negative narrative has also washed over them,” he says.
Thomson Reuters Corp. TRI-T saw its share price drop by 18 per cent over three days last month as part of the broader sell-off after Anthropic released new AI-backed productivity tools for lawyers. Chief executive officer Steve Hasker said at the time that the plunge in value “represents anxiety and not fundamentals.”
Brad Dunkley, co-founder and chief investment officer of Waratah Capital Advisors Ltd., a Toronto-based asset management firm, says he sees several risks in the current AI obsession, among them the vast amounts of capital spent.
“If you analyze the industry structure and take away the ‘new thing’ halo, I see a dozen or more competitors doing essentially the same thing and offering very low pricing,” he says.
Mr. Dunkley acknowledges that “AI is probably the greatest human invention of all time.” But he cautions that the hype reminds him of the fibre optics boom, which went bust as part of the dot-com bubble in the early 2000s, when there was also “an undifferentiated product, no proven business model and a massive capital spend.”
He says it’s a given that the terminal value for some software companies will be zero.
“Even before the invention of AI, it’s the natural course,” he says, pointing to long-gone products he used to use, such as WordPerfect.
But the valuation drawdown, “without any significant diminishment in business prospects, was too much,” he says.
“At the very least, there’s a trade here. The risk for buying some of these names is now much lower,” he adds.
Mr. Dunkley argues the value for leading software companies was never in their code-writing ability but in network effects, business processes and, most importantly, the trust enterprises have in the system.
He prefers Canadian software companies. “I like the ones in a position to take advantage of this chaos and deploy capital,” he says.
He believes companies such as Constellation Software will continue to use their free cash flow to find opportunities to generate high returns.
“They make investment decisions every week, quarter and year, and can adjust better than a single-focus company like Salesforce Inc. CRM-N, for example,” he says.
He’s also been buying Lumine Group Inc. LMN-X and Topicus.com Inc. TOI-X, both spin-offs of Constellation Software.
Recently, Waratah took a new position in Waterloo, Ont.-based Descartes Systems Group Inc. DSG-T, a name he hadn’t owned for years.
“In every industry, there’s a tight correlation between valuation and return on invested capital,” Mr. Dunkley says.
“Unless you believe that return on invested capital is going to crash, these are good buys right now.”