Software & Services – Falling Knife

There are gems in the wreckage.

• The once great and highly valued software and services sector is being wiped out as a result of AI hype, meaning that the sector is now a contrarian paradise and an ideal way to take a bet on the AI bubble bursting.
• The sell-off of the sector has been ongoing for 18 to 24 months, and with the market deciding that the whole sector is headed for the scrap heap, no one has been spared.
• The sector is broad and within it are companies that are going to be badly affected by AI, companies that will flail against the tsunami and fail, and a few that will embrace it and thrive.
• These are the few that one wants to own because, for as long as they can keep growing their earnings at 10% or more, they are as cheap as I have ever seen in my career.
• Hence, the question becomes who thrives and who dies, and this is not an easy question to answer.
• Anthropic’s latest product announcements are deeply threatening to some parts of the white-collar workforce, as the promise now is that the agent will write software, run enterprise processes, create pictures and videos, analyse companies and manage investment portfolios better than a human can using products from the established industry.
• This has accelerated an exodus that was already well underway, and much of the sector now looks deeply oversold and is widely reviled by the market.
• These are sorts of conditions and chart patterns that I like, and if the sector can go from hated to just tolerated, then there are handsome returns to be made.
• However, picking the winners and losers here is not easy, and the risks of getting stuck in a value trap for years or losing one’s shirt are very real indeed.
• The activities most at risk are businesses such as selling data or IT support, as these are the easiest to replace, which is why the valuations of some of my competitors, like Gartner and Forrester, have been hammered.
• Even the regular AI chatbots are very good at finding and compiling data, and so it looks to me that businesses that rely on this activity have a very difficult time ahead.
• Both Gartner and Forrester have a meaningful part of their business in this area, and so I do not think that their shares look very appealing even down here.
• The other area I do not want to touch is consumer, because in this segment, most of the time, price is more important than product quality, and here AI could easily replace that part of the market.
• Enterprises are far more quality sensitive as horrible mistakes and inaccuracies can have financial and legal consequences and result in a lower quality product.
• Hence, what I am looking for are companies that sell to enterprises that are embracing AI and putting it into their products, which in turn is making their software or service more valuable.
• This will let them continue growing and avoid margin compression, meaning that they will meet or exceed their estimates, making them some of the best bargains the market will see this year.
• There is no doubt in my mind that some of this sector is going to really suffer from this, and another part of it will try to fight against the AI threat, meaning that only a subsegment of the sector is going to recover to anything close to its former glory.
• Hence, I am looking for enterprise software or service companies that are partnering with the AI upstarts and finding ways to use AI tools to refine their capabilities to an enterprise grade of quality and reliability.
• The rewards for success are probably somewhere in the region of a 2-3x gain, but with the way sentiment is against the sector right now, it could be a long and painful wait.
• Given how the sector has performed, it is now inversely correlated to the AI trade, meaning that for those who want to hedge against the bubble bursting (as it surely must at some stage), this is a great place to look.
• I am searching for candidates now.