- Software stocks were battered this week as Anthropic's Claude AI raised concerns of disruption.
- Morningstar says software fears were largely overdone and sees buying opportunities.
- The plunge represents a good entry point for Microsoft and ServiceNow stocks.
The outlook quickly became dire for software stocks this week as investors envisioned a world where Anthropic's Claude AI assistant rendered entire companies and IT departments useless.
The bottom fell out of the sector as the iShares Expanded Tech-Software Sector ETF (IGV) fell 19% from January 26 to February 5.
But Morningstar says fears are largely overdone, and the chaotic burst of selling represents a prime dip-buying opportunity.
"We see little evidence that the bear case is unfolding — retention rates and other software metrics appear solid. In short, we acknowledge the risks but believe the fears are overblown," Dan Romanoff, a senior equity analyst at Morningstar, said as the sell-off was still going strong midweek.
"We do not believe enterprise software customers are going to vibe code internal solutions such that the application vendor's models are threatened en masse," he continued. "There may be some pressure on seat counts, but there is no evidence to show that this is happening—and automation is not a new trend."
Software stocks rallied on Friday, with IGV rising 3% and the Nasdaq up more than 2%.
With such a dramatic sell-off, Romanoff said there are opportunities throughout the software sector. He pointed to two beaten-up stocks in particular that he thinks have "substantial upside": Microsoft (MSFT) and ServiceNow (NOW).
Shares of Microsoft and ServiceNow are down 17% and 35% year to date, respectively.
Romanoff has a $600 "fair value estimate" for shares of Microsoft, implying upside of 50%, and $200 for ServiceNow, which would represent 100% upside.
Still, he warned of volatility, saying, "The software landscape is not for the faint of heart at present."
Despite fears that AI will eat the software industry, Romanoff said investors may be giving the new technology too much credit, and that firms have publicly said they still largely view AI with skepticism.
"For all of the hype, AI products are not generating substantial revenue for software vendors, as management teams fear hallucinations and rogue agents," Romanoff said. "This is supported by disclosures from publicly traded software companies, which generally indicate that AI solutions account for approximately 2% of revenue (or ARR), and further by OpenAI's revenue, which skews heavily toward consumer subscriptions."
He also drew historical parallels to prior instances of automation that did not cause major disruptions to labor markets.
"Seat counts may be pressured at some point in the future, but we certainly did not see that with sales reps, given the emphasis on automation in Salesforce's revolutionary CRM approach 25 years ago," Romanoff said. "We can also look at headcount, which continues to increase across functional areas. Again, it is certainly possible that these fears may manifest more directly, but they are not occurring at this point."
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