Selling software stocks before the crowd paid off for Nick Evans, a Polar Capital fund manager. His warning to potential bargain hunters: most shares are still toxic and few firms will survive.
“We think application software faces an existential threat from AI,” said Evans, whose $12 billion global technology fund beat 99% of peers over one year and 97% over five.
Fears that sophisticated AI tools like Anthropic PBC’s Claude Cowork will disrupt software businesses sent their stocks tumbling this year. An exchange-traded fund tracking the U.S. software sector is down 22%, a sharp contrast to semiconductor stocks that have soared as AI spurs computing demand.
Application software, which helps users perform tasks such as writing documents and managing payrolls, looks particularly at risk, according to Evans. Apart from a small position and some call options in Microsoft Corp., the fund manager has sold all other holdings in the sector, including SAP SE, ServiceNow Inc., Adobe Inc. and HubSpot Inc. “We won’t go back to these companies,” he said in an interview.
In his view, AI coding tools have improved so much that they can already replicate and modify much existing software. That means established firms now face much greater competition from their own clients, who are racing to develop new tools internally to cut costs, as well as AI startups.
Companies such as SAP that make complex software packages will likely be more resilient, according to Evans. But with AI tools “getting dramatically more powerful,” there is considerable uncertainty about their long-term valuations, he said.
Seven out of the top 10 positions of the fund as of end-January were semiconductor companies, including top holding Nvidia Corp. that occupied nearly 10% of the portfolio. Aside from chipmakers, Evans said he’s bullish on firms that make networking gears, fiber optics, and those that provide power and energy infrastructure to data centers.
Squeeze on cashflow
The market rout triggered by the threat of AI disruption could cause another headache for software companies. Employees often receive shares as part of their compensation and managers may have to make up for the lost equity value by paying out more cash, Evans said. Any effort to buy AI startups to boost growth may add to the financial strain, he said.
“We don’t believe current prices reflect the terminal value uncertainty or the pressure on free cash flow,” he said.
A debate over the scale of the threat is raging on Wall Street. Strategists at JPMorgan Chase & Co said last week that software stocks could rebound following recent “extreme price action.” They favor stocks like Microsoft and ServiceNow.
There are areas of software Evans considers to be less vulnerable to disruption. In January, the fund manager increased holdings in infrastructure software firms that provide the foundation of systems which support consumer and enterprise applications. His investments in the sector include Cloudflare Inc. and Snowflake Inc.
Recent results from infrastructure software companies Datadog Inc. and Fastly Inc. showed that demand for the plumbing for the internet is soaring. Datadog shares rose over 10% last week, while Fastly more than doubled.
Evans also has a neutral view on cybersecurity software as he sees no immediate threat from AI. Still, less than 7% of his fund is invested in infrastructure software and cybersecurity stocks.
Outside of those two sectors, Evans expects only a few companies will survive the painful shakeout ahead. He predicts that most will go the way of newspapers in the 2000s, when the print media was decimated by the internet.
Investors should be “significantly underweight application software and they have to react quickly, because as the models get better, the disruption is accelerating,” he said.
Ren writes for Bloomberg.
