The current landscape of the stock market presents intriguing possibilities for savvy investors, particularly within the software sector. Despite the S&P 500 reaching its second-highest valuation in 155 years, significant opportunities remain for those willing to dig deeper.
The S&P 500 and the iShares Expanded Tech-Software Sector ETF typically move in sync. However, recent data reveals a stark divergence. As of April 10, while the S&P 500 lingered just 2% below its peak, the software ETF was languishing 37% beneath its record high. This disparity indicates that established software stocks might be undervalued, with Adobe and Microsoft emerging as standout options for potential buyers.
The Impact of AI on Software Stocks
Software stocks have faced considerable downward pressure since late October, largely driven by concerns that artificial intelligence might diminish demand for high-margin software products. Adobe, for instance, has seen its shares plummet 46% from its recent highs due to anxiety around AI’s role in the industry.
However, a closer examination of Adobe’s performance reveals a different narrative. The company’s AI-driven annual recurring revenue soared more than threefold compared to the previous year in its fiscal first quarter, which ended on February 27, 2026. Additionally, subscription revenue, a crucial component of its business model, surged by 13%. Rather than viewing AI as a threat, Adobe has adeptly integrated it into its offerings, enhancing its existing platforms.
The Value of Customer Loyalty
Another critical factor to consider is the high switching costs associated with Adobe’s professional software, such as Photoshop. With decades of customer relationships under its belt, Adobe has built a level of client loyalty that is unlikely to erode quickly. This intangible asset positions the company favorably in a competitive market.
Moreover, Adobe’s commitment to shareholder value is evident through its robust share repurchase program. Over the past 20 years, nearly a third of its outstanding shares have been retired, significantly boosting earnings per share. Currently, Adobe’s forward P/E ratio stands at 8.5, the lowest it has been in over a decade.
Microsoft: A Strong Contender
Microsoft also stands out as a compelling investment opportunity in the current climate. Like Adobe, Microsoft has faced challenges due to fears surrounding AI’s impact on enterprise software sales, resulting in a nearly 30% drop in its stock price since late October.
Despite these concerns, Microsoft’s operational metrics reveal resilience. During its fiscal second-quarter report, which concluded on December 31, the company demonstrated 15% constant-currency sales growth, largely attributed to its cloud computing and AI-driven divisions. Azure, the second-largest cloud infrastructure service globally, has experienced a resurgence in yearly sales growth, nearing 40% thanks to the incorporation of generative AI and large language model solutions.
Legacy Strengths and Future Growth
Microsoft’s traditional segments continue to excel, even as they reach the tail end of their initial growth phases. Both Windows and Office remain dominant in their categories, generating substantial profit margins. This ongoing profitability allows Microsoft to reinvest in high-growth initiatives and pursue strategic acquisitions.
Additionally, Microsoft boasts an impressive capital return policy. In terms of nominal dollars, it leads all U.S. public companies in annual dividend payouts. This commitment to returning value to shareholders adds another layer of attractiveness to its stock.
An Unprecedented Value Proposition
Microsoft’s shares present a value proposition that has not been seen in over a decade. Currently trading at a forward P/E ratio of 19.5, the stock is 34% below its average over the past five years, making it the most affordable it has been since the mid-2010s.
Key Takeaways
- Software stocks, particularly Adobe and Microsoft, are currently undervalued compared to historical trends.
- Adobe has successfully integrated AI into its business model, resulting in increased revenues despite market fears.
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High switching costs and customer loyalty bolster Adobe’s competitive position in the software industry.
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Microsoft’s legacy products continue to generate strong cash flow, supporting investments in growth areas.
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Both companies have robust capital return programs, enhancing their attractiveness to investors.
In conclusion, the software sector is presenting rare opportunities for investment, especially in well-established companies like Adobe and Microsoft. As they navigate the evolving landscape shaped by AI and other technological advancements, they remain well-positioned to deliver value to their shareholders. For investors looking to capitalize on these discounted valuations, now may be the perfect time to act.
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