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In the US stock market’s recent correction from its all-time high, the technology sector has been one of the worst performing sectors. We see some attractive bargains within the tech sector following the selloff, particularly in the software industry. Whilst there are concerns about a US growth slowdown this year due to ongoing trade and policy uncertainty, the software industry is nevertheless poised to grow over the next decade thanks to the relentless expansion of our digital world. In the near term, the software industry is less vulnerable to trade wars thanks to its resilient earnings drivers. The integration of Artificial Intelligence (AI) tools across businesses is a catalyst for rapid growth for the software industry.
Growth shielded from trade war uncertainty
The US software industry generates 45% of revenue from outside the US, but only 7% comes from China, which is facing the brunt of US tariffs. This is in contrast to the semiconductor or technology hardware industries, which generate significantly more revenue from China and are more susceptible to US export restrictions or retaliatory actions from China. Moreover, the retaliation of non-US economies against US tariffs has been focused on goods and commodity imports, with software largely overlooked.
Meanwhile, the software industry continues to grow, with products being deployed for efficiency gains, cloud computing, enhancing customer experiences, data analytics, remote work and collaboration, cybersecurity, electronic designs and so on. With the rollout of more smart devices and exponential growth in data generation, demand for the software industry to provide the necessary code to manage the technology hardware and the digital universe is likely to keep rising. Since 2005, earnings in the US software industry have grown at an average annual rate of 11%, according to Bloomberg data. Consensus expectations are for 13% earnings growth in 2025 and 14% average annual growth over the next three years.
AI development
AI tools support software development. However, what is largely absent from consensus expectations for now is the impact of AI developments, which remain in the early stages. In October 2024, the Google’s CEO noted that over 25% of the company’s new code was generated by AI, highlighting its use to boost productivity. This should translate into profits down the road.
The emergence of China’s low-cost AI-powered chatbot DeepSeek has also demonstrated that AI tools can be developed at lower costs. This should benefit software platform providers, who can integrate AI tools and operate at lower costs. This would support greater adoption of AI technology and applications throughout the economy, while boosting the development of cloud infrastructure. Although the gaining popularity of DeepSeek could also imply downward pressure on pricing in China, we believe the expansion of usage would offset such pressures.
Further AI developments could also lead to monetisation opportunities through AI agents: software programmes that can autonomously complete tasks to achieve certain objectives through independent decision making. A pickup in monetisation could drive an expansion of the valuation multiples for software stocks.
Reasonable valuation, with resilient earnings growth
The software industry, represented by the MSCI US software and services index, is currently valued at a 29x price-earnings (PE) ratio, based on consensus 12-month forward earnings. While this may seem high compared to the PE ratio of the broader US stock market (MSCI US index) at 21x, this can be justified by the relatively more resilient earnings of the software industry. In the past 19 years (2005-2024), the software industry has only had two years of negative earnings growth, in 2009 (-5.7%) and in 2020 (-0.7%). This compares favourably with the broader US stock market which has seen five years of negative earnings growth in the same period, with contractions also significantly deeper (-11% on average).
The relatively limited earnings downside explains why investors are willing to pay a higher valuation for software stocks. It is estimated that most of the revenue in the software industry is subscription based, where customers pay monthly or periodically to use the software. This business model is viewed as giving a more predictable recurring revenue for the industry.
Furthermore, the software industry’s current PE of 29x is at a discount to its own historical average of 32x over the past year and 31x over the past five years. This implies software’s current valuation is at a 6-9% discount to its own trading history.
Nevertheless, we should not overlook the risks, namely: (a) Although the industry is relatively resilient in a downturn, it is not immune from a recession. While we do not expect one this year, the industry could still see earnings fall if the US economy does contract; b) While we expect interest rate cuts in the US this year, interest rate hikes could lead to lower valuation for the sector; c) A decline in corporate IT budgets or slower-than-expected AI developments could also lead to slower-than-expected earnings growth for the industry.
Risks notwithstanding, the reasonable valuation, resilient earnings growth, catalyst from AI development and lower vulnerability to trade wars underpins the attraction of investing in software industry equities now.
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