Is software the next hunting ground for value investors?
Given recent AI disruption fears and subsequent share price falls, should software stocks be on value’s radar?
Autheurs
Not so long ago, the most pressing concern by far for many investors had next to nothing to do with geopolitics. Instead, the attention of the broader market was focused squarely on the extent to which artificial intelligence (AI) could hurt the prospects of software companies – leading some high-profile players in the sector to suffer sharp declines in their share price. So, does that now bring them onto the radar of value investors?
Technology is not an area most investors readily associate with value investing – yet to believe value managers are restricted solely to buying the likes of financials, energy and mining stocks is to labour under a fundamental misunderstanding of the discipline. In both theory and practice, what constitutes “value” evolves through time – in other words, today’s stock market darlings can be tomorrow’s disappointments and vice-versa.
Indeed, one of the most striking illustrations of this point specifically concerns the technology sector. At the start of 2000, just as dotcom mania was reaching its peak, the 10 largest tech stocks in the US were, in size order, Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun Microsystems, Qualcomm and HP. Between them, they accounted for a quarter of the main S&P 500 index.
So how many of these businesses have we had exposure to in one or more of our contrarian value portfolios in the intervening years? Since 2000 – and each time buying in on deeply discounted absolute valuations that placed them in the cheapest parts of the market – we have held positions in no fewer than seven of that group: Cisco, Dell, HP, IBM, Intel, Oracle and Microsoft.
When disruptors are disrupted
To a great extent, the optimism surrounding those 10 businesses (and plenty of others) back in 2000 centred around the idea that they were managing to disrupt a variety of areas in which they were operating – or, as their advocates liked to say at the time, they represented “a new paradigm”. Of course, what such thinking tends to ignore – then and now – is that, in due course, disruptors are themselves disrupted by newcomers.
That brings us back to the question of whether “big software” is now a standout opportunity for value portfolio managers. It is an idea that has been put to us multiple times this year – and understandably enough, perhaps, given the price falls seen on the back of fears about AI disintermediation. In the 12 months to the end of March, the MSCI Software sector fell almost 9% versus a 19% rise in the overall index.
And yet, in themselves, falling share prices are not necessarily indicative of value. Our job as value investors is to remain extremely disciplined in analysing businesses that screen as cheap on their proven earnings power. And as the following chart shows, while the cyclically-adjusted price/earnings or “CAPE” ratio of the software sector may be down from a high of nearly 70x, with the sector still trading on 56x – it isn’t as though the whole sector has become indiscriminately cheap in absolute terms.
As a point of comparison, the average CAPE multiple we’ve paid when adding stocks – from any sector – to our portfolios has been 9.1x. Even when we have bought into the tech sector, our average purchase multiple there has been 10.2x.
Software sector CAPE ratio 2016-26
Source: Schroders, Data ranges from January 2016-January 2026.
Of course, sector average multiples don’t tell the whole story, and we remain alive to pockets of contrarian opportunity emerging amid the perceived “AI losers” in the sector. Indeed, we are currently looking closely at a few companies that fall into that category. However, we will continue to hold our discipline and only consider companies that trade on low multiples of their proven earnings and proven cash flow. Fundamental valuation remains our north star. A share price that’s fallen a long way from peak simply isn’t enough.
Disciplined valuation criteria
At its core, value investing is about avoiding overheated areas where stocks are “priced for perfection” and identifying opportunities where sentiment is depressed and share prices have fallen to irrationally low levels. The vagaries of human nature, which underpin global stock markets, mean these pockets of “fear” and “greed” are dynamic and constantly evolving – and thus new areas of interest to value investors constantly emerge.
Five years ago, with interest rates perceived to be anchored near zero and oil prices collapsing during the Covid lockdowns, banks and energy companies sat firmly in that “fear zone”, trading at deeply discounted multiples of through-cycle earnings. And while select opportunities continue to exist in those areas today, those sectors are no longer as indiscriminately cheap as they once were. However, the good news is we are identifying plenty of fresh opportunities in new sectors – often in more asset-light industries that were, until recently, the domain of quality-growth investors.
Some luxury goods companies, for example, have moved from being widely loved to increasingly out of favour as the growth outlook has slowed. At the same time, alcoholic beverage producers – long viewed as dependable quality-compounders – are facing structural concerns around shifting consumer preferences, such as the growing popularity of weight-loss drugs.
That said, done properly, value investing is not just a case of blind contrarianism. Again, falling share prices do not automatically equate to value, which means for a long time we steadfastly ignored the siren calls that stocks in both these sectors were “cheap”. Only when we were wholly satisfied their valuations chimed with our process did we buy into selected businesses – such as Ambev, Diageo and Pernod Ricard.
Similarly, given a sufficiently large fall in their share prices, it is possible more technology and software stocks could begin to appear on valuation screens – but, even then, there would be no guarantee of investment. We would remain guided by our process, undertake our own fundamental analysis and invest only on terms that meet our strict criteria. And if these stocks never hit a price that is acceptable to us, that too is fine.
The importance of fundamental analysis
We are not core investors and will leave others to seek to make returns from current valuation levels – continuing only to look at value shares, do deep, fundamental analysis and build our clients a diversified portfolio of the most attractive opportunities we can find. In this, we firmly believe we have four material advantages:
- A large and diverse team boasting more years of experience than ever before and a full-time data scientist.
- A mission statement seeking outstanding returns for clients and a culture that demands excellence, teamwork and improvement in everything we do to try and achieve that.
- A rigorous and proven investment process that has been followed for decades and includes our ‘Seven Red Questions’ framework to identify and avoid potential value traps.
- Proprietary data on an archive of more than 2,500 historic stock notes and all our trades, which provides us with a real advantage when it comes to utilising AI and further improving our investment process.
This combination of resources, culture, a consistent process, and data allows us to demonstrate not only that we follow our process, but that it adds value. For more than a decade, we have recorded and tracked our process efficacy – measuring the accuracy of our normalised profit estimates, risk scores, and whether we buy or sell too early (amongst a host of other data points).
Encouragingly, the evidence suggests the process is effective and outcomes also support this: our buy recommendations have risen by an average of ~30% over three years, compared with ~17% for passes. The positive spread is also present at the 25th and 75th centiles of observations.
Three-year returns from buys and passes
Past performance provides no guarantee of future results and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of investments to fall as well as rise.
Source: Schroders. Returns are 3 years after archive entry. Data covers all archive entries from May-2015 to Dec-2022 (to allow for 3 years of subsequent returns for analysis).
Finally, it is important to note the value opportunity today remains very attractive in absolute terms – and, despite recent strong performance, our portfolio valuations remain low versus both history and benchmark indices as shown below. This can be attributed to a discipline of trimming exposures as they reach our fair values and carefully recycling the proceeds into more lowly-valued exposures where the capital risk and reward outcomes are superior.
Market CAPE vs illustrative value portfolios
Source: LSEG, Schroders, March 2026. The illustrative portfolio CAPE is determined by taking the weighted harmonic mean of the individual stock CAPEs each month. Stock CAPEs are calculated by taking the market capitalisation and dividing by the inflation adjusted 10-year rolling average earnings. Data ranges from March 2020 to March 2026. The portfolios are illustrative and included to demonstrate valuation differences.
At a time of heightened geopolitical stress, significant market concentration and elevated valuations elsewhere, such an unrelenting focus on valuation – and the consequent guard against “style drift” – should serve to offer extra reassurance for investors and allow them to remain invested in equities when global indices look to be expensive.
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