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Software stocks have fallen heavily this year after a long period of strong performance.
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Meanwhile, hardware stocks are reaping the benefits of the AI boom as their profits soar.
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“You build the car and the engine, but you don’t have any passengers in software,” said Baird’s Ted Mortonson.
The fast-growing adoption of generative artificial intelligence has shaken one of Wall Street’s most successful tech companies over the past decade.
Software stocks, known for their high profit margins and asset-light business models, have consistently outperformed their asset-heavy, lower-profit hardware counterparts since 2014.
The NYSE Arca Computer Hardware Index is up 312% over the past decade, compared to a 576% gain for the Dow Jones US Software Index over the same period.
But that dynamic has been turned on its head this year as companies race to buy AI-enabled GPU chips from hardware suppliers including Nvidia, AMD, Super Micro Computer, Broadcom and Dell.
Year-to-date, hardware technology stocks outperform software technology stocks by a whopping 30 percentage points.
Software stocks including MongoDB, Salesforce, Snowflake and Workday have come under heavy fire this year after their earnings results failed to convince investors that AI-powered gains are imminent.
It is difficult to monetize AI as a software company
The dynamics at play, says Baird director and technology strategist Ted Mortonson, reflect the fact that software companies are struggling to generate revenue from AI, while hardware companies are booming.
“This GenAI cycle is infrastructure, all infrastructure,” Mortonson told Business Insider this week. “The cloud titans are now spending $200 billion this year, a 50% increase on data centers. That is the horsepower, or engine, of Gen AI.”
Mortonson said that while hundreds of billions of dollars are spent on expensive GPUs to develop large language models, few applications can deliver a significant return on investment for software companies and their customers.
“30% of the Fortune 500 have moved to the cloud. 10% of that is Gen AI-enabled. So we still have a long way to go before software and an acceptable return on invested capital become a reality. That’s why you don’t see it in software. There is no return on invested capital because there are no applications. So you build the car and the engine, but you have no passengers in software,” Mortonson said.
Mortonson explained that one of the key challenges for companies to make good use of generative AI technologies is the need to organize and structure their data in a format that Gen AI can understand.
That process could take at least 15 months, and based on Mortonson’s recent conversations with software-focused tech executives, very few of them have even started the process.
“It won’t happen until late 2025 to 2026. It’s just not there. It’s a citizen of nothing,” Mortonson said.
IT budgets are tight
Software companies are also facing tight IT budgets as their customers reprioritize their spending from software to GPU hardware.
“Large companies realize that AI is a ‘must-get-it-right’ proposition, and are therefore considering intermediates and hardware spend, at the expense of software spend at the moment. We expect this to continue for the foreseeable future,” Blue Chip Daily strategist Larry Tentarelli told Business Insider.
“Everyone is looking critically at the SaaS side, every place, because IT budgets are so tight right now,” says Mortonson.
This dynamic means that hardware stocks will continue to outperform software stocks through 2025, Mortonson said.
“We are in a mini-hype cycle. This is what it comes down to until we can tune the infrastructure, reduce costs, and have the applications designed to work with this next-generation architecture. Until that happens and the data is migrated, enterprise software GenAI will not become a reality,” said Mortonson. “The cart is before the horse when it comes to GenAI software. There are simply no applications.”
Steve Eisman, known for ‘The Big Short’, told CNBC this week that he also expects hardware stocks to continue their outperformance over software stocks.
“The moats that some software companies, not all, but some, have around their businesses are not going to be that high. You can argue that the revaluation of hardware will continue and that some parts of the software will be derailed,” Eisman said.
Read the original article on Business Insider
