Capital Ideas^™ 
Investment insights from Capital Group

New AI tools are fueling ongoing concerns about the durability of traditional software business models, contributing to a sharp decline in the once-favored pocket of the technology sector. For investors, the resulting dispersion underscores the value of portfolio balance and selectivity, whether within software or across the broader market.

One of the more surprising developments to date has been how few incumbent software vendors have delivered truly differentiated, compelling AI-centric products that can change end-user outcomes.

Instead, many of the most impressive AI-driven software advances have emerged from private companies such as Databricks, Anthropic’s Claude Code and OpenAI’s Codex. These platforms highlight what is possible when AI meaningfully reshapes workflows rather than being layered incrementally onto existing products. From an investment perspective, this gap between innovation in private markets and execution among public incumbents may remain a key tension in the coming year.

As a result, public valuations across software have compressed, and stocks have experienced largely indiscriminate selling, often without regard to company-specific fundamentals such as balance sheet strength, cash flow durability or competitive positioning. Beneath the surface is a growing concern that the terminal value of some software franchises could be materially impaired if AI-driven alternatives fully disrupt their offerings and incumbents struggle to adapt.

Importantly, while risks to software have risen and some of the more pessimistic scenarios could ultimately play out, AI disruption hypotheses remain difficult to validate in real time. Enterprises continue to purchase software, and fundamentals across much of the sector remain healthy. To date, we are not yet observing broad-based AI pressure in pricing, growth, or margins.

That said, our investment team remains selective, focusing on software companies that are deeply embedded in customers’ operations or serve specialized markets. Larger, more diversified software leaders such as Microsoft also benefit from multiple revenue streams and distribution advantages that may support longer term adaptation.

Confidence in software would improve if incumbents demonstrate AI products that deliver in areas including real productivity gains and redefining workflows as opposed to incremental improvements. Demonstrated success on this front would suggest that incumbents can leverage their scale, data and distribution to compete effectively in an AI-driven landscape. 

More broadly, other areas of technology, including semiconductors, have held up relatively well, and the software sell-off should not be viewed as a signal to abandon the sector altogether. Moreover, as of late, large-cap and AI-focused technology stocks have been relatively insulated from recent geopolitical tensions.

Software’s rout also reinforces the importance of diversification. Additional sectors are beginning to attract interest and show momentum, including health care, energy, industrials and mining.