The S&P North American Technology Software Index tracks the performance of 111 software stocks. It has underperformed the S&P 500 (^GSPC +0.55%) by 19 percentage points during the past year, the worst relative performance for the software industry since the bear market of 2022.
Excluding that incident, software stocks have not underperformed the S&P 500 so badly at any point in the past decade. And the reason for that trend is artificial intelligence (AI). Specifically, investors are worried that AI will disrupt traditional business models and reduce demand for many software products.
Morgan Stanley analysts Sanjit Singh and Keith Weiss see things differently. "Productivity unleashed by AI will expand the pool of developers and spur a wave of app modernization initiatives." In that context, the recent underperformance in software stocks creates a buying opportunity seen just once in the past decade.
Here's why AppLovin (APP 1.99%) and Atlassian (TEAM +4.94%) are my picks for the best AI software stocks to buy now.
Image source: Getty Images.
AppLovin: 45% upside implied by the median target price
AppLovin develops ad tech software that helps brands engage consumers and monetize web content with targeted campaigns. The company initially focused on mobile gaming, where it helped developers market and monetize apps, but it more recently expanded into e-commerce advertising. That feature is part of a new self-service platform that streamlines the onboarding process and will eventually automate every workflow.
AppLovin has differentiated itself in two important ways. First, it earns revenue based on ad performance (i.e., cost-per-action), whereas competitors like The Trade Desk simply take a percentage of ad spend. Second, the artificial intelligence (AI) that powers its recommendation engine (Axon) outperforms similar targeting tools from other advertisers.
Indeed, Morningstar analyst Mark Giarelli says Axon has played a central role in the company's success. "AppLovin is driving a 45% higher return on ad spending than [Meta Platforms] and 115% higher compared with secondary advertising platforms like TikTok, Pinterest, Snapchat [by Snap], and YouTube," he wrote in a recent note to clients.
Wall Street estimates AppLovin's adjusted earnings will increase at 58% annually through 2027. That makes the current valuation of 66 times earnings look reasonable, especially when the company beat the consensus earnings estimate by an average of 21% in the last six quarters.
Among 32 analysts, AppLovin has a median target price of $774.50 per share. That implies 45% upside from its current share price of $533. Patient investors should feel comfortable buying a small position today.
NASDAQ: APP
Key Data Points
Atlassian: 84% upside implied by the median target price
Atlassian develops work management and collaboration software for development and operations (DevOps) teams and non-technical teams like marketing and human resources. The company also develops IT service management software. Consultancy Gartner has recognized Atlassian as a technology leader in DevOps, marketing work management, and enterprise service management platforms.
Atlassian has differentiated itself in two ways. First, it invests more in R&D than its peers because it relies on self-service sales and word-of-mouth marketing. Second, it is the only work management software vendor that connects technical, non-technical, and IT service teams on a common platform, which not only fosters better collaboration across the enterprise, but also affords the company numerous opportunities to upsell existing customers.
Atlassian has introduced a suite of generative AI features called Rovo. It supports intelligent search, process automation, and code generation to improve productivity and efficiency across business teams. As a well-established software vendor in several product categories, Atlassian could be a substantial winner as the AI boom unfolds.
Wall Street expects Atlassian's adjusted earnings to increase at 22% annually through the fiscal year ending in June 2027. That makes the current valuation of 31 times earnings look reasonable, especially because the company beat the consensus earnings estimate by an average of 16% over the last six quarters.
Among 34 analysts, Atlassian has a median target price of $225 per share. That implies 84% upside from the current share price of $122. With shares trading 62% below the high, investors have a great opportunity to buy a small position.
