- Software stocks have been slammed this year after a long period of strong performance.
- Meanwhile, hardware stocks are reaping the benefits of the AI boom as their profits soar.
- "You're building the car and the engine, but you have no passengers in software," Baird's Ted Mortonson said.
The fast-growing adoption of generative artificial intelligence has shaken one of Wall Street's most successful tech trades over the past decade.
Software stocks, known for their high profit margins and asset-light business models, have consistently outperformed their asset-heavy and lower-profit hardware counterparts since 2014.
The NYSE Arca Computer Hardware Index is up 312% over the past 10 years, compared to a gain of 576% for the Dow Jones US Software Index over the same period.
But that dynamic has been flipped on its head this year as companies race to buy AI-enabled GPU chips from hardware providers, including Nvidia, AMD, Super Micro Computer, Broadcom, and Dell.
Year-to-date, hardware tech stocks are outperforming software tech stocks by a whopping 30 percentage points.
Software stocks, including MongoDB, Salesforce, Snowflake, and Workday, have been slammed this year after their earnings results failed to convince investors that AI-fueled profits are imminent.
It's hard to monetize AI as a software company
The dynamic at play, according to Baird managing director and tech strategist Ted Mortonson, is reflective of the fact that software companies are having difficulty monetizing AI while hardware companies enjoy booming business.
"This GenAI cycle is infrastructure, all infrastructure," Mortonson told Business Insider this week. "The cloud titans are now spending $200 billion this year, which is up 50% on data centers. That's the horsepower, or the engine of Gen AI."
Mortonson said that while hundreds of billions of dollars are being spent on expensive GPUs to develop large language models, there are few applications that 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 are Gen AI capable. So, we have a long way to go for software and an acceptable return on invested capital to materialize. That's why you're not seeing it in software. There is no return on invested capital because there's no applications. So, you're building 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 can be understood by Gen AI.
That process can take 15 months at minimum, and based on Mortonson's recent conversations with software-focused tech executives, very few of them have even started the process.
"It's not going to happen until late 2025 to 2026. It's just not there. It's a nothing burger," Mortonson said.
IT budgets are tight
Software companies are also dealing with tight IT budgets as their customers reprioritize their spending away from software and towards GPU hardware.
"Major corporations realize that AI is a 'must get it right' proposition, and as a result are overweighting semis and hardware spend, at the expense of software spend currently. We expect this to continue for the foreseeable future," strategist Larry Tentarelli of Blue Chip Daily told Business Insider.
"Every body is scrutinizing on the SaaS side, every single seat, because IT budgets are so tight right now," Mortonson said.
This dynamic means that hardware stocks will continue to outperform software stocks through 2025, according to Mortonson.
"We're in a mini hype cycle. This is the bottom line, until we can get the infrastructure tuned, reduced costs and the applications are designed to work off this next-generation architecture. Until that happens and the data is migrated, the enterprise software GenAI will not materialize," Mortonson said. "The cart is in front of the horse as it relates to GenAI software. There's just no applications."
Steve Eisman of "The Big Short" fame told CNBC this week that he, too, expects hardware stocks to continue their outperformance relative to software shares.
"The moats that some of the software companies, not all but some, have around their businesses are not going to be quite as high. You can make an argument that the revaluation of hardware is going to continue and that some parts of software will derail," Eisman said.