Software Sector Rotation: A Portfolio Allocation Play on Quality Amid AI Disruption

The software sector is caught in a powerful liquidity-driven sell-off, creating a stark divergence from the broader market. A basket of software-as-a-service stocks tracked by Morgan Stanley has fallen roughly 15% so far this year, marking its worst start to a year since 2022. This turmoil was reignited last week when AI startup Anthropic unveiled a new tool, causing sharp declines in shares of key incumbents like Intuit, Adobe, and Salesforce. The sell-off highlights a deep-seated investor anxiety about disruption, with many buy-side funds seeing no compelling reason to own software stocks despite their battered valuations.

The performance gap has widened dramatically. While the Nasdaq 100 hovers near record highs, established software names are languishing at multi-year lows. This reflects a clear market rotation away from perceived growth stagnation toward sectors with clearer AI monetization paths, like semiconductors. The core issue is that incumbents have yet to demonstrate meaningful revenue acceleration from their own AI initiatives, leaving them vulnerable to the narrative of being disintermediated by agile new entrants.

Yet, this sell-off may have compressed valuations to a point of structural mispricing. Despite the selloff, the sector's forward earnings multiple has fallen to about 18 times forward earnings, a level that is historically low. This compression occurs even as earnings growth for the sector is expected to slow to around 14% in 2026, down from 19% in 2025. For institutional investors, this sets up a classic quality-versus-disruption trade. The sector's traditional strengths-high margins and recurring revenue-are being overshadowed by fear, but the valuation has now priced in a high degree of pessimism. The key question for portfolio construction is whether this represents a temporary liquidity event or a permanent reassessment of the software business model's durability.

Individual Stock Analysis: Valuation and Quality Metrics

For institutional investors, the current software sell-off demands a granular assessment of capital allocation efficiency and risk-adjusted return profiles. The sector's battered valuations have created pockets of opportunity, but only for companies demonstrating durable quality and clear paths to growth.

AppLovin presents a compelling case for a conviction buy. The company is executing a powerful platform transition, with its AI-powered Axon-2 adtech platform growing 68% year over year last quarter. This growth is not at the expense of quality, as it has driven gross margins to 82%. The stock's recent pullback, trading nearly 22% below its 52-week high, appears disconnected from this fundamental strength. Management's planned expansion beyond mobile gaming and into a self-serve ad manager offers a tangible catalyst for future capital appreciation, making it a high-quality, growth-oriented allocation.

UiPath offers a more nuanced picture. The company shows solid execution with gross margins of 84.9% and a 14% year-over-year increase in cRPO to $820 million. However, the bear case highlights a slowdown in customer expansion, with net revenue retention declining to 107%. This tension between strong margins and moderating expansion metrics suggests a company in transition. The consensus "Hold" rating reflects this uncertainty, positioning UiPath as a lower-conviction holding that may benefit from a broader sector rotation but carries execution risk.

GitLab represents a value play with significant downside. The stock is trading near its 52-week low and has seen a 31% annual price decline in 2025. While the company is introducing new pricing models and AI agents, the market has clearly priced in a period of stagnation. For a portfolio seeking quality, GitLab's current profile does not meet the bar; its depressed valuation is a reflection of fundamental challenges that have yet to be resolved.

The established giants are also under pressure. Adobe shares have been battered, with a Citi analyst raising the price target to $387 from $366 but maintaining a Neutral rating. This underscores the market's wait-and-see stance on the company's AI monetization. Salesforce, meanwhile, saw its stock plunge 11% following Anthropic news, a sharp reaction to disruption fears. Yet, the company is making strategic moves to become a leader in agentic AI, which could provide a long-term structural tailwind. For now, both names are caught in the liquidity-driven sell-off, their valuations compressed but their near-term growth narratives still unproven.

The bottom line is one of selective opportunity. AppLovin stands out as a high-quality growth story trading at a discount. UiPath offers quality but with visible growth headwinds. The others are either deeply discounted for a reason (GitLab) or are facing a narrative crisis (Adobe, Salesforce). For institutional capital, the focus should be on companies where the current price offers a meaningful risk premium for demonstrable operational strength.

Portfolio Construction: Sector Rotation and Risk-Adjusted Allocation

The sector's turmoil creates a clear opportunity for tactical capital allocation. The poor performance, driven by liquidity and disruption fears, has compressed valuations to a point where the risk premium for owning quality names has widened materially. For institutional portfolios, this sets up a classic quality-versus-disruption trade. The thesis is to overweight companies demonstrating strong execution and durable economics, while maintaining a neutral stance on those where the narrative crisis outweighs near-term fundamentals.

AppLovin is the prime candidate for an overweight position. Its gross margin of 82% and explosive growth in its AI-powered Axon-2 platform provide a concrete counter-narrative to sector-wide pessimism. The stock's recent pullback, trading nearly 22% below its 52-week high, appears disconnected from this operational strength. For a portfolio seeking conviction, AppLovin offers a high-quality growth story at a discount, with a clear path to expansion beyond its core market. This represents a targeted bet on successful platform monetization.

Adobe, by contrast, warrants a neutral, wait-and-see stance. The stock has been battered, but the market's reaction reflects a cautious growth outlook rather than a fundamental breakdown. A recent analyst raised the price target to $387 from $366 while maintaining a Neutral rating, a move that underscores the sector's narrative crisis. The valuation has compressed, but the catalyst for a re-rating remains the company's ability to demonstrate meaningful revenue acceleration from its AI initiatives. For now, the risk-adjusted return profile does not justify an overweight, but the stock's depressed level offers a potential entry point if execution improves.

The key risk to this allocation is that AI disruption accelerates faster than companies can monetize new platforms. The recent selloff was reignited by a new tool from AI startup Anthropic, highlighting the speed of technological change that can outpace traditional software business models. This scenario would require a sector-wide reassessment, as many buy-side investors currently see no compelling reason to own software stocks regardless of valuation. The portfolio construction must therefore be dynamic, with a clear exit if evidence emerges that the monetization timeline for AI platforms is materially shorter than anticipated.

In practice, this means a selective, quality-focused overweight in the software sector. The allocation should be concentrated in names like AppLovin that are executing well, while avoiding those where the disruption narrative is most acute. The bottom line is that the sector's traditional strengths-high margins and recurring revenue-are being overshadowed by fear, but valuations have now priced in a high degree of pessimism. For institutional capital, the opportunity lies in identifying the few companies where the current price offers a meaningful risk premium for demonstrable operational strength.

Catalysts and Risk Factors: What to Watch for Thesis Validation

The thesis that the software sector is mispriced hinges on a shift in sentiment from fear of disruption to recognition of new monetization pathways. The near-term catalysts are clear: Q4 earnings reports will be the first major test of whether companies can demonstrate AI-driven revenue acceleration or are succumbing to margin pressure. For names like UiPath, which is actively promoting its agentic automation platform, the focus will be on concrete adoption metrics and pipeline growth. A strong showing here could validate the narrative of incumbents successfully pivoting to new AI models. Conversely, any sign of deceleration in customer expansion or profitability would reinforce the bear case and likely trigger further sector rotation.

Institutional flow data will provide a parallel signal. A sustained outflow from software funds would confirm the current rotation thesis, as many buy-side investors see no near-term catalysts to justify a valuation reset. The recent sell-off, reignited by Anthropic's new tool, exemplifies this dynamic. A reversal in flows, however, could signal a bottom is forming and that the sector's depressed valuations are beginning to attract capital. This data point is critical for portfolio managers assessing the liquidity backdrop.

The primary risk to the mispricing thesis is that AI disruption accelerates faster than companies can monetize new platforms. The speed of change is unprecedented, as portfolio manager Bryan Wong noted, creating a high level of uncertainty. If new entrants like Anthropic rapidly capture market share from established players, it would require a sector-wide reassessment. This scenario would likely see software valuations compress further, as the traditional quality factors of high margins and recurring revenue become less relevant. For now, the wait-and-see stance from analysts, reflected in a consensus Hold rating for UiPath, underscores the market's caution.

The bottom line is that validation will come from a combination of operational execution and a shift in the institutional narrative. Watch for signs that AI monetization is moving from promise to revenue, and monitor flows for a change in the capital allocation trend. Until then, the sector remains a high-conviction, high-risk trade for those willing to bet on the durability of the incumbent model.