Did ASX software stocks just find their catalyst?

For much of the past year, software stocks have been among the biggest casualties of the AI boom.

As investors piled into Nvidia, Broadcom and the broader semiconductor trade, software companies were sold on fears that AI would erode their competitive moats. Shares in Xero (ASX: XRO), WiseTech Global (ASX: WTC), Pro Medicus (ASX: PME) and Life360 (ASX: 360) all tumbled as investors questioned whether AI would make their products less valuable.

But over the past few months, sentiment has quietly begun to shift, and Microsoft's (NASDAQ: MSFT) latest earnings - which sent its shares skyrocketing more than 15% overnight - may prove to be the catalyst that cements a recovery.

The world's largest software company by revenue reported 18% earnings growth and 23% earnings-per-share growth, while Azure generated more than US$100 billion in annual income  for the first time.

The recovery isn't confined to Wall Street. The table below, compiled by my colleague Kerry Sun, shows that many of Australia's biggest software names have rallied strongly from their 52-week lows, even if most remain well below last year's peaks.

From AI fears to AI confidence

To assess whether the recovery has further to run and the five ASX software stocks they're watching, I spoke with Marcus Today's Henry Jennings and TMS Capital's Ben Clark.

Clark earlier this year urged investors to "run into the fire, not away" and snapped up shares of Microsoft and several beaten-down ASX tech names as negativity swept the sector.

Education

Run into the fire, not away: Ben Clark is buying into the growth sell-off

View

His call has aged well. He had argued the market was confusing AI fears with deteriorating business fundamentals and used the sell-off to add to Microsoft and several software names. Microsoft's latest results, he says, are another sign that the thesis is playing out.

"I think it's the tick that we needed for that next leg to come through ... we've already seen the lows in these stocks," Clark says.

Microsoft's numbers certainly backed that up, but importantly, these results provided tangible evidence that businesses are prepared to pay for AI-powered software rather than simply experiment with it.

Clark says investors also received something they hadn't seen from every AI winner.

"There's a much clearer plan in terms of how they're going to monetise it," he says. 

"We're seeing it flow through to the business's financials faster... it feels like there's more transparency around how the business is going to financially harness AI into the future."

Jennings agrees Microsoft's results were more confirmation than surprise.

"The stock had been underwhelming this year and was due for a bounce. It was good to see Copilot now has 30 million subscribers. Azure was obviously the standout, and the Anthropic stake helps, although whether that valuation is sustainable is another question," he says.

The market is rotating

The shift isn't confined to Microsoft. The iShares Expanded Tech-Software Sector ETF (BATS: IGV), widely regarded as the benchmark for global software stocks, has rallied around 27% from its recent low.

Canada's software-heavy technology index has rebounded by a similar amount, while the Betashares S&P/ASX Australian Technology ETF (ASX: ATEC) is up around 15% from its April lows.

Clark believes investors are rotating away from the companies building AI infrastructure and towards those actually using it to grow earnings, with a key reason being valuations.

Normally, fast-growing software companies are among the first casualties when long-term bond yields rise. This time has been different.

"One of the things that I think has been interesting this earnings season is we've seen bond yields go up, but software stocks have gone up with them; normally they're very negatively correlated.

The reason they're not is because the earnings multiples that they're trading on are very low. Some of these companies like Adobe are trading on a PE of 14. Because the multiples have compressed so much, they're much less sensitive," he says.

Meanwhile, he believes many semiconductor names remain vulnerable after an extraordinary run.

"The semi bubble... money had to come from somewhere to fund these businesses getting to trillion-dollar market caps. This spending boom is not going to last forever," he says. 

Jennings has reached a similar conclusion.

"Hardware just got silly, and sentiment has shifted."

He also questions whether the market's enthusiasm for AI infrastructure can continue indefinitely.

"Capex isn't seeing the results people need to justify valuations. Chinese Kimi models aren't helping sentiment either. Do you really need the power of the latest model to do what you want? Compute is getting cheaper and becoming more of a commodity."

Why software's moats may be stronger than investors thought

Both investors argue that fears AI would destroy software businesses now look overstated.

Jennings believes regulation and years of product development continue to provide powerful competitive advantages.

"It's not easy to force your way in with an AI version that doesn't satisfy legal or regulatory requirements," he says.

He points to WiseTech Global (ASX: WTC) and Xero (ASX: XRO) as examples.

"WiseTech has to be 100% compliant with regulations. Xero also has a moat around audit requirements. They're not businesses you can build in an afternoon with Claude," Jennings says.

Clark also believes investors are becoming more comfortable that many software businesses will benefit from AI rather than be disrupted by it.

"I think with each quarter that we see these earnings results there is more investor confidence that these businesses are going to be okay. They're not all going to be okay, but broadly they are," he says.

Could reporting season spark an explosive recovery?

With reporting season underway, both Clark and Jennings see opportunities among Australia's largest software names, albeit for different reasons.

Clark believes one factor is being overlooked. Unlike many previous reporting seasons, Australia's major software companies have largely avoided issuing profit warnings or downgrades in the lead-up to their results. 

With valuations still well below historical averages, simply meeting - or modestly beating - expectations could be enough to drive a sharp re-rating.

"I think there is a lot of upside for multiple expansion to happen from here," he says.

He expects Pro Medicus (ASX: PME) to continue benefiting from AI adoption in healthcare, while WiseTech remains one of his highest-conviction ideas if investors can look beyond the founder-related headlines. Clark also highlights Life360 (ASX: 360), which TMS has been adding to during the sell-off and expects to report strongly.

Jennings' preferred names are Xero and WiseTech.

"They're big names, they're liquid and they've been beaten up," he says. "I think that bounce can continue."

He also likes TechnologyOne (ASX: TNE), describing it as another quality business that has been caught up in the broader software sell-off.

Neither investor is declaring the all-clear. Jennings notes Marcus Today's portfolios recently moved largely to cash after trimming U.S. technology exposure, while Clark says the coming weeks will determine whether software's recent gains develop into a more durable recovery.

Why investors should be watching software this August

Microsoft's results may have provided another tick that software's recovery is real, but the sector's biggest test is still ahead.

Australia's reporting season will reveal whether local software companies are also beginning to translate AI into stronger earnings and clearer growth pathways.

 After a year of valuation compression, expectations remain subdued, meaning companies may not need spectacular results to surprise investors. Simply delivering on guidance - or modestly exceeding it - could be enough to trigger significant share price moves.

Key reporting season dates:

• 6 August - REA
• 11 August - 360
• 12 August - SEK
• 17 August - IRE
• 18 August - PME
• 20 August - MP1
• 27 August - XRO (Annual Meeting)