Software stocks have faced broad selling pressure this year, but investors may be overlooking rising service demand in the cybersecurity sector as artificial intelligence amplifies potential threats from malicious actors. According to Manthan Shah, US Investment Head at WestBridge Capital, which manages over $7 billion in assets, many investors are currently selling first and asking questions later. However, he believes that in hindsight, the current period will be viewed as an excellent entry point into the security space, which remains one of their top long-term growth areas.
For months, software stocks have been widely sold off as investors worry that products from AI companies like OpenAI or Anthropic could divert demand from traditional providers, weakening their growth potential and pricing power. The rise of so-called "AI agents," capable of executing multi-step processes without human intervention, has posed particular challenges for software-as-a-service (SaaS) stocks. Cybersecurity software makers have not been immune. The Global X Cybersecurity ETF (BUG.US) has fallen 15% year-to-date, recently closing at its lowest level since November 2023. While this performance is better than the 31% plunge in a dedicated SaaS index, it significantly lags behind the S&P 500's 3.4% decline and the tech-heavy Nasdaq 100's 4.2% drop.
However, not all software is the same, and in the case of cybersecurity, investors may be misreading the situation. The same AI agents seen as eroding traditional businesses are also being used for malicious purposes—a risk likely to become more pronounced as AI models grow more powerful. Hackers have already used AI tools to breach over 600 firewalls across dozens of countries, including Mexican government agencies. This threat supports the view that broader AI adoption will drive increased demand for protection from cybersecurity software. Shah notes that AI will significantly expand the potential attack surface, meaning demand for security solutions is set to grow substantially in the future.
Take JFrog Ltd. (FROG.US) as an example. The Sunnyvale, California-based company saw its shares rise 17% in March, marking its best monthly performance since November, after analysts highlighted that attacks on software supply chains underscore the value of its security product portfolio. Guggenheim analyst Howard Ma wrote in a March 25 report that such attacks are likely to become more common as AI agents proliferate.
The sell-off has been heavily influenced by headlines. Amid nervous market sentiment and high uncertainty—whether from AI or geopolitical tensions like the Iran conflict—investors have become extremely sensitive to news. Last month, cybersecurity stocks fell following a report suggesting an AI model from Anthropic PBC posed an "unprecedented cybersecurity risk." A similar reaction occurred in February when Anthropic introduced new safety features for its Claude AI model.
Yet, Wall Street believes investors may be reacting in the wrong direction, as these developments highlight the growing importance of digital security. Baird analyst Shrenik Kothari wrote in a March 27 report that more powerful models increase, rather than decrease, the need for governance, calling the sell-off another episode of irrational panic. Raymond James analyst Adam Tindle shares this view, stating that the narrative of AI disrupting the security sector is fundamentally flawed, though herd mentality can frustratingly lead to capitulation selling that ignores fundamentals.
This helps explain why analysts are upgrading cybersecurity stocks. Last month, Arete Research raised its rating on Palo Alto Networks Inc. (PANW.US) from Sell to Buy, arguing that the stock's weakness was overdone as AI agents are shifting IT budgets toward different types of security products. CrowdStrike Holdings Inc. (CRWD.US) has also received multiple upgrades, with Piper Sandler analyst Rob Owens viewing AI as an opportunity rather than a substitution threat, predicting it will "create the next multi-billion-dollar security market" as companies seek to protect new attack surfaces.
Admittedly, AI developers may eventually offer services highly similar to traditional providers, reigniting disruption concerns even as overall demand for security services grows. Additionally, cybersecurity stocks are not cheap, especially compared to deeply discounted stocks in other parts of the software sector. For instance, CrowdStrike trades at about 78 times forward earnings, making it the ninth most expensive stock in the S&P 500, though its valuation has fallen significantly from 128 times in July. Palo Alto Networks trades at around 42 times expected earnings for the next 12 months, placing it among the index's 50 most expensive stocks. Similarly, Fortinet (FTNT.US) and SentinelOne Inc. (S.US) trade at premiums well above the S&P 500 and Nasdaq 100 averages.
Ryan Isherwood, Chief Investment Officer at Significance Capital Management, which holds Palo Alto Networks stock, noted that it is difficult to call these stocks value plays, particularly since it may take years to determine whether growth has been disrupted—a risk that cannot be disproven in the interim. He added that while it is uncertain whether security stocks will command the same premium multiples as in the past, cybersecurity remains the most attractive area within the software sector. "We don't want to touch many application software stocks," he said, "but within software, cybersecurity looks like the best house in a bad neighborhood."
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