Why Software Companies Are Losing Their Moats

In this video, Morningstar’s Michael Field examines whether artificial intelligence is strengthening or weakening the competitive advantages that have long made software businesses attractive investments. While software companies have historically benefited from high switching costs, recurring revenue, and scalable business models, AI is introducing new competitive pressures that could make it easier for customers to change providers and harder for incumbents to maintain their edge.

Field discusses how AI-powered tools are lowering barriers to entry, accelerating product development, and forcing software firms to continually innovate to justify premium valuations. He also explores which types of software companies may be best positioned to benefit from the shift, where competitive moats remain strongest, and how investors should think about software stock valuations as the industry evolves.

The takeaway: AI isn't eliminating the investment case for software, but it is changing the rules. Investors need to look beyond growth rates and consider which companies can sustain durable competitive advantages in an increasingly AI-driven market.

The full research, Opportunities in Artificial Intelligence, dives into:

• A clear investment case for AI, including bull and bear scenarios, valuation signals, and bubble risk analysis.
• A combined equity and manager research framework ranking US AI-themed funds by true AI exposure.
• Identification of AI “hidden gems” and “false friends”, where manager positioning and fundamentals diverge.

Robby Greengold: Some of the stocks that have been impacted have not rebounded because they haven’t been able to convince investors that their prospects are brighter. I’m talking about software, of course, and like I said, the industry over the past year has fallen 20%, and a lot of that was earlier this year.

Greengold: Can you talk about what the impact has been to their moats? Can you briefly explain what our economic moat ratings are on the equity research team?

Michael Field: Yeah, so economic moat ratings, deriving from the Warren Buffett reference a very, very long time ago, are ultimately about sustainable competitive advantages. I think our USP is that we don’t just say, “I worked on the buy side years ago, before this, and we used to look at stocks and say, ‘Yeah, it’s got a competitive advantage,’ or point to the management team.” That’s not the Morningstar way. 

It comes down to five specific moat sources, and unless a company fits that bill, it simply doesn’t have a moat. Then, quantitatively, we look at how long the moat will actually last, and on the back of that we decide whether it’s a wide-moat, narrow-moat, or indeed no-moat stock. Again, it’s those very specific conditions. We try to be very long term; that’s the whole point of Morningstar’s methodology.

Field: But when Claude came out with the plug-in earlier this year, we revised our entire universe that was subject to this. Our entire software universe, anything to do with that. We reviewed the moats on 132 companies, I believe, and we downgraded about a third of those companies. A lot of them went from narrow moat to no moat. Most of them went from wide moat to narrow moat. That sounds pretty shocking on the outset, because that, qualitatively, comes with downgrades to the share prices, which had absolutely tanked over that period as well. So it changed the dynamics there. But ultimately what it came down to is uncertainty.

For the most part, we’re not saying Claude is going to totally remove the need for software stocks, or that these stocks are dead and their business models are gone from tomorrow morning onward. That hasn’t been the case. There was obviously a danger when the Claude plug-in came out that companies could basically code their own software and not need to buy a generic product anymore. They could make something bespoke. That’s the whole concept.

In reality, however, it’s our thought that software companies exist for a reason. They’ve been around a long time. They have lots of switching costs, which is the primary moat source for these companies. We think that once you install them, once you train your staff on them, once you’ve embedded them in your infrastructure, it doesn’t make a whole lot of sense to remove them. It costs you a lot of time and effort, and often money, to remove those products or to build your own. But what it does create is a whole lot of uncertainty. We don’t know how the business models will work for some of these companies going forward, and we don’t have visibility on how they’re going to sell things.

Before, if we think about the likes of Salesforce and Adobe, we thought they had long-term moats. We thought they had wide moats and could generate excess returns on capital for about 20 years. We said, “Yeah, they can do it. They’ve been doing it this long, and it’s going to take someone else a very long time to build up that scale and that IP to challenge them.” What we said after this was, “Look, we still think they have that IP. We still think they’re in a good place, but we just don’t think they have that visibility anymore.” Maybe their competitive advantage is only 10 years from now on, not that full 20-year high-water mark, which is why we downgraded a lot of moats.

You can see from the chart on the slide in front of you that a lot of that comes in areas like IT services and enterprise software. That’s where most of the moat downgrades happened, and indeed the price downgrades on the back of it.

One last comment on it: it’s not that we don’t like these companies anymore or that we’re telling people to stay away from them. But the level of uncertainty that’s crept in is still dragging those share prices down. You’ve seen that recently even in some of the results from the last week.

Greengold: To be clear, are we seeing these concerns play out in the numbers?

Field: So, yes and no. This is the danger with software. You spoke to portfolio managers who spoke to companies, and you get some good bottom-up insights from those individuals. But what we’re not seeing is people putting their hands up and saying, “Yeah, I downloaded that Claude plug-in and we’ve written our own HR software; we don’t need human resources software anymore.” We don’t have that anecdotal evidence to back it up.

What we have is the numbers from the companies and the clients themselves saying they’re spending less on certain products. You saw that with IBM, whose share price was down 25%. I think that was only yesterday. It feels like a week ago now; time is moving very quickly for me. What they’ve said is that people are shifting their spending toward hardware and away from the software and infrastructure that they used to sell, and they’re getting left behind as a result.

Field: You could easily say, “Well, why don’t they shift as well? Why don’t they move their whole product line and adapt?” But the question is how temporary this is going to be. If you have IP and a competitive advantage in these types of software and services products, do you abandon that to go into the unknown and chase hardware sales, or do you stick to your knitting and wait for the cycle to rebound?

This is the difficulty, and it’s why share prices are still being held down. Investors don’t have the visibility or insight into whether this is just businesses trying to do more with less, pulling back on budgets and moving money to the places they really have to spend it, or whether they’re saying, “Look, we’re not going to buy those products anymore.”

The only positive I can take from this is that we’re not seeing evidence of people saying, “No, we’ve created our own software. We’re just not going to buy this anymore.” That hasn’t happened. So the hope is that the cycle will rebound for at least some of these companies, the strong ones.