Software Bear Market: 2 AI Stocks With 40% and 52% Upside to Buy Now, According to Wall Street

The S&P North American Technology Software Index, which tracks 111 software stocks, has declined 32% from the all-time high it hit in September. That puts the index deep in bear market territory. The primary reason for the drawdown is artificial intelligence.

Investors are worried AI agents will disrupt the software industry by reducing demand and profit margins. In recent weeks, Anthropic has released plugins for its enterprise AI tool (Claude Cowork) that automate work across a broad range of departments, from sales and finance to marketing and legal.

Several experts (including Nvidia CEO Jensen Huang) think the sell-off is illogical because many software companies are incorporating AI capabilities to their products. "The market is selling indiscriminately," writes Kriti Gupta, strategist at JPMorgan Chase.

In that sense, the knee-jerk reaction has created a buying opportunity for patient investors, and most Wall Street analysts see Microsoft (NASDAQ: MSFT) and Cloudflare (NYSE: NET) as undervalued.

Image source: Getty Images.

Microsoft: 52% upside implied by the median target price

Microsoft has a strong position in several software markets, including office productivity, enterprise resource planning, business intelligence, and cybersecurity. The company has integrated generative AI copilots into its software products, and that strategy is resonating with customers. Paid Microsoft 365 Copilot seats soared 160% in the December quarter, according to CEO Satya Nadella.

Microsoft Azure also has a strong presence in cloud computing. While the company still trails Amazon Web Services, it has steadily gained share in infrastructure and platform services due to its deep integration with enterprise software products, robust support for hybrid clouds, and strength in artificial intelligence.

To elaborate, Azure is the only major cloud platform that delivers OpenAI frontier models via API (application programming interface). That means Microsoft is often the middleman when enterprises develop custom AI applications based on OpenAI models, including the models that power the popular application ChatGPT.

Microsoft reported encouraging financial results in the December quarter. Revenue rose 17% to $81 billion, driven by strong sales growth in cloud services, commercial software, and consumer software. Meanwhile, non-GAAP net income increased 24% to $4.14 per diluted share. Yet, shares fell sharply following the report because Azure revenue narrowly missed estimates and investors are concerned about AI spending.

Wall Street estimates Microsoft's adjusted earnings will increase at 15% annually through fiscal 2027 (ends in June). That makes the current valuation of 26 times earnings look quite reasonable. Most analysts agree with that statement. Microsoft has a median target price of $600 per share, which implies 52% upside from its current share price of $395.

Cloudflare: 40% upside implied by the median target price

Cloudflare provides application, network, and security services that protect and accelerate infrastructure and applications. It also provides a developer platform that lets businesses build and deploy applications. The company has key advantages in speed and scale: It operates the fastest cloud network in most countries, and protects about 20% of all websites.

Morgan Stanley ranks Cloudflare as one of the companies best positioned to benefit from the proliferation of AI agents. Not only does it provide the fast and secure infrastructure AI agents require, but also its platform integrates seamlessly with every major public cloud. That sets it apart from hyperscalers like Microsoft and Amazon.

Cloudflare reported solid fourth-quarter financial results. Paying customers increased 39% and net revenue retention was 120%, meaning the average spend per existing customer jumped 20%. Net revenue retention has accelerated in three straight quarters. Meanwhile, revenue rose 33% to $614 million and non-GAAP earnings increased 47% to $0.28 per diluted share.

Cloudflare stock currently trades 31% below its high, partly because Anthropic recently released Claude Code Security, which scans codebases for vulnerabilities and suggests software patches. Shares still trade at 28 times sales, but that is a tolerable valuation for a company whose revenue is forecast to increase at 45% annually through 2027.

Indeed, Wall Street's median target price of $245 per share implies 40% upside from the current share price of $175. However, I would start with a very small position in Cloudflare and add more shares if the price drops another 15% or so.

JPMorgan Chase is an advertising partner of Motley Fool Money. Trevor Jennewine has positions in Amazon and Nvidia. The Motley Fool has positions in and recommends Amazon, Cloudflare, JPMorgan Chase, Microsoft, and Nvidia. The Motley Fool has a disclosure policy.