Software is eating the world, and virtually no business is left untouched by it. The undeniable tailwinds fueling the industry have also led to strong returns for SaaS stocks lately as they’ve gained 39.4% over the past six months, outpacing the S&P 500’s 14% rise.

Nevertheless, investors should tread carefully as AI will commoditize many software products, and backing the wrong horse could result in hefty losses. With that said, here are three software stocks we’re passing on.

Palo Alto Networks (PANW)

Market Cap: $306.8 billion

Founded in 2005 by security visionary Nir Zuk who sought to reimagine firewall technology, Palo Alto Networks (NASDAQ: PANW) provides AI-powered cybersecurity platforms that protect organizations' networks, clouds, and endpoints from sophisticated threats.

Why Are We Hesitant About PANW?

1. Gross margin of 70.4% reflects its relatively high servicing costs
2. Competitive market means the company must spend more on sales and marketing to stand out even if the return on investment is low
3. Efficiency fell over the last year as its operating margin declined by 7.4 percentage points because it pursued growth instead of profits

Palo Alto Networks’s stock price of $374.40 implies a valuation ratio of 21.7x forward price-to-sales. If you’re considering PANW for your portfolio, see our FREE research report to learn more.

Alarm.com (ALRM)

Market Cap: $2.66 billion

Processing over 325 billion data points annually from more than 150 million connected devices, Alarm.com (NASDAQ: ALRM) provides cloud-based platforms that enable residential and commercial property owners to remotely monitor and control their security, video, energy, and other connected devices.

Why Should You Sell ALRM?

1. Offerings struggled to generate meaningful interest as its average billings growth of 8.7% over the last year did not impress
2. Estimated sales growth of 4% for the next 12 months implies demand will slow from its two-year trend
3. Operating margin failed to increase over the last year, indicating the company couldn’t optimize its expenses

Alarm.com is trading at $54.26 per share, or 2.8x forward price-to-sales. Read our free research report to see why you should think twice about including ALRM in your portfolio.

Pegasystems (PEGA)

Market Cap: $5.93 billion

With a "Center-out Business Architecture" approach that transcends organizational silos, Pegasystems (NASDAQ: PEGA) develops software that helps organizations automate workflows and use artificial intelligence to improve customer experiences and business processes.

Why Do We Think PEGA Will Underperform?

1. Products, pricing, or go-to-market strategy may need some adjustments as its 3.6% average billings growth over the last year was weak
2. Customer acquisition costs take a while to recoup, making it difficult to justify sales and marketing investments that could increase revenue
3. Day-to-day expenses have swelled relative to revenue over the last year as its operating margin fell by 6.5 percentage points

At $36.06 per share, Pegasystems trades at 3.3x forward price-to-sales. Check out our free in-depth research report to learn more about why PEGA doesn’t pass our bar.

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