March 6 (Reuters) - U.S. chip stocks were the biggest

beneficiaries of last year's artificial intelligence investment

craze, but they have stumbled so far this year, with investors

moving their focus to software companies in search of the next

best thing in the AI play.

Tariff-driven volatility and a dimming demand outlook

following the emergence of lower cost AI models from China's

DeepSeek have shifted the spotlight away from semiconductor

shares.

Several analysts see software's rise as a longer-term

evolution as attention shifts from the components of AI

infrastructure.

There has been a pretty clear rotation in part due to

DeepSeek, the semiconductor outperformance last year and

restrictions on U.S. chip exports to China, said David Russell,

global head of market strategy at TradeStation.

"Investors are looking for the next three-to-five-year

stories ... those companies that are going to benefit from what

Nvidia ( NVDA ) has already done."

The Philadelphia SE Semiconductor index has dropped

5.6% this year, while industry heavyweight Nvidia ( NVDA ) has

slumped nearly 13%.

In contrast, some software companies have rallied, with

Atlassian ( TEAM ), CrowdStrike Holdings ( CRWD ), Palantir

Technologies ( PLTR ) and Cognizant up between 7% and

19%.

Exchange-traded funds tracking software companies have also

notched inflows.

The iShares Expanded Tech-Software Sector ETF has

pulled in over $1.87 billion this year through February 28,

according to Morningstar data, compared with more than $1

billion in outflows each for the iShares Semiconductor ETF

and the VanEck Semiconductor ETF.

The inflows to the IGV fund have already outpaced last

year's total net inflows of $446 million, VettaFi data showed.

The iShares and VanEck chip ETFs pulled in $2.46 billion and

$6.55 billion, respectively, in 2024.

The shift is a natural progression for AI investing as the

use cases for the technology are primarily in software, said

Adam Turnquist, chief technical strategist at LPL Financial.

LPL, an investment advisory firm, favors software over chips.

Morgan Stanley also favors software companies as adoption of

AI tech increases.

"The second stage of the innovation cycle is when people

start utilizing products and that's when the software companies

start getting paid ... we're now starting to see the ascendancy

of the software part of the equation," said Keith Weiss, equity

analyst at Morgan Stanley.

The shift comes as investors question how much longer chips

can maintain 2024's rate of growth, when many software companies

underperformed.

DeepSeek's lower-priced chatbot highlighted how competition

will drive down profits for direct-to-consumer AI products and

enterprise software companies may find it easier to monetize new

technology, said Brian Mulberry, portfolio manager at Zacks

Investment Management, who has trimmed holdings of Nvidia ( NVDA ) since

last June.

Semiconductor stocks have also been affected by an

escalating Sino-U.S. trade war.

DIVERGENT TRENDS

Analysts who spoke to Reuters named companies including

Palantir ( PLTR ), Microsoft ( MSFT ), Oracle and

Salesforce ( CRM ) as favored software plays.

However, performance of these stocks has diverged sharply

this year.

Palantir ( PLTR ), which sells AI software to companies, has rallied.

Microsoft ( MSFT ) and Salesforce ( CRM ) are down 4.9% and 12.6%,

respectively, hit by a broader selloff in U.S. stocks and as AI

returns have yet to meaningfully show up on corporate balance

sheets.

Morgan Stanley's Weiss said it could take until 2026 for

those returns to benefit some companies.

Valuations are still expensive, with Microsoft ( MSFT ) and Oracle

trading around 27 and 23 times forward earnings, respectively,

compared with Nvidia's ( NVDA ) 24.6, according to data compiled by LSEG.

Still, some investors are willing to play the long game.

"We don't need more Nvidia ( NVDA ) chips, we need applications,"

said Lisa Shalett, chief investment officer, Morgan Stanley

Wealth Management.