Opportunities in Europe’s “Digital Sovereignty”?

0:01Tyler Crowe:We're talking opportunities in Europe's digital sovereignty on Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime Fool contributors Lou Whiteman and Matt Frankel. So today we're going to hit a couple of listener questions as we like to do here on Tuesdays, and it's been a kind of a slow news week, at least from companies issuing press releases. So we're going to do two whole segments dedicated to listener questions. We're going to talk about valuation. We're going to talk about how we use our cash and our dry powder, our investing strategies.

0:37Tyler Crowe:But we wanted to start today with a couple of news articles that I'm going to string together into a theme that we're going to call Europe's digital sovereignty. And we'll start off with a big story that came out today related to Apple, who's in a bit of a, to use the British parlance, a row with the European Union about its digital privacy rules and its Siri AI assistance. Basically, Apple's not looking to get an extension or a waiver, an exemption, and EU's like, no, follow our rules. So basically, it's going back and forth, and it's not pretty. But the bigger theme here, because this is one story of many that we've seen recently around Europe, and it's this theme of digital sovereignty, I want to say nationalism.

1:22Tyler Crowe:That isn't quite the right word. But basically, Europe is looking like they want to make a more concerted effort to own things, to be a bigger player in a lot of the discussions that we have around things like AI, semiconductor manufacturing, payment rails, social media, and they're looking to build their own products. And this isn't just Europe either. This is kind of a worldwide thing. China announced earlier that it's deploying a$250 billion fund to make build data centers nationwide for its kind of, we'll call it its home-cooked AI, inside of relying on the anthropics or the open AIs of the world.

2:00Tyler Crowe:Now, the Chinese digital market has always been kind of a walled garden with the Baidus and the Alibabas not necessarily playing as well with U.S. companies. So that's not much of a game changer when we talk about AI and digital development here. But does the emergence of these rules and these European initiatives to put kind of, I wouldn't say full on gates, but screen doors, I guess you will, around European markets, kind of alter the thesis on big tech companies or AI deployment or anything that you've been seeing recently. What do you say, Matt? It's not surprising that Apple's not thrilled by this.

2:35I mean, Apple intelligence and several of its newer features have been either delayed or limited in the EU in recent years. Google, meta amazon are also dealing with all this it's it's not just apple um it's also not surprising on the other hand that europe wants more digital sovereignty we're doing the same thing uh for example when it comes to the chip makers uh you know the investments we're making in like intel's foundry and things like that nations are realizing that depending on foreign suppliers for critical infrastructure and technology needs it's a national security concern but as to the question of does this changed the thesis?

3:09My short answer is yes, but not as much as you might think. So all the companies I just mentioned, Apple, Google, Meta, Amazon, they all depend on Europe for anywhere between 20 and 30 percent of their revenue. And if we see their sales decline by 10 to 20 percent or their margins decline by 10 to 20 percent, which I view as kind of the worst case scenario by this news, it wouldn't completely change my thesis. Smart investors, like you said, already assume that China is essentially a closed market when it comes to evaluating these stocks. But I don't think the same thing is needed with the EU here.

3:41I'm not rethinking any of my big tech investments on this news.

3:45Lou Whiteman:I don't know if you have to rethink your investments, but I'm not sure that just looking at today's profit and loss statement and extrapolating off of that is really the way to look at this. Because I think there could be less foreseen, if not consequences. Part of what makes Apple Apple is iOS is just everywhere. It's ubiquitous. It feeds into the Apple store development and it feeds into the just kind of the network effect that it's enjoyed. To the extent that this trend towards regionalism instead of globalism causes kind of a balkanization of tech, I think it makes every company, including Apple's products, just less powerful, maybe less profitable over time.

4:28Lou Whiteman:This isn't just a tech story. It's playing out all over the place. Automotive is a real one where it's definitely happening. You kind of just have the U.S. market and the global market going in separate directions. The big picture here is like the 80s, the 90s vision of globally dominant companies is getting overhauled by just geopolitics about what's going on. U.S. companies can evolve and survive. I don't think it's again, I'm not sure I'm going to change investments right now, but I'm watching this because make no mistake. The status quo that has been in place over the years was highly favorable to the U.S.

5:04Lou Whiteman:tech champions, to U.S. companies. I am doubtful that whatever replaces the status quo will be as favorable to the U.S. brand, the U.S. companies. So I do think it could have really, really hard to predict or hard to quantify right now changes. I do think it could change the thesis for some of these companies over time.

5:25Tyler Crowe:And to that point, too, obviously, the changes of the thesis and not necessarily a good way for the big companies. But one of the if I were to flip the script a little bit here, it does seem like there would be some opportunities because if Europe wants to build out the capacity for the things that we're talking about here, chip makers, AI tools, things like that, there should be an opportunity for the building and the infrastructure. and a lot of the, you know, you could call them the champions of this sort of build out in Europe, similar to what we've had in the United States. Perhaps they haven't quite emerged yet, but I'm just thinking along the lines of, it is such a nascent market relative to what we see globally.

6:08Tyler Crowe:I saw a quote from ASML, the builder of the lithiography machines that basically etch the chips and they're like the soul maker in the world. and he said 80 % of my sales are to Asia, 1 % of them are to Europe. So clearly this is a very, very small market and that leaves us an opportunity. So if you were to kind of like start looking at the tea leaves, maybe thinking about companies, perhaps opportunities where Europe building out this, it doesn't necessarily have to be American companies either, but opportunities that where this redundancy or this European digital sovereignty, digital infrastructure, national, regional infrastructure, where do you see some potential opportunities?

6:55Yeah, well, I mean, the one thing I would say is that digital sovereignty means that there's going to be a lot of duplicate infrastructure, you know, throughout the world. We're seeing this in the U.S. I mentioned the chip foundries that they're being built here, you know, data centers, other things like that. So there are a few types of winners that I see. There are some companies that produce equipment and software and things like that that is so unique that there's literally no equivalent. Applied materials comes to mind. You already mentioned ASML is a company that I think is just an opportunity just in itself, no matter what.

7:26Data center infrastructure, companies like Vertiv, ticker symbol VRT, Qantas services, PWR that do like the electrical work for data centers. They're more obvious beneficiaries. Hundreds of billions of dollars in new data centers. Networking companies like Cisco, you know, European infrastructure, if the digital sovereignty trend continues, it'll still need switches and routers no matter what. So I see a lot of opportunities kind of throughout the market. But those are just some that I could think of off the top of my head.

7:57Lou Whiteman:I think there are opportunities. I mean, for some of these, like the, you know, infrastructure companies that are in the U.S., they only have so much capacity and they may not have that capacity in Europe. They're unlikely to fly all their workers over to do Europe. So I I do think look at the European champions. Snyder Electric is a great company that is doing a lot of business in the U.S. because there isn't this business in Europe. I think you could see them switch the ground, which I think does the the electrical cabinets that all these things go in. That is, again, a European champion that could benefit.

8:30Lou Whiteman:We're not going to see comfort systems get a boost because they need more air conditioners in Europe. That's just not going to go to them. So I think all in selectively, this should end up with more spending, but also less efficiency. So the bigger picture thing is to think about, you know, where a company sits on the value chain, whether or not it's going to be good or bad, whether they will be less efficient or have more opportunity and kind of make decisions based on that.

8:56Tyler Crowe:Might have to do some real follow-up deep dives on the European, like actually companies that are traded on the European markets here, because this could be an interesting story to follow in the coming months and years. Coming up after the break, we're going to jump into listener questions.

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9:36Tyler Crowe:Hey, everyone, as we get into our questions here, Just a quick reminder, if you want your question asked on air, go ahead and email us at podcasts at fool.com. That's podcasts with an S at fool.com. We'll try to answer it as best as we can. Our three requests is always keep it foolish, keep it short enough, we can read it on air and we can't give out any personalized advice. So try to ask it in a sense of like, what would an investor do in this sort of situation? So with those kind of rules in mind here, our question to start out today is from Nowindra Wickramasinga. I hope I said that right. I apologize if I got it wrong.

10:13Tyler Crowe:Her question is, the current Shiller-CAPE ratio in national debt has made me a bit nervous, and I want to know what your thoughts on about adjusting a portfolio accordingly. This is a sign to start increasing cash or rotate investments into defensive companies. Some of the ones that you've mentioned here, we have Waste Management, NextEra Energy, Berkshire Hathaway, and saying, you know, doing this rotation to cite strong earnings in the S &P 500. Thanks. So before we get started on this, Matt, I don't know if everyone's necessarily familiar with the Shiller-CAPE ratio. So just give us a quick rundown of what that is before you, you know, get into the thoughts on valuation related to it.

10:51So if you're not familiar, CAPE stands for Cyclically Adjusted Price to Earnings Ratio. So essentially, it takes the market's collective PE ratio, which is one of the most common valuation metric used. But instead of using the trailing 12-month earnings, it uses 10 years of inflation-adjusted earnings. So the idea here is that you're comparing current valuations against what we would consider normalized earnings across many market environments, not just earnings that result from recent trends like the AI infrastructure boom, for example. So the listener's right. The Shiller Cape is very high right now.

11:23It's about 38. That's more than twice its long-term average, which is 16 to 17, depending on what time period exactly you're looking at. In the dot-com bubble, it peaked at 44, just for reference. So my short answer is that this is not a reason to be worried all by itself. For most of recent history, meaning my investing lifetime and I'm in my 40s, the Shiller Cape has been above its long-term historical averages. And if you had become defensive every time it crossed, say, 25 or 30, you would have missed out on a ton of upward moves. So having said that, I use an elevated CAPE as kind of a sign that I should expect more moderate returns over, say, the next five to 10 years.

12:03But on a short-term basis, we've seen time and time again that an elevated ratio doesn't really predict much.

12:09Lou Whiteman:Yeah, I push back a bit. I think it is a reason to be worried. But I think what Matt's saying, and I agree with it, it's just not actionable. I really worry about the market today. I think we are more likely than not near a top and probably closer to the end than the beginning, all of those cliches. The thing is, though, the Cape was a 37 a year ago. And so I had just as much reason to be worried then. And in fact, I sort of did think, wow, how long this could go on then. I would have been a mistake for me a year ago to adjust my portfolio due to those worries in hindsight. And, you know, maybe now is the time to take action or maybe we'll be having the same conversation another six months to a year.

12:49Lou Whiteman:So I think I think the listener is correct to be noticing this. And we can talk about, you know, maybe how you think about this in terms of what you do with your money. But I also, yeah, I don't think it's time to throw all my money under a mattress because these things can remain this way for a lot longer than I would think.

13:08Tyler Crowe:I thought we were going to list off as many cliched end of the line sort of question. Ninth inning, end of the line, rotting off of the sunset. We'll just throw them all out there to make sure that we covered all our bases here. So we kind of talked about the valuation thing, but now talking about the idea of rotating into defensive companies or maybe businesses that aren't necessarily as exposed to a lot of the trends that we're seeing in the S &P 500, which is, let's be honest here, the AI infrastructure build out, the Mag-7, a lot of those companies. So to the companies that were asked here, we got Waste Management, NextEra Energy, Bircher Hathaway, companies like that.

13:44Tyler Crowe:Is that the move that you would do when you see these elevated valuations? Or is that just kind of, you know, a milquetoast way of kind of doing it? It's like, yeah, we're getting into these. They're overvalued, but they're safer. So is this kind of the rotation you would do? Or is there something else that you'd normally do in these sorts of situations? Yes. So first of all, defensive companies aren't immune to valuation-related concerns. So the stocks mentioned in the listener's question, companies like Waste Management and NextEra, they actually trade for somewhat high multiples compared to their own history right now.

14:15So they could actually be a little compressed as well. I'm going to give kind of a more financial planner type answer to the question. So ask yourself a few questions. So number one, ask yourself if your asset allocation right now makes sense for your investment goals, your time horizon, and your willingness to withstand an occasional 30 % drawdown. If it doesn't, then move a little bit more defensively, regardless of what the CAPE ratio or any other market indicator is doing. Second, ask yourself if you're confident in the businesses that you own in terms of their ability to survive a recession.

14:47And finally, I would say if you're investing consistently, regardless of what the market is doing, because averaging into stocks over time, it's a great defensive mechanism against valuation risk because you're going to end up buying more of your shares at cheaper prices over time regardless?

15:05Lou Whiteman:Yeah, my answer for this is I'm always defensive and it's kind of just like my philosophy on investing. All right. I'm always trying to find the opportunities that I think are out of favor or at least not fully appreciated by the market. Not to use the term, hidden gems, so to speak. Right. I don't want to chase momentum. So over the past year, I've been buying a lot more financial services companies. I've been buying industrial companies that just don't have the multiple. It's not because I think that the tech is going to crash. It's just, I don't want to chase momentum. I want to go where I see value.

15:36Lou Whiteman:I can't time the market, but I can try and avoid getting caught up in the market's current mania. It doesn't insulate me because, as Matt says, when a downturn comes, everybody tends to feel it. It's not like you escape things going down, but I feel like it can help avoid total wipe out. So, yes, I am looking at the case. I am looking at where tech is valued and I am investing elsewhere. it's not really because I think the sky is falling or that things are going to come down right now. It's because I just don't find a lot of value in things when they are, say, fully loved by the market.

16:13Tyler Crowe:Investing optimistically, but underwriting pessimistically in the sense of, you know, yeah, of course I want my things to go up, but I'm going to make my investments based on the idea that they could go down and trying to build in some sort of, as using Seth Klarman's book, Margin of Safety, built into the valuation that you use can be pretty effective in at least helping to ease some of those valuation concerns. Coming up next, we'll talk about how cash and the dry powder our investments actually also included in valuation and how we use that for a strategy.

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18:14Tyler Crowe:It's Tuesday. We're going to do two investor questions here. Our second one comes from Matt Popek, and this is related to basically your cash position. Now, the question is, I know that there's some discussion of money market funds recently and how much cash is available, as he quotes, on the sidelines. Is there any downside to using a money market fund? And he gives the example of Vanguard's money market fund. Basically, most brokerages have their own some sort of money market fund, either Vanguard, fatality, you name it. Is there a place to park the vast majority of savings or in this case, you know, cash for a brokerage?

18:51Tyler Crowe:To Lou and you, Matt, specifically, where are you keeping your dry powder for future investments these days? Money markets don't feel quite like the stock market, at least to Matt here, even if it isn't a brokerage. So before you guys answer, I just want to kind of give a little bit of context to Matt and hopefully it'll better understand this. When you hear the term money on the sidelines, either here or I think I hear it all the time on CNBC, I think it's one of their most common used terms, that is money actually in money markets funds. It is actually what the Federal Reserve Bank of St. Louis tracks.

19:26Tyler Crowe:Now, it might not necessarily reflect all available money to invest in the stock market because maybe some people are using certificates of deposit or longer dated treasuries, but money market is a decent approximation. And according to the Federal Reserve Bank of St. Louis, about$8 trillion worth of money is in money market accounts today. And$2.2 trillion of that is actually in retail investors. You, me, Lou, Matt, all of us, that is in those sort of accounts. So after that little long background, guys, do you use money market accounts? Is this the best way to do it? What are some of the other strategies?

20:06If I'm being honest, most of the time I'm fully invested or at least pretty close to it. I like to contribute money to my brokerage account pretty much every time I get paid and allocate it where I see the best opportunities. And there always are some. There's always cheap stocks somewhere. But in times where there's either a lack of attractive opportunities or, you know, just nothing that's getting me excited or elevated uncertainty in the market, I do often let my cash accumulate for a little while. Right now, I have 7 % of my portfolio in cash. I sold a couple of stocks not that long ago. and that's a lot for me.

20:36My cash management strategy isn't that different from money market accounts. My broker happens to also offer a high yield savings account and I can easily transfer money between those two. So that's where I put any of my uninvested cash. Right now I get a little more than 3 % and I'm fine with that at times when I want a little bit more financial flexibility to save for opportunities I really want.