For all its success and the money it has made for one of the most notable investors of all time, Warren Buffett’s investment philosophy is relatively simple. We know that because he is very generous with his investment wisdom. He prefers good businesses and sticks with them for as long as they stay good businesses. He believes when a company is doing well, the stock eventually follows.
One mark of a company that’s doing “well” is that its stock valuation is in line with its fundamentals and not too far removed. If we extrapolate it for the whole stock market and GDP, there is the Buffett Indicator, which helps us gauge whether the stock market is in sync with the GDP or its growing at a different pace.
The Buffett Indicator and an overvalued stock market
First of all, it’s important to understand that the Buffett Indicator is not a very “thorough” indicator. It doesn’t take into account the differences and the different sectors of the market, which is an important factor. Still, if you want something rudimentary to tell you whether the stock market is overvalued or fairly valued, the Buffett Indicator is it. It divides the total market capitalization of the stock market with the quarterly GDP of the country.
For the U.S., the indicator is flashing a warning for the second time this year. In the second quarter, the indicator reached a dangerously high 187%. Last week, the ratio pushed past 180% again. If we take into account the GDP, which was 8% in the second quarter, the market seems equally overvalued (or even a shade more). The gap between stock market valuation and GDP is not that wide, and the market here is fairly valued.
But if the market in the U.S. crashes or begins to normalize, we might see the effects reflected (maybe to a smaller extent) in TSX as well.
An overvalued stock to keep an eye on
Venture capital stocks tend to fly below the radar of most investors, but there are some that you should keep an eye on, especially if an impending market crash can get you a discount. One of these stocks is People Corp (TSXV:PEO), a management consulting company that has seen very steady and powerful growth in the last five years.
This Winnipeg-based company has a market cap of $790.8 million, and it has been growing its revenues continuously since 2015. The net income has faltered for some quarters in the past five years, but revenue has only increased quarter over quarter. This overvalued stock returned about 266% to its investors in the past five years, and if we stretch back further, the growth (and CAGR) becomes even more attractive.
If the Buffett Indicator is right, and the stock market is severely overpriced across the border, a market crash, or at least a correction, might be on the horizon. People Corp is currently overvalued, but if a market correction can knock down the price to fair territory, you may want to consider adding this powerful growth stock to your portfolio.
Speaking of Warren Buffett...
Motley Fool Canada's market-beating team has just released a new FREE report that gives our three recommendations for the Next Gen Revolution.
Click on the link below for our stock recommendations that we believe could battle Netflix for entertainment dominance.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Adam Othman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends People.