Use your ISA to invest like Buffett

Using an ISA to shelter company shares is a no-brainer. Outside a stocks and shares ISA shares are subject to capital gains tax (CGT) at rates of 18 to 28%, 25% extra income tax on dividends for higher-rate taxpayers, and 36.1% income tax for additional-rate taxpayers.

Since reinvesting dividend income is a major source of returns, an ISA is a particularly attractive option for higher-rate taxpayers. And because ISAs aren't declared on tax returns, ISA income does not reduce the income tax personal allowance. For the 2012/13 tax year this is £8,105 for people aged under 65, rising to £10,500 for those aged up to 74, and £10,660 for the over 75s. The basic personal allowance reduces for people with incomes over £100,000. For people over the age of 65, enhanced allowances fall if their income exceeds £25,400.

A higher-rate taxpayer with a portfolio outside of an ISA paying a 4% dividend yield stands to lose 25% of returns to income tax, reducing the after-tax yield to 3%. An ISA offers an immediate advantage, although that may be reduced at the few brokers that still charge more for an ISA than a standard account. Basic-rate taxpayers save nothing until they make capital gains or move up to a higher tax bracket.

CGT is due when a share is sold at a profit. Individuals are exempt from paying tax on gains below £10,600 in the current tax year, rising by 1% a year over the next two years. Since investment in a stocks and shares ISA is subject to an annual limit, set at £11,280 for the current tax year, a new ISA investor will not achieve gains above the taxable threshold until investments have grown considerably. Over the long term, though, the benefits could be substantial.

The government-sponsored Kay Review spelled out last summer precisely why investors should be thinking in terms of long-term gains. The short-term trading mentality of fund managers and other market participants has reduced the competitiveness of large listed companies by rewarding decisions that maximise short-term profit at the expense of investment.

Fallen giants such as ICI, GEC and Royal Bank of Scotland prioritised cost cutting, financial engineering and acquisitions that boosted returns in the short term at the expense of investment in products and services. The result: lower returns in the long run.

Professor John Kay's solution is to get fund managers to behave more like Warren Buffett, the American asset manager who Kay, along with many others, describes as the world's best. Since they operate on behalf of the pension savers and private investors who ultimately own the companies, he'd like them to behave like owners, holding smaller portfolios of shares and supporting them in maintaining and strengthening their competitiveness. Some do, but not enough.

For individual investors this means doing the research, because the City's so often short-termist. It means determining the underlying profitability of companies, rather than relying on share prices moved by easily manipulated statistics like return on equity and earnings per share, and favouring companies where profitability is likely to remain stable or grow for many years.

Looking for companies that may be immune to the short-term imperative will help, and where the directors own significant shareholdings. Harder perhaps than selecting the shares is having the confidence to hold them long enough, perhaps even indefinitely, to reap the rewards.

Currently, only companies listed on the main market of the London Stock Exchange and certain foreign exchanges can be included in an ISA. Alternative Investment Market companies, typically smaller and less well established, do not qualify, although the government has indicated it might change its mind.