Hamish McRae: Buffett's value approach to investing fits well in our new low-inflation world

Warren Buffett's fame as the world's greatest investor is such that his annual meeting of Berkshire Hathaway shareholders and admirers this Saturday in Omaha, Nebraska is well over-subscribed. So he is auctioning seats on eBay. Nothing so new there, though: a lunch with him last year, also auctioned on eBay, went for $250,000.

The myths about Buffett have long run ahead of the reality. Despite his wealth - some $35bn - he is famed for his modest lifestyle, living in the same modest house in Omaha all his working life. But he does also have a $4m house in the plush Laguna Beach area of Los Angeles. He is also famed for driving an old pick-up truck ... but he does have a private jet too. But the clever element of the myth is that it is consistent with his investment philosophy, which is buying value and sticking with good investments. It all fits together, and has been hugely successful.

It is a good time to try to apply the value principle to investment. We have come through the worst bear market for nearly 30 years and followed that with a big bounce. But in recent months the markets on both sides of the Atlantic have been stuck. In the US they are stuck at quite a high level, for the market is on a prospective price-earnings ratio of nearly 18. Here in the UK values may be less stretched, a prospective p-e of below 15, but we all know that if the US takes a tumble, we tumble too.

Enter Mr Buffett. We won't know what he says to his 14,000 shareholders until he speaks, but we do know his thoughts from previous interviews and statements. He believes there is little value around. Instead he is hanging on to most of his cash pile, even though it is earning very low interest, and he is holding on to his investments in currencies (a bet against the dollar) and in high-yielding bonds. And, like so many investors, he regrets that he did not sell more of his holdings closer to the top of the market in 2000.

All good common sense, of course, but is it really right, given the good recovery in profits now happening in the US, the huge gains in productivity, and the solid worldwide recovery now in place? And if interest rates are going to remain reasonably low, what else do you do with the money?

Well, the first point to make is that the US market has recovered rather better than the UK one. The first graph shows the relative performance of the Dow and the Footsie from the start of last year. Such comparisons are always a bit crude: the Dow is less representative than the Footsie, these figures are in local currencies and therefore do not reflect the fall of the dollar vis-à-vis the pound, and the two markets bottomed on different dates. Nevertheless, the US performance is appreciably better and accordingly, to the value investor, probably is a less good buy.

Is the US economic outlook really so benign? The next two graphs suggest it may well be. One shows two measures of employment. There has been huge concern in the US about the jobless nature of the recovery. This may be overplayed. Not only do the very latest figures suggest that American employers are hiring again, if you look at household survey data rather than payroll data, employment has recovered very well.

The next graph shows what has been happening to long-term interest rates. I have taken 10-year Treasury bonds as a measure, rather than a short-term rate, as they give a more realistic indicator of the interplay between the cost of money and inflationary expectations. The most obvious feature, of course, is the plunge in rates, but note also how after a little kick up earlier this year, rates have eased back a bit. There is little sign in the markets of the concern that the Fed will tighten policy too quickly in the months ahead or conversely that it will allow inflation to reawaken.

Indeed, you could make a case that the US market ought to have done even better recently, given the improvement in the profits outlook. The broker Brewin Dolphin has just put out a note drawing attention to the contrast between the very good profits figures and the lacklustre performance of Wall Street.

The final chart shows how the prospective price-earnings ratio has changed over the past few months, with the darker bars showing the market now appreciably better value than it was in January. The lighter bars show "fair value", a calculation also based on prospective earnings but divided by the yield on 10-year Treasuries. Thanks to the fall in long-term rates in the past three months, the fair value p/e has come down a bit. In other words, relative to fixed-interest securities, US shares are better value now than they were three months ago. The broker expects the US market to move higher in the next few weeks. It will be intriguing to see whether Warren Buffett agrees.

My guess would be that he will retain his stance that US stocks are in general fully priced but argue that there are a few companies where there is real value to be had. But we will see.

Now think about the UK. Why have our markets not done better? One reason is that the improvement in profits has taken longer to come through and, thanks to the fall of the dollar, has not been so marked in sterling terms. Half the earnings of the Footsie come from exports or foreign subsidiaries: our largest bank, HSBC, does its sums in dollars. Another reason is the Shell effect: if Shell can shock the market in that way, could there be other nasties about? Finally, the UK equity market has been depressed by the unloading of shares by the life companies to comply with the new solvency regulations. That was a truly stupid bit of regulation but that is the sort of thing we have to live with.

Look ahead and the land is brighter. Our firms too are in a sweet spot of the world economic cycle. Demand has risen, which helps sales revenue, but the costs associated with that increase in sales have yet to follow. Expect the good results to continue awhile yet.

So there is better value here. That leads to one final question: how well will the equity market cope with higher short-term rates?

I think the answer is OK. The Bank of England will not increase rates to such an extent that they damage the recovery, or at least it won't do so in the absence of inflation. The Bank is obliged to meet, as far as possible, its inflation target. That is expressed in terms of current inflation, not asset inflation, and at present it is being undershot. So unless there some catastrophe round the corner, it seems reasonable to assume that the market can move upwards out of its present range before the year end.

The big issue, though, is getting people accustomed to investment in a low-inflation world. We had, prior to the bursting of the bubble in 2000, become so accustomed to double-digit equity returns, that the modest average real returns of 6-7 per cent of the past century seem unexciting. Warren Buffett makes a very good point when he says there is little value out there. But we may have to get used to that. He certainly acknowledges that investment will be tougher. He put it this way:

"Overall, we are certain Berkshire's performance in the future will fall far short of what it has been in the past. I remain hopeful that we can deliver results that are modestly above average. That's what we're paid for."