2015 Semiannual Report to Shareholders

This shareholder letter is part of the Bretton Fund 2015 Semiannual Report (pdf).

August 20, 2015

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of June 30, 2015, was $25.83. The fund’s total return for the quarter was 1.41%, while the S&P 500 Index returned 0.28%. The total return for the fund for the first half of 2015 was 0.43%. Over the same period of time, the total return for the S&P 500 Index was 1.23%.

Total Returns as of June 30, 2015

2nd QuarterFirst Half 20151 Year (A)Annualized
3 Years (A)
Annualized Since
Inception (A)
Bretton Fund1.41%0.43%10.68%12.60%13.81%
S&P 500 Index (B)0.28%1.23%7.42%17.31%15.71%

(A) 1 Year, 3 Years and Since Inception returns include change in share prices and, in each case, include reinvestment of any dividends and capital gain distributions. The inception date of the Bretton Fund was September 30, 2010.

(B) The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the US stock market, as determined by Standard & Poor’s, and captures approximately 80% coverage of available market capitalization.

Performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. You may obtain performance data current to the most recent month-end here or by calling 800.231.2901.

All returns include change in share prices, reinvestment of any dividends, and capital gains distributions. Indices shown are broad-based, unmanaged indices commonly used to measure performance of US stocks. These indices do not incur expenses and are not available for investment. The fund’s expense ratio is 1.50%. The fund’s principal underwriter is Rafferty Capital Markets, LLC.

Contributors to Performance

The largest contributor to performance was our position in the large banks (Wells Fargo, JPMorgan, and Bank of America), which contributed 1.2% to the fund’s performance as more evidence emerged of the health of the US economy. We gained another 1.0% from our small manufacturer of hurricane-resistant windows, PGT, which successfully integrated a merger and is benefitting from an improved housing market in coastal Florida. Our healthcare investments IPC and Community Health Systems each contributed 0.5%: IPC benefitted from a shift toward outcomes-based payments by Medicare, and Community Health Systems was helped by the Supreme Court verdict upholding the Affordable Care Act.

The largest detractors from performance were the railroads (Union Pacific, CSX, and Norfolk Southern), which collectively cost us -1.1% on the heels of declining coal volumes, and Ross Stores, which cost us -0.6%.

Portfolio

Security% of Net Assets
Wells Fargo & Company11.0%
Ross Stores, Inc.7.0%
Union Pacific Corp.6.5%
PGT, Inc.4.8%
Valspar Corp.4.2%
American Express Co.4.2%
Armanino Foods of Distinction, Inc.4.1%
AutoZone, Inc.4.1%
Discovery Communications, Inc.4.0%
Flowserve Corp.3.9%
JPMorgan Chase & Co.3.8%
MasterCard, Inc.3.7%
Nordson Corp.3.5%
Bank of America Corp.3.5%
CSX Corp.3.4%
IPC Healthcare, Inc.3.3%
Carteru2019s, Inc.3.1%
Community Health Systems, Inc.2.9%
MEDNAX, Inc.2.8%
The Gap, Inc.2.3%
New Resource Bank1.6%
Aflac, Inc.1.5%
T-Mobile US, Inc.1.4%
NexPoint Credit Strategies Fund1.3%
Norfolk Southern Corp.1.2%
NexPoint Residential Trust Inc.0.8%
Cash*6.0%

*Cash represents cash and other assets in excess of liabilities.

We exited three companies in the quarter: Coach, America’s Car-Mart, and Standard Financial. Our total loss on Coach was -22.0%, which was -13.3% on an annualized internal-rate-of-return (IRR) basis, our weakest investment to date. While its international business was strong, we underestimated how vulnerable its US business was to competition, and we no longer see a clear path to a Coach resurgence in a reasonable time frame. Car-Mart’s total gain was 19.4% and IRR 8.5%, a decent return, if not a bit disappointing in the context of alternative investments. Car-Mart continued to grow its business nicely, but the relaxation of consumer lending standards from third-party lenders created the toughest competitive environment in its history soon after we bought in. Standard Financial, our last remaining thrift conversion, returned 48.5% for an IRR of 10.1%, a good return given the low risk of the investment.

The fund initiated five investments during the quarter: Valspar, AutoZone, Nordson, MEDNAX, and T-Mobile.

Valspar
Valspar is best known for its paints sold at Lowe’s and Ace Hardware. The US paint market is fairly consolidated, with Sherwin-Williams and PPG dominating the professional category and Valspar and Masco leading the do-it-yourself (DIY) charge through Lowe’s and Home Depot, respectively. (A fifth player, Berkshire Hathaway’s Benjamin Moore, sells through independently owned franchised stores.) In December Lowe’s announced that it would move away from its Lowe’s-branded/Valspar-made paint and bring in an HGTV-branded line from Sherwin-Williams. While Valspar still sells its Valspar-branded paints at Lowe’s, the loss of revenue led some to question the company’s prospects.

Paint as a whole only represents about a third of Valspar’s revenue. The bulk of the company’s revenue, and even more of its profits, comes from industrial coatings—paint for things that aren’t obviously painted, e.g., the metal insides of food and beverage cans are coated to prevent interaction with food contents. Traditionally, this was accomplished with coatings containing bisphenol A (BPA), which turns out to be an endocrine disruptor with potentially harmful health effects. The US Food and Drug Administration has banned BPA from products for infants while reviewing its appropriateness for general use, and France has gone ahead and banned it altogether. As it happens, Valspar is the leading manufacturer of BPA-free food coatings.

We expect Valspar to weather the Lowe’s transition; its paints are selling well in other channels, and the non-decorative coatings business is booming. We own a growing, cash-generative consumable products company that pays out that cash to investors.

AutoZone
AutoZone is the largest retailer of auto parts, with nearly $10 billion of revenue across its 5,070 stores in the US and 420 stores in Mexico. For the past 15 years, AutoZone has followed a steady, lucrative formula: it has taken 2.5–3% sales-per-store growth, combined it with 2.5–3% store growth, and generated revenue growth of about 5.5%. Through economies of scale, including squeezing its vendors on price and payment terms, it has converted this to 7% operating-income growth and generated a torrent of cash flow that it has used to aggressively buy back its own shares, the effect of which is pretty powerful: that 7% annual operating-income growth led to 18% annual growth in earnings per share.

One concern that has weighed on the company is that it is increasingly difficult for AutoZone, with over 5,000 stores in the US, to find 150 new sites each year that are not already well-served by an existing AutoZone. Another is the shift away from the DIY sector—consumers who buy a product that they plan to install themselves, the core of AutoZone’s business—to the do-it-for-me (DIFM) sector—professional mechanics, a market that AutoZone historically hasn’t focused on. Today’s cars are far more complicated than the cars of even 20 years ago, with the effect that an increasingly small percentage of the population has the ability or inclination to tinker with cars. These concerns may end up having the same solution: AutoZone is moving aggressively to build its DIFM business by using its existing store and distribution center footprint to also serve mechanics. It is a small player in the DIFM market today, but its early efforts have gone well. It has an unrivaled nationwide network and the ability to compete with any other vendor.

Another item of note is the changing fleet composition in the US. After the financial crisis, many Americans held off on buying new cars, which led to a lot of old cars on the road— old cars that needed to be repaired often. As consumers resumed buying new cars en masse, some investors are concerned these cars will replace the aging, frequently repaired ones. This concern recedes somewhat when viewed in context of an overall shift in American vehicle usage: the average age of an automobile in the US is only a year older than it was during the crisis and has increased by three years over the last 20. The fleet is larger than ever. We expect that this larger, older auto fleet will require maintenance and repairs.

Nordson
Nordson is the global leader in industrial adhesive dispensing systems. As anyone who has tried to use double-sided tape can attest, sticky products are difficult to apply. Nordson’s machinery enables producers of consumer packaged goods to apply all kinds of adhesives in the war against stale food, soggy potato chips, and mildewed diapers, and it also has a brisk business in electronics and healthcare.

As a capital equipment manufacturer with a global customer base, Nordson has been impacted by the recent strength of the dollar against both the euro and the yen. However, we believe the underlying economics are strong, with rapid growth in demand for consumer packaged goods in emerging markets and a continued focus on packaging quality in developed markets. Forty percent of Nordson’s revenue comes from parts and consumables for its installed base, so we can look forward to years of future consumable sales with each new piece of Nordson equipment that’s sold.

MEDNAX
Building on our theme of a growing healthcare market, we invested in MEDNAX, the nation’s largest provider of neonatal and pediatric specialty medicine, as well as the largest provider of anesthesiologists.

MEDNAX dominates neonatology; MEDNAX’s doctors care for about a quarter of all babies treated in neonatal intensive care units (NICU). We expect MEDNAX to maintain its NICU leadership position and expand into related fields, where its 1,700 pediatric specialists (out of 11,400 nationwide) run the gamut from hospitalists to cardiologists.

At the same time, we look to MEDNAX to continue its ongoing consolidation of the highly fragmented anesthesiologist segment. Although MEDNAX’s anesthesiologists handle 1.5 million cases per year, they still represent less than 2% of the nation’s anesthesiologists.

MEDNAX is a highly cash-generative business, producing enough cash to both rapidly acquire medical practices and buy significant amounts of its own stock, both of which increase shareholder value and both of which we expect the company to continue for years.

T-Mobile
Mobile phone network economics around the world are the stuff of microeconomic textbooks. Markets that kept the number of operators at three or below, such as France in the 2000s, had cozy oligopolies with slow technological upgrades and high prices. Markets that went with five or more, such as the Netherlands in the 2000s, had furious price competition and skimped everywhere else.

The mobile phone market here in the US has consolidated into four nationwide networks over the past two decades and would have merged down to three if not for regulators blocking AT&T’s purchase of T-Mobile. AT&T and Verizon are industry giants and offer the full menu of telecom services, and Sprint is now majority owned by the Japanese technology conglomerate SoftBank. T-Mobile is the last major wireless asset remaining in the US, and its majority owner, German telecom giant Deutsche Telekom, has made it clear it would part with T-Mobile for the right price. We think it’s only a matter of time before someone will want in on the mobile network business and have to buy T-Mobile to do so. In Europe, telecom companies have had success offering the quadruple play of TV, Internet, home phone, and mobile phone service, and it’s easy to see that working in the US. DISH Network, the satellite TV company, has accumulated massive blocks of spectrum that it needs to deploy with a partner. Comcast has been blocked from buying Time Warner and, in effect, from making any further acquisitions in cable; however, it has a huge network of WiFi routers that would complement a mobile phone network. In the meantime, we own a valuable asset with a fast-growing subscriber base.

Portfolio Management

As of May 1, the two of us—Stephen and Raphael—are now jointly managing the fund. Raphael has settled back into the Bay Area, and we’re in the process of moving to a bigger office in San Francisco. Having two sets of eyes and industry knowledge has allowed us to cover many more companies and get the fund more fully invested.

As always, thank you for investing.

Stephen Dodson             Raphael de Balmann
Portfolio Manager         Portfolio Manager