This letter is an excerpt from the Bretton Fund 2010 Annual Report. Here’s the full report (pdf).
February 24, 2011
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of December 31, 2010, was $15.92, and the total return for the fund since its inception on September 30, 2010, was 6.13%. Over the same period of time, the total return for the S&P 500 Index was 10.76% and the total return for the broader Wilshire 5000 Total Market Index was 11.59%. Considering we spent much of the quarter putting cash to work for the new fund, our return wasn’t too shabby on a risk-adjusted basis, though obviously not spectacular.
Shareholders should note well that the Bretton Fund is a long-term investment vehicle, and one can’t draw too strong of a conclusion—one way or another—from three months of stock price movements. Next year’s annual report will have a full year to review and won’t be an “annual report” covering just an inaugural three months.
Fund Performance
Total Return as of December 31, 2010
| Since 9/30/10 Inception (A) | |
| Bretton Fund | 6.13% |
| S&P 500 Index (B) | 10.76% |
| Wilshire 5000 Total Market Index (C) | 11.59% |
(A) 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 broad market-weighted average dominated by blue-chip stocks and is an unmanaged group of stocks whose composition is different from the Fund.
(C) The Wilshire 5000 Total Market Index is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States.
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. All returns include change in share prices, and reinvestment of any dividends and capital gains distributions. Current performance may be lower or higher than the performance data quoted. 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. You may obtain performance data current to the most recent month-end here or by calling 800.231.2901. The fund’s expense ratio is 1.50%. An investment in the fund is subject to investment risks, including the possible loss of the principal amount invested. The fund’s distributor is Rafferty Capital Markets, LLC.
Contributors to Performance
The stock that contributed the largest effect to NAV, for an increase of 39¢, was CapitalSource, now the fund’s largest holding, which ended the year valued 22% over our average cost of $5.80.
The only investment that ended the year valued below our original cost was Apollo Group. The company’s stock price declined 11% from our average cost per share of $44.42, causing a negative impact of 19¢ on the fund’s NAV.
Other major contributors were Ross Stores, which added 18¢ to the NAV by increasing 12% over our average cost, and Aflac, which rose 6% over our average cost, adding 10¢ to the NAV.
Portfolio
| Security | % of Net Assets |
| CapitalSource Inc. | 13.5% |
| Aflac Inc. | 12.2% |
| Ross Stores Inc. | 10.3% |
| Apollo Group Inc. | 9.6% |
| Federated Investors Inc. | 4.3% |
| CSX Corp. | 4.2% |
| Carter's Inc. | 4.2% |
| Norfolk Southern Corp. | 4.1% |
| American Express Co. | 4.0% |
| Kaiser Federal Financial Group | 3.8% |
| Union Pacific Corp. | 3.5% |
| Standard Financial Corp. | 0.4% |
| Cash* | 25.9% |
*Cash represents cash equivalents less liabilities in excess of other assets.
One of the core tenets of the Bretton Fund is that we will invest only in what I believe to be the best investment opportunities. We do not attempt to mimic market indices or invest across all industries. Surprisingly, this makes us a rather atypical mutual fund. A more conventional fund will invest in a wide variety of stocks, rarely owning any security greater than 5% of assets. And it’s designed to not look too different from the rest of the market, a strategy that may be great for marketing the fund and building assets, but not ideal for shareholders seeking excellent long-term results.
The Bretton Fund is set up for investors who don’t mind a little lumpiness in their returns in the short term if they can achieve attractive performance over the long run. We are investors, not traders. Given our long time horizon and portfolio selectivity, our investing approach has more in common with a private equity investor or a venture capital fund than it does with a hedge fund.
Our largest holding is CapitalSource, a finance company that lends to the healthcare industry (think nursing homes, hospitals) and ran into problems when its real estate investments, which weren’t really core to its original business, started deteriorating when commercial real estate prices started dropping in 2008. At the peak of the financial crisis, the market valued CapitalSource as if it were teetering on the brink of bankruptcy or would be forced to raise capital that would wipe out existing shareholders. CapitalSource solidified itself by selling off its poor investments and acquiring the assets of a failed bank on the cheap. This has refocused the firm on lending and gives it a source of stable, low-cost deposits to fund its loans. Its focus on the large, but specialized, healthcare industry gives it industry know-how that allows it to make attractive loans more ably than larger banks lacking that expertise. Most important, CapitalSource is well capitalized: Its ratio of tangible equity to assets, a measure of how much “cushion” a bank has, is about 20%, compared to the average bank’s ratio of 7%. We purchased CapitalSource shares below their book value.
Another significant holding, and our poorest performer to date, is Apollo Group, better known as the parent company of the University of Phoenix, the ubiquitously marketed for-profit university. I believe the long-term economic trends for Apollo Group are strongly in its favor. Fifty years ago, a student in the United States could graduate high school with minimal technical skills besides literacy and basic math and easily find a job that would support a middle class lifestyle for the rest of his life. Whether he was working at an auto plant or as a bank teller, he could pretty easily pick up the skills he needed for the job within a few months. This is no longer possible. Our economy trends toward greater complexity; we need more advanced skills that change more frequently. The same student graduating high school now can’t expect the same quality of life without acquiring additional skills.
The University of Phoenix and other for-profit universities are not alternatives for those students who will attend elite, liberal-arts colleges; they’re places where people who wouldn’t have gone to college in the first place can learn a profession. University of Phoenix provides tangible, technical skills (e.g., accounting, nursing, tech support) that help make a high school graduate employable. Community colleges can often provide some of the same benefits at a lower cost, but for-profit schools have been more responsive to changing requirements in the economy. They can also deliver the education in ways that better suit the working student, including online courses and classes that have rolling start dates.
The stock price declined in October due to concerns that the US Department of Education’s stricter proposed rules on their funding of student loans, which account for most of Apollo’s revenue, will impair its business model. There have been ethical violations by some aggressive University of Phoenix recruiters who exaggerated the value of a University of Phoenix degree and misled students. This isn’t good. This isn’t good from either a societal benefit standpoint or an investor’s perspective. From what I can tell, management has treated these missteps seriously and has reacted decisively to stop deceptive recruiting practices. Even before the Department of Education’s rules have been finalized, Apollo removed all financial incentives for enrollment quotas for their recruiters and voluntarily instituted a free, three-week screening/orientation process to weed out students who might drop out or not benefit from the university. They also more closely monitor their recruiters’ communications. These steps, combined with the upcoming student-loan rules, will lead to much lower enrollment numbers in the near term, and the market reacted negatively to this news. I believe the market overreacted. It has a tendency to do that. Overreactions like these to short-term events create great return opportunities for investors with a long time horizon.
At the end of the year, Apollo’s shares were selling for about $40 a share. The company has over $6 per share in net cash that it doesn’t need, which will likely be distributed to shareholders over time. Factoring in that excess cash, an investor at this price is paying less than $34 per share for a business that I expect will earn well over $4 per share per year, even factoring in the lower student enrollments (it earned $1.61 per share the past three months). I believe the long-term economic trends and valuation at these levels make this an attractive investment. I also believe that, while it made mistakes in enrolling students who should not have been enrolling, overall, Apollo provides a net benefit to its students. The major risk to this investment is if the Department of Education or Congress pass even greater restrictions on student loans, well beyond the most stringent version of the current proposal.
As a whole, our three railroad investments (CSX, Norfolk Southern, and Union Pacific) make up about 12% of the fund. The volume of rail traffic is inextricably linked to the US economy. Warren Buffett has said railcar loadings are his favorite economic indicator. The wonderful thing about railroads, as opposed to other transportation businesses such as airlines or trucking, is that there are typically only two major railroads for a given route. It is prohibitively expensive for a new company to build a network of railroad tracks from scratch, and this allows rail companies to raise prices a few percentage points each year. Railway traffic is up significantly from its trough in 2009, though is still well below its 2006–2007 peak. Given its inexorable relationship with the economy, it is only a matter of time before rail volumes reach these levels and eventually surpass them as our economy grows. The volumes of 2006–2007 applied at today’s higher rail prices would mean materially greater earnings for railroads, and I believe we’ll be rewarded given the prices at which we bought our shares.
There have been no sales yet in the portfolio since the fund’s inception.
Investing, Not Trading
If you ask an intelligent businessperson to buy ownership stakes in privately held businesses, he’ll likely evaluate those businesses with some basic questions: How much money does the business make? How tough is competition? What are the expansion opportunities? Is it a well-run business? And most important, how much is this business worth?
But if you take that same businessperson and ask him to invest in the stock market, he starts thinking about all kinds of other questions: How’s the stock market doing? What’s the S&P 500 at? How’s the market going to do this year? When will the Fed raise rates? Are growth stocks going to make a comeback? How much will China let the yuan float this year? Will investor sentiment sour on silver in the second quarter, causing a rush to, or panic from, gold? Would that cause a contango in oil futures?
You get the idea.
Buying a piece of a small, private business is the same economic transaction as buying shares of a company traded on the stock market. There’s something about liquidity and constant pricing information that turn thoughtful investors into rabid traders.
Our goal is to approach investing that first way, in an environment where it seems like most people are approaching it that second way. Insight into a few businesses and patience are our primary tools.
Market Outlook in 2011
I occasionally get the question, “What’s the market going to do this year?” I have no idea. I submit that the question is even a little silly because it’s really asking, “By what percentage will the quoted prices of the 500 largest, publicly-traded companies change, on a market-capitalization-weighted basis, between January 1, 2011, and December 31, 2011?” This is not a question based on long-term economic analysis. While stock prices gravitate toward their underlying value, there are a myriad of arbitrary variables that determine stock prices on a given day, not the least of which is the mood and sentiment of traders that day. I believe these types of questions are impossible to get right in any meaningful way consistently, and I’m skeptical of any investment strategy predicated on answering them correctly.
The questions I believe that are more relevant are ones like “Will Ross Stores be able to open new stores in the Northeast and the Midwest? Will people keep shopping at Ross?” Or “Will consumers and businesses continue to use American Express cards?” Because the answers to these questions rely on dramatically less variables, we have a better chance of reaching the correct conclusions and making stronger investing choices for our portfolio.
Thanks
I’d like to thank you for being a shareholder, especially in these early days. If you have questions about the Bretton Fund or want to reach me, e-mail me at stephen.dodson@brettonfund.com.
Thank you for investing,
Stephen J. Dodson
President
Bretton Capital Management