October 19, 2011

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of September 30, 2011, was $14.76, and the total return for the fund for the quarter was a decline of 10.81%. Over the same period of time, the total return for the S&P 500 Index was a decline of 13.87%, and the total return for the Wilshire 5000 Total Market Index was a negative 15.04%.

Total Return as of September 30, 2011

Since 6/30/20111-Year and Since
9/30/2010 Inception
Bretton Fund-10.82%-1.60%
S&P 500 Index-13.87%1.14%
Wilshire 5000 Total Market Index-15.04%0.58%

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%.

The Market
The default stance of many market watchers appears to be a strong desire for the stock market to go up continuously. Investors seem to watch daily movements closely, rooting for the market to go up and cheering when it does—despairing when it doesn’t. All this dear attention is misplaced.

The stock market is not a nebulous entity with its own wants and desires or a fickle god we have to appease for a plentiful bounty. It’s merely an aggregate of the current, quoted prices of many different stocks, each of which is a piece of a business whose value is eventually determined by its earnings. With few exceptions, traders bidding up or down a stock price on a given day doesn’t impact how much that business will earn in the future, and thus its value. Say you own a profitable apartment building full with tenants who rarely move out, and every morning, various real estate investors stop by to tell you what they think your building is worth. If one day’s estimate is 5% lower from the previous day’s, your building didn’t somehow lose 5% of its value due to a change in one day’s opinion. The building’s value is based on how much it can produce in rent, just as it was the previous day.

The aggregate earnings of all businesses taken together is based on the total amount of goods and services people exchange with each other—in other words, an economy. If investors should be rooting for anything, they should be rooting for the engineers at GE to produce more efficient jet engines, for the scientists at Genentech to discover more life-saving drugs, for the middle managers at Wal-Mart to make prices even lower, for the product managers at Google to deliver us better information. These are the activities that produce wealth over time, not “up days” in the market.

A rational investor who can accurately value certain businesses often needs the occasional market decline to find high-return opportunities. The major caveat is that this only works if an investor has a long time horizon. The investor who is forced to sell, be it through leverage or temperament, is at a material disadvantage to an investor who can make the great investments that arise when others panic.

Portfolio Changes
The recent downturn in the market allowed the fund to invest more of its cash, reducing it down from 26% of the fund at the beginning of the year to 11% currently. Some areas of the stock market seem moderately attractive, though not as much as late 2008 and early 2009. I’m finding the best opportunities in financial services, as many of these companies’ stock prices declined sharply due to investment losses during the financial crisis, but whose earnings have recovered and in some cases grown considerably.

The only new addition to the fund is JP Morgan Chase. Its market value declined significantly in recent months, and the fund was able to acquire shares at a low price compared to its earnings ability. Banks in general have an uncertainty that arises from the long time gap between when loans are made and when they’re due. Large banks like JP Morgan are especially opaque and complex due to the huge number of loans of varying types and other lines of business. An investor will never have perfect clarity investing in a bank, but there are strong clues an investor can pick up on to deduce approximate future earnings and where one is in a credit cycle.

JP Morgan’s losses on the loans made during the ebullient days of the housing bubble have mostly flowed through its system: the major indicators of loan quality (e.g., charge-offs, delinquencies, problem loans) have for the most part improved for seven consecutive quarters, and its cushion against future losses (loss reserves and equity capital) is at some of its highest levels ever. It is not insignificant that management is candid and highly capable. Additionally, much of its earnings is fee-based that recurs annually. New loans eventually replace bad loans, and cash generated from the business accretes to shareholders over time. With its shares trading at only five to six times underlying earnings, there’s a wide margin of safety and an attractive return potential.

No investments were closed out in the quarter.

Contributors to Performance
The fund’s performance continued to be weighed down by Aflac, which caused the fund’s NAV to decline by 44¢. As a whole, the railroads owned by the fund (CSX, Norfolk Southern, and Union Pacific) dragged the NAV down by 47¢. The earnings of these companies continue to increase, and I expect the declines in their stock prices to be temporary, “quotational” losses, not permanent impairments of value.


Security% of Net Assets
Ross Stores, Inc.11.3%
The Gap, Inc.9.9%
Apollo Group, Inc.9.5%
Aflac, Inc.9.2%
Carteru2019s, Inc.5.3%
New Resource Bank4.9%
CSX Corp.4.9%
CapitalSource, Inc.4.9%
American Express Co.4.7%
JP Morgan Chase & Co.4.5%
Union Pacific Corp.4.3%
Norfolk Southern Corp.4.3%
Standard Financial Corp.3.8%
Peoples Federal Bancshares, Inc.3.7%
SI Financial Group, Inc.3.6%

*Cash represents cash equivalents less liabilities in excess of other assets.

Ross Stores
Since the fund’s inception, Ross Stores has had the biggest positive impact on the fund’s performance and is now the largest holding. While its stock price has increased 36% over the fund’s average cost, the fund continues to hold its shares as the future returns remain attractive.

Shoppers at Ross dress for less. The Ross shopper is not someone who regularly walks into Barneys or Saks asking for this season’s Dolce & Gabbana dress in a specific color. It’s also not the shopper who goes to JC Penney or Kmart and just wants something that looks nice for a low price. The typical Ross shopper is someone who stays abreast of fashion trends and covets name brands, but can’t (or won’t) pay full price.

Ross acquires large volumes of excess inventories of clothes and household goods that fashionable, mass-market brands (e.g., Calvin Klein, Juicy Couture, DKNY) aren’t able to sell to department stores at full price. Ross then sells them at deep discounts in stores that would most generously be described as spartan.

It’s a fundamentally different shopping experience from what mainstream department stores offer, which strive to exude elegance and comfort. At Ross, the racks are not neatly segmented by brand and their densities can appear cluttered in comparison. What Ross does offer is high-quality, well-recognized brands for 20–60% less. Ross updates its stores’ inventories frequently and offers what management calls a “treasure hunt experience” for its shoppers, who may not be looking for a specific item, but revel in finding hidden gems at deep discounts (a search for “ross haul” on YouTube yields visual examples).

Fashion labels will always make too much of something; they just don’t know what ahead of time. Ross, along with its main competitor TJX (the T.J. Maxx and Marshalls stores), have a symbiotic relationship with apparel companies, offering terms like single shipment and final sale that give the clothes manufacturers efficiency and certainty for large amounts of excess inventory. This scale combined with the complexity of quickly buying and distributing disparate items to stores nationwide have made this niche hard for new entrants to compete. Some online retailers, such as Gilt Groupe, have been successful selling excess inventory of high-end, luxury items of a specific variety, but the volumes and styles of mass-market fashion brands are more suitable to the tactile perusal of physical shopping. Competition from department stores is mitigated due to the structurally different experience those stores are set up to provide. The major threat I foresee to Ross’s continuing success is if this mode of shopping fades over time.

The company has grown remarkably, and management has done it thoughtfully, focusing new-store growth in existing markets, and then adjacent ones, instead of a contemporaneous, nationwide build-out. Over the past 10 years, revenue has grown at an annualized rate of 11% per year and net income 14%. Its no-frills stores aren’t expensive to build, and its entrenched competitive position allows it to achieve returns on its invested capital close to 50% (it’s above 80% when taking into account its excess cash). Management has returned extra capital to shareholders through dividends and by buying back its own stock, resulting in net income on a per share basis growing by an annualized 18% over the past 10 years. The investment outcome for Bretton Fund shareholders is not premised on Ross compounding its earnings at the same rate in the future, but I estimate Ross could eventually double the number of stores it has in the US. Ross is very popular in its current markets, and it has little presence yet in the Northeast and Midwest, giving it plenty of room for expansion.

Odds & Ends

  • The Bretton Fund is now available through E*TRADE and Pershing, who added us to their respective fund platforms.
  • I wrote an article for Advisor Perspectives on the faulty logic of the current style-box system.
  • The Wall Street Journal noted our performance a couple months ago.

As always, thank you for being a shareholder,

Stephen J. Dodson
Bretton Capital Management