This shareholder letter is part of the Bretton Fund 2012 Annual Report (pdf).

February 19, 2013

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of December 31, 2012, was $18.84. For the quarter ended December 31, 2012, the fund’s total return was -1.06%, compared to -0.38% for the S&P 500 and 0.10% for the Wilshire 5000. For the full calendar year, the fund’s total return was 15.66%, while the S&P 500 and Wilshire 5000 returned 16.00% and 16.06%, respectively. The Bretton Fund’s returns include a long-term capital gain distribution of $0.7939 per share made on December 26, 2012.

The year’s performance put the fund in the 58th percentile of all mutual funds classified in Lipper’s “multi-cap core” category (778 funds) based on total return during 2012. The average fund in the category returned 15.05%.

Total Returns as of December 31, 2012

4th Quarter1 YearSince Inception -
Annualized (A)
Bretton Fund-1.06%15.66%13.29%
S&P 500 Index (B)-0.38%16.00%12.78%
Wilshire 5000 Total Market Index (C)0.10%16.06%12.63%

Calendar Year Total Returns

Bretton FundS&P 500 Index (B)Wilshire 5000
Total Market Index (C)
9/30/10 – 12/31/106.13%10.76%11.59%
Cumulative Since Inception (A)32.46%31.15%30.77%

(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 principal underwriter is Rafferty Capital Markets, LLC.

4th Quarter

The largest impact to the fund during the quarter, taking 1.5% off the NAV, was Ross Stores, whose stock price declined 16% in the quarter despite nothing about its business changing. It continues to build stores and sell more merchandise, and I believe it continues to be attractively valued. The largest positive contributors were New Resource Bank and Aflac, which contributed 0.8% and 0.9% to the fund’s NAV, respectively.

The fund did not initiate or eliminate any investments during the quarter.

Contributors to Performance for 2012

By far the largest contributor to the fund’s performance for the full year was The Gap, adding 6.5% to the fund’s returns. Other positive contributors were Aflac, Carter’s, and JPMorgan, each adding roughly 2% to the fund. Ross added 1.5%.

The main detractor from the fund’s performance was Apollo Group, which reduced the fund’s NAV by 2%. The two eastern railroads, CSX and Norfolk Southern, together negatively impacted the fund by 1.3%.


Security% of Net Assets
America's Car-Mart, Inc.7.7%
Ross Stores, Inc.7.4%
Aflac, Inc.7.1%
Wells Fargo & Company7.1%
CSX Corp.5.5%
JPMorgan Chase & Co.5.1%
American Express Co.4.9%
Union Pacific Corp.4.4%
The Gap, Inc.3.8%
Carter’s, Inc.3.8%
New Resource Bank3.4%
Norfolk Southern Corp.3.3%
CapitalSource, Inc.2.8%
Standard Financial Corp.2.1%
SI Financial Group, Inc.1.8%
Apollo Group, Inc.1.1%

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

Portfolio Discussion

America’s Car-Mart
The fund’s most recent addition—and only new investment in 2012—continued to open dealerships, expanding into Georgia. As the only provider of size at the low end of the used-car market, it has a long runway to expand its dealerships. The company has been able to return significant capital to shareholders through large stock buybacks, while also growing rapidly, something few companies can do. The company’s share price ended the year 6% below the fund’s average cost and trades for an attractive price.

Ross Stores
Ross continued executing on its game plan superbly: Its stores increased in popularity, and it opened up new stores. It estimates that its earnings per share, which haven’t been released yet, increased 23% in 2012, which is on top of a 22% increase the year prior.

The stock’s total return during 2012 was 15%. It’s no longer as cheap as it was two years ago, but it remains well below what I believe the company will eventually be worth. Shoppers are increasingly enjoying the bargain-hunting experience of finding brand names at discounted prices. Ross and its main competitor, TJX (operator of T.J.Maxx and Marshalls), are the only firms that have the size required by apparel makers to buy their excess clothes quickly and in one order. Ross estimates it could eventually double the number of stores it has now, and if the new stores look anything like its current ones, which have returns on capital well over 50%, shareholders are likely to benefit nicely.

Aflac’s core business of providing supplemental health insurance in Japan and the US performed well again, with its earnings per share from operations increasing 5%. Aflac was also helped by lower investment losses, as the European banking crisis stabilized, and its overall earnings per share, including its investment results, increased 48%. The stock returned 26%.

Aflac is a great, defensible business trading for a low price, though there are risks to the investment. Its investments in European banks, while reduced and manageable, are not insignificant, and the Japanese yen, where three-quarters of its business comes from, has been weakening compared to the US dollar. The price of Aflac’s stock is so low and its business is so solid that I believe its growing earnings will more than surmount these potential challenges.

Wells Fargo
Wells Fargo increased its earnings per share by 19% as losses from the real estate crisis continued to recede in 2012. Its stock returned 27% during the year. The bank’s new challenges are low interest rates and weak loan demand, but it has significant advantages that will help in the long run as those difficulties dissipate. Its deposit franchise, which I believe to be the best in the US, is a structural competitive advantage, providing it with a cheaper source of capital to fund loans. I also believe Wells Fargo is the best bank at offering multiple financials products to its customers, meaning that if you take out a mortgage from Wells Fargo, there’s a good chance you’ll also open a credit card and checking account with Wells. It has done this exceptionally well in its historical footprint of the western US, and since it acquired Wachovia (for a low-ball price during the financial crisis, I’ll note), its new East Coast customers are looking increasingly like their western counterparts by using Wells for more of their financial needs.

Wells Fargo has plenty of room to grow and has been steadily gaining market share by offering banking services that people want (lots of branches and ATMs, online access with all the bells and whistles, integrated financial services). Despite all this, and a capital cushion near all-time highs, Wells Fargo still trades at a low price compared to its earnings.

JPMorgan Chase
Like Wells Fargo, JPMorgan continued to benefit from lower losses on its real estate loans. Despite large trading losses that have become known as the “London Whale” fiasco, JPMorgan’s earnings per share rose 16%, and the stock returned 36% in 2012.

Our investment in JPMorgan benefits from the same economic forces driving Wells Fargo: lots of potential customers in a new geography (JPMorgan acquired its West Coast presence by buying Washington Mutual out of FDIC receivership during the crisis), a low-cost deposit base, and increasing demand for services like financial advice and asset management. While I’m not wild about the opacity and complexity of its trading operations, the low price of its shares provides us a margin of safety, and I continue to believe management is highly capable and shareholder-centric.

American Express
American Express’s business fundamentals were solid in 2012: Cardholders continued to increase the amount they charge to their AmEx cards, the company added more cardholders, defaults were very low, and it was able to return more capital to shareholders. The stock’s total return was 24%. The company did incur some significant charges near the end of the year, and its earnings per share declined 5% from 2011. Net of these charges (which include the cost of laying off call-center employees in its travel business as travelers more frequently book online), earnings per share increased 8%.

I wrote about our American Express investment last year: “American Express has many elements I look for in an investment: a long runway, a defensible business, management that thoughtfully pays out its earnings to shareholders, and a reasonable valuation.” Nothing’s changed.

The Gap
Gap estimates its earnings per share increased 43% during 2012, which was a result of cotton prices falling down to normal levels, reduced shares outstanding due to stock buybacks, and prescient fashion calls. Apparently, colored pants are “in.” The stock’s total return was 70%.

Carter’s also benefited from lower/normal cotton prices. It estimates its 2012 earnings per share, once finalized, increased 33% net of some special charges. The stock’s total return was 40%. Carter’s sells its baby clothes through traditional retailers like Macy’s and Target, but has been increasingly selling its clothes directly to consumers through its own stores and website. It recently acquired a company that, as a franchisee, operated Carter’s stores in Canada, and it’s been successfully expanding its north-of-the-border presence since. The company just introduced international shipping from its website and found a lot of pent-up demand from surprising locales—surprising to me, at least—like Russia and Hong Kong.

Apollo Group
Not all the fund’s investments performed well in 2012. The performance of Apollo’s stock price was abysmal: It declined 61% during the year. I did not anticipate how much enrollment would fall at its universities as a result of regulatory changes and tougher competition from traditional colleges, as well as how cyclical demand is. In its most recent fiscal year, student enrollment dropped by 14%, revenue by 10%, and earnings per share (net of special gains and charges) by 27%. The fund was fortunate (read: lucky) to sell half of its stake early in the year before the decline. While the company is likely not worth what I initially thought it was, the price it’s trading for now undervalues the company.

Small Banks
Like Wells Fargo and JPMorgan, the fund’s small banks also have rebounded from the financial crisis and have performed well. The bank stocks’ total returns during 2012: New Resource Bank 29%, CapitalSource 21%, Standard Financial 15%, SI Financial 18%.

The railroads were a mixed bag. Much of the cargo that makes up trains’ volumes is coal, which is primarily used for making electricity and steel. Coal use has been on the wane, but the railroads’ pricing power and market share gains from trucks have usually more than made up the difference. Until 2012. The main alternative to coal in the North American power grid is natural gas, and with so much cheap natural gas flooding the market from fracking and other drilling advancements, coal use dropped sharply. The eastern railroads CSX and Norfolk Southern derive about 30% of their revenue from coal and were the hardest hit. Coal volume dropped roughly 15%. CSX managed to improve its earnings per share by 7%, and its stock returned -4%. Norfolk Southern’s earning per share declined 1%, and its stock’s total return was -12%. Despite their near-term challenges, there remains no cheaper way, by far, to move large goods over long distances than rail, and it’s essentially impossible to construct a large railroad from scratch in the US today. The rails, even with less coal, will be moving a significant portion of America’s goods for decades to come.

Union Pacific, which only gets 20% of its revenue from coal, fared much better and demonstrated how good railroads’ economics can be even with flat volume. Carloads were down slightly, but revenue increased 7% and earnings per share by 23%. Its stock’s total return was 21%.

Investments Initiated in 2012
America’s Car-Mart

Investments Exited During 2012

InvestmentInternal Rate of Return (Annualized Return)
Peoples Federal Bancshares16%

Investment Environment

After four straight years of positive returns, the market hasn’t left a lot of easy money lying around. An investor with both the ability and the nerve to put money to work during the financial crisis of 2008–2009 was effectively trying to pick out investments that would yield 30%+ annually over the next few years from a field of merely 15%/year opportunities. These days, it feels more like hunting for 10–12% returns in a 6–8% world. Interest rates are artificially low and the pain of the financial crisis has ebbed, which together have pushed up asset prices to almost fair value in the case of stocks, and in the case of bonds, to egregious values. I come across slews of mediocre, slow-growing companies selling for excessively high prices simply because they pay a decent dividend, as income-seeking investors have crept into dividend stocks, viewing them as bond alternatives.

Bonds themselves are dangerously priced. A refresher on bond math: The value of a 10- year bond with a 2% coupon and yield would see its value fall by 9% from a mere 1% increase in its interest rate. The yield on a 10-year US Treasury bond, now around 2%, was north of 5% as recently as 2007. Bond returns have been excellent; investors have received their interest payments and their bonds’ values have increased as rates have approached zero. But at 2%, there’s not a lot of room left for rates to go lower. They will go up eventually. And when they do, investors in long-term bonds will see their principal values plummet.

Don’t bond investors understand this? Maybe. Interest rates fluctuate in response to bond investors and Federal Reserve fiat, but overall bull and bear bond cycles tend to span decades. Our current bull bond market started three decades ago in 1981. When its bear predecessor started, which is the last time we were in a similar situation with bonds yields this low, Harry S. Truman was in the first year of his presidency. There aren’t a lot of bond investors today who were investing then. There’s a real difference between conceptually knowing how interest rates affect bond values and viscerally understanding how a mere 3% increase in rates can destroy a significant portion of your accumulated wealth. I’ve heard the argument that one could “get out” in time before rates rise. I heard similar arguments about dot-com stocks in 2000 and Las Vegas condos in 2006.

The fund’s struggle to find compelling returns with low risk has manifested itself in a high cash balance (close to 30% of assets) and only one new investment made during the year. The amount of cash dragged down performance; on the portion of the fund that was invested, the fund’s investments materially outperformed the market. The Bretton Fund does not have a mandate, explicit or implicit, to be fully invested in stocks at all times, which is unlike the large majority of other stock mutual funds. The fund’s overall mandate is to make attractive investments for capital that has a long and indefinite time horizon; it’s not a fund “product” that’s designed to be allocated to and from depending on the level of the market.

This difference can be a disadvantage in the short run when markets appreciate rapidly, but I believe it’s a huge advantage over a multiyear period. The opportunity set available today is not likely to be the same range of opportunities that will be available six months or a year from now. Renowned investor Seth Klarman puts it this way: “Limiting your opportunity set to the one immediately at hand would be like limiting your spouse to the students you met in high school.” If your investment horizon were only a year, you’d put what you have to work pretty much right away. But if you had a five-, ten-year investment horizon, or longer, you’d probably be a little more patient and more willing to wait for the higher return, no-brainer opportunities.

I assure investors that the goal of the fund is not to constantly hold high levels of cash. The goal is to put substantially all of the fund’s capital to work in high-return/low-risk investments; there just aren’t very many of those around right now. I continue to diligently evaluate the current opportunity set, and I’m finding the more intriguing situations in the smaller regions of the public company universe that are too small for larger funds. It’s a competitive advantage the Bretton Fund has, at least at its current size. The market doesn’t need to go down per se for the fund to put more of its capital to work; only a handful of opportunities need to present themselves.

2012 Reading

My favorite business/economics book I read in 2012 was Race Against the Machine, an e-book by Erik Brynjolfsson and Andrew McAfee. The authors, an economics professor and a research scientist, respectively, at the MIT Sloan School of Management, posit that as the speed of technological progress accelerates, the relative value that an unskilled worker provides, in comparison to capital and highly skilled labor, gets smaller and smaller.

As they note, the prospect of machines replacing people is nothing new:

At least since the followers of Ned Ludd smashed mechanized looms in 1811, workers have worried about automation destroying jobs. Economists have reassured them that new jobs would be created as old ones were eliminated. For over 200 years, the economists were right…. [But there] is no economic law that says everyone, or even most people, automatically benefit from technological progress.

Technology progresses, and workers try to keep up with those advances, a dynamic Harvard economists Claudia Goldin and Lawrence Katz call a “race between education and technology.” Brynjolfsson and McAfee are concerned that while gains from education are linear, technological changes are exponential. Since the 1970s, per capita GDP has increased quite significantly, but median income hasn’t.

Technology has advanced rapidly, and the good news is that this has radically increased the economy’s productive capacity. However, technological progress does not automatically benefit everyone in a society. In particular, incomes have become more uneven, as have employment opportunities. Recent technological advances have favored some skill groups over others, particularly “superstars” in many fields, and probably also increased the overall share of GDP accruing to capital relative to labor.

The stagnation in median income is not because of technological progress. On the contrary, the problem is that our skills and institutions have not kept up with the rapid changes in technology.

A nice pairing with the book is an essay in The Atlantic by Adam Davidson that gives human texture to the abstract phenomenon. Davidson, who also cohosts the Planet Money podcast for NPR and writes a weekly column for the The New York Times Magazine, spent time at an auto parts factory in South Carolina following two workers: Maddie, an entry-level employee, and Luke, a highly skilled technician.

It’s hard to imagine what set of circumstances would reverse recent trends and bring large numbers of jobs for unskilled laborers back to the US. Our efforts might be more fruitfully focused on getting Maddie the education she needs for a better shot at a decent living in the years to come…. I came to realize, though, that Maddie represents a large population: people who, for whatever reason, are not going to be able to leave the workforce long enough to get the skills they need. Luke doesn’t have children, and his parents could afford to support him while he was in school. Those with the right ability and circumstances will, most likely, make the right adjustments, get the right skills, and eventually thrive. But I fear that those who are challenged now will only fall further behind.

It might be tempting to see this as a result of government policy—and to pick a politician to blame—but the phenomenon has been occurring across the world for a while, in places with different taxes, regulations, and safety nets. While not an overt investing theme of the fund, stagnant median income and a divergent middle class do impact our companies.

Bretton in the News

In October, mutual fund columnist and podcaster Chuck Jaffe interviewed me on his show, MoneyLife. You can find a link to the iTunes recording (on which I spoke a little too fast and mumbled too often) on the Bretton Fund website, along with, helpfully, a transcript (pdf). An excerpt:

Chuck Jaffe: So the question becomes, when you talk about being a value manager, are you looking to be able to buy a dollar for a quarter, for 50 cents, for 75 cents, or we are looking for pennies?

Stephen Dodson: A lot of that depends on what’s currently available in the market. The sort of ideal company you can find is what I call—and other investors use the same term—are “compounders.” They’re dollars that next year are going to be worth $1.10, the year after that are going to be worth $1.20, then the year after that are going to be worth $1.35, and so on. If you can acquire those at $0.75, that’s a great investment. And you can just sort of sit back and let those companies do all the work for you and compound value.

We diligently continue our search for cheap compounders, the holy grail of returns.

Thank You

As always, I appreciate your being an investor in the fund,

Stephen J. Dodson
Bretton Capital Management