April 17, 2012

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of March 30, 2012, was $18.96, and the total return for the fund for the quarter was 11.66%. Over the same period of time, the total return for the S&P 500 Index was 12.59%, and the total return for the Wilshire 5000 Total Market Index was 12.76%.

Total Returns as of March 30, 2012

1st Quarter1 YearAnnualized Since
9/30/10 Inception
Bretton Fund11.66%16.61%17.80%
S&P 500 Index12.59%8.54%17.46%
Wilshire 5000 Total Market Index12.76%7.24%17.29%

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, 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%.

Contributors to Performance
The largest contributor to the fund’s performance was Gap, whose stock price increased 41% and increased the fund’s NAV by 3.5%. The share prices of the fund’s large banks also rose significantly: JP Morgan by 38% and Wells Fargo by 24%. Together, they added 2.6% to the fund’s performance. Ross Stores (again) was a major contributor, adding 2.3% to the NAV. The fund’s return was dragged down by Apollo Group, which took 0.9% off the NAV.

One year is too short of a time period to make any definitive judgments about performance, but I will note that the The Wall Street Journal ranked (pdf) Bretton Fund #1 for the past year out of the 299 funds that Lipper categorizes as “multi-cap value” (details and disclosures at the link). As I said in the annual report, the fund’s goal remains the long-term compounding of capital, and periods of underperformance are inevitable.

The US stock market as a whole is up substantially from the recent lows of last fall, and while the benefit of this is bigger numbers on people’s account statements, the downside is the increased difficulty of finding attractive new investments. The fund did not make any new investments in the past quarter; the last new addition to the portfolio, Wells Fargo, was initiated almost six months ago. I like to think this lack of activity comes not from a lack of effort, but from an abundance of patience. The current stock market is neither euphoric nor despondent. It feels about fairly valued, with financial services continuing to be the cheapest area. Of course, this doesn’t mean much in terms of what it will do next, though long-term investors should be rooting for a nice bout of panicked selling.


Security% of Net Assets
Ross Stores, Inc.11.4%
The Gap, Inc.10.9%
Aflac, Inc.8.2%
CSX Corp.7.4%
Carteru2019s, Inc.5.9%
JP Morgan Chase & Co.5.2%
American Express Co.4.8%
Wells Fargo & Company4.6%
Norfolk Southern Corp.4.3%
New Resource Bank4.1%
Union Pacific Corp.3.8%
CapitalSource, Inc.3.5%
Peoples Federal Bancshares, Inc.3.2%
SI Financial Group, Inc.3.0%
Apollo Group, Inc.2.9%
Standard Financial Corp.2.8%

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

Principal v. Agent
One of the biggest challenges an investor has with publicly traded stocks is the very little say outside investors have in what a company does with its earnings. As a company generates cash from its business, it has to decide whether to pay out its earnings to shareholders or invest it back into the business. In theory, the decision between these two choices comes down to how high of a return the company can achieve by investing further into the business. If it can generate high returns by, say, opening new stores or acquiring another business, it should use its cash for those projects. If the marginal returns look mediocre, or if the company has more cash than it needs, it should distribute it to shareholders.

But this is in theory. The friction that often causes this theory to break down is the divergence in goals between management, who have almost all the say in capital-allocation decisions, and shareholders, who have little. Occasionally, a large, activist investor can accumulate a big enough stake to force a change, or coordinated investors can nudge management in a certain direction, but for the most part, it’s really up to the CEO. A truly pernicious management team can decide to pay itself exorbitant compensation at investors’ expense, and this does happen. This type of conflict of interest is a bit, well, obvious. More often, the conflict is subtler. A board of directors doesn’t want to sell their company because they would lose their director fees. A CEO serially acquires companies because his compensation is based on the size of the company.

The even less obvious divergence of interests comes from non-financial incentives. We’re complex creatures, with lots of wants, and higher compensation addresses only some of them. People often want to feel important, to be a big deal. In the prelude to the financial crisis, the CEOs of a couple of large banks seemed to be driven purely by the desire to build the biggest bank, regardless of the cost to shareholders, and acquired dozens of companies on this basis. In the technology world, some CEOs seem more driven to be seen as cutting-edge and relevant, using shareholder money to make enormous acquisitions with scant prospects of ever paying off. Making an expensive, “game changing” acquisition is more likely to get on the cover of a magazine than issuing a dividend.

A stock market investor needs to understand what will happen to the cash a company earns; it’s one of the most important things an investor needs to know. Imagine that a talented restaurateur wants you to invest in her new restaurant that she’s going to run. You look it over and think it’ll be quite successful, but the catch is that she has complete control over what happens to the cash once it’s earned. She could use it to expand the number of seats in the restaurant, open more restaurants, maybe give herself a raise, or pay it out to you. She could even use it to buy a swimming pool repair company if she so desired. How would you go about thinking about investing with her? You’d probably ask her outright what she plans on doing with the cash. You’d look very closely at what she’s done in the past. Sometimes the best decision for the business will be to plow all the capital into expansion, and sometimes it will mean slower expansion and a higher investor payout. What will she do in those situations? What you’re really trying to figure out is if she genuinely cares about your financial returns. If she doesn’t, why would you invest with her?

The importance of capital allocation is surprisingly overlooked by investors as a whole. Not all earnings are equal. A company that returns capital to shareholders by buying back its own stock while cheap is worth much more than a comparable company that dilutes its shareholders by issuing stock for expensive acquisitions. Almost all the companies in the Bretton Fund pay out a portion of their earnings through dividends, stock buybacks, or both. A few of the fund’s companies—JP Morgan, Gap, and Norfolk Southern—paid out effective yields (the ratio of dividends plus buybacks over the share price) last year of about 10% or more. Not only are these businesses attractively priced compared to their earnings, but management has demonstrated they care about shareholders and have mechanisms in place to distribute those earnings to investors.

A Little Press
Earlier this year, the Mutual Fund Observer profiled the Bretton Fund, and David Snowball, a veteran of FundAlarm, had a few nice things to say:

Bretton is an ultra-concentrated value fund managed by the former president of Parnassus Investments. It has shown remarkable—and remarkably profitable—independence from style boxes, peers and indexes in its brief life.… Bretton has the courage of its convictions. Those convictions are grounded in an intelligent reading of the investment literature and backed by a huge financial commitment by the manager and his family. It’s a fascinating vehicle and deserves careful attention.

Thank you for investing,

Stephen J. Dodson
Bretton Capital Management