This shareholder letter is part of the Bretton Fund 2013 Annual Report (pdf).

March 4, 2014

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of December 31, 2013, was $23.44. For the quarter ended December 31, 2013, the fund’s total return was 5.86%, compared to 10.51% for the S&P 500. For the full calendar year, the fund’s total return was 26.53%, while the S&P 500 returned 32.39%.

Total Returns as of December 31, 2013

4th Quarter1 YearSince Inception -
Annualized (A)
Bretton Fund5.86%26.53%17.21%
S&P 500 Index (B)10.51%32.39%18.50%
Wilshire 5000 Total Market Index (C)10.11%33.07%18.57%

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)67.60%73.69%74.01%

(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 total annual operating expense ratio from the prospectus dated May 1, 2013 was 1.50%. The fund’s expense ratio for the fiscal year ended December 31, 2013 can be found in the financial highlights included within this report. 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 biggest impact on the fund’s performance during the fourth quarter was Wells Fargo, which added 1.2% to the NAV. Other significant, positive contributors were Armanino Foods, Norfolk Southern, and American Express, which added 0.9%, 0.9%, and 0.8%, respectively. The investment that had the biggest negative impact was America’s Car-Mart, which took 0.4% off the NAV.

The fund made one new investment during the quarter, initiating a position in Bank of America. The rationale behind the investment is similar to those for Wells Fargo and JPMorgan: 1) These banks have inherent competitive advantages (e.g., structurally lower costs), and they provide an important service that isn’t going away or being replaced. 2) While they made mistakes preceding the financial crisis and are still recovering, they’re well past the worst of it. 3) Their shares are selling substantially below what they’re worth. The fund did not eliminate any investments during the quarter.

Contributors to Performance for 2013

Our tiny pesto sauce maker, Armanino Foods of Distinction, was the biggest contributor to performance for the full year, adding 3.9% to performance. The Eastern railroads CSX and Norfolk Southern staged a nice comeback and together added 3.8% to the fund. Well Fargo was close behind, increasing NAV by 3.1%, and Ross Stores added 2.3%. There were no material detractors for the year.

Cash and Recent Performance

As in 2012, the fund’s investments did quite well, but our overall performance was held back by our cash levels, which averaged 20% throughout the year. Last year, I wrote, “After four straight years of positive returns, the market hasn’t left a lot of easy money lying around.” Let’s now make that five years in a row and even slimmer pickings. The current market is priced within the realm of reason, but it’s definitely on the high side of that range and possibly stretching the upward bounds of that definition. That doesn’t mean the market will crash imminently; the market could eventually grow into its valuation. What it does mean is that the risk–reward ratio from stocks overall is just so-so and we don’t see a lot of compelling investments right now. We own some great businesses, many of them still at low prices, but not enough to fill out a full portfolio.

A reasonable question might be, “Why don’t I just buy the most attractive stocks of the bunch, even if the expected returns are just so-so? Wouldn’t that help the fund keep up with the S&P 500?” That is, indeed, what I believe the large majority of mutual fund managers do. Many mutual fund managers think of themselves as “products” that are meant to track a specific benchmark closely and remain fully invested all the time. But what that means in times when valuations are high is that you’re committing your capital to a mediocre return with a fair amount of risk because you have to buy something—anything. Would you invest that way with most of your net worth if you were buying private businesses? “Say, I’ll sell you this laundromat that’ll give you a 3–4% return. But there’s a good chance the building will get torn down and you’ll lose most your investment. How ’bout it?” The appropriate response to this type of solicitation is “Go pound sand,” not “Oh, why not? I’ve got nothing else better to do.” You’d keep looking for a better deal. Fractional ownership in public businesses is no different. In essence, we’re telling Mr. Market to go pound a little bit of sand right now. He has a tendency to come back with better options.


The fund made a long-term capital gain distribution on December 26 of $0.39674. For the second year in a row, the fund avoided incurring any short-term capital gains, which are taxed at a higher rate. The capital gain represented 1.7% of the NAV compared to the fund’s 26.5% gain. The fund’s primary goal isn’t to completely avoid taxes—if it was, we would just avoid making money—but we try hard to reduce them by avoiding short-term capital gains and not turning over our portfolio frequently. Of our 18 holdings, nine of them have been with the fund since the fund’s first reporting period back in 2010. Portfolio turnover was 6.85% in 2013.


Security% of Net Assets
Wells Fargo & Company12.1%
Coach, Inc.7.1%
Ross Stores, Inc.6.3%
America's Car-Mart, Inc.6.3%
Armanino Foods of Distinction, Inc.6.0%
Aflac, Inc.5.5%
Norfolk Southern Corp.5.2%
American Express Co.4.7%
JPMorgan Chase & Co.4.6%
Bank of America Corp.4.3%
Union Pacific Corp.4.3%
CSX Corp.4.0%
Carter’s, Inc.3.0%
New Resource Bank2.1%
The Gap, Inc.1.5%
Standard Financial Corp.1.4%
SI Financial Group, Inc.1.1%
Apollo Group, Inc.0.9%

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

Portfolio Discussion

Wells Fargo
Wells Fargo continues to add customers, pare its bad-loan losses, return capital, and achieve record earnings. Earnings per share increased 16% this past year. Its stock’s total return was 38%, yet the ratio of its share price to its current earnings is still only 11, well below the market average and well, well below a reasonable ratio for a business that can grow while also returning cash to shareholders. Banking in the US is still relatively fragmented, and Wells Fargo consistently gains market share by adding customers who open new checking accounts or take out small business loans. I believe it to be the most conservatively run of the major banks, and it has significant excess capital that’ll be distributed to shareholders at an increasing rate. All of this—for a low, low price—is why Wells Fargo is our largest holding.

The New York–based luxury handbag maker continues to expand its business quite successfully in Asia, while its US business remains stagnant due to competition from “hotter” brands. Most of Coach’s growth will likely come from international markets, specifically Asia, as it’s still in the early stages of selling there. Sales in China grew 35% last year. Revenue there is now about half the size of its North American sales and could eventually be larger, as is the case with many other luxury goods companies that got earlier starts there. Coach returns almost all its free cash flow to shareholders, making its total shareholder payout—dividends plus stock buybacks—around 7%. We initially acquired Coach in February 2013, and our total return so far is 18%.

Ross Stores
Ross just keeps doing what it does. It sold lots of brand-name clothes at steep discounts and continued to build out stores. It has a structural competitive advantage in purchasing excess inventory (i.e., stuff that can’t sell for full price) from large apparel makers since Ross can take entire lots of unwanted clothes quickly and efficiently from vendors who would rather not dribble them out to hundreds of small retailers over many months. The stock returned 40% last year, and the company estimates its earnings per share increased 9%.

America’s Car-Mart
Car-Mart struggled during the year as increased competition from aggressive lenders made it tougher for Car-Mart to sell cars on reasonable terms. Much of the used-car industry outsources the loan portion of the transaction to banks and fixed-income investors, but Car-Mart believes that doing both the selling and the lending in this portion of the market gives it a long-term competitive advantage because it can make better loan decisions, more effectively collect payments, and have a dedicated source of funding if/when outside credit dries up.

The downside is that Car-Mart is more susceptible to competition and larger loan losses if third-party finance companies prodigally lend on loose terms, which can happen every now and then like it is now. But these influxes of capital don’t last long. The losses at this end of the loan market run high by nature, and unless you have serious domain expertise, net returns can be elusive. Ultra-low interest rates pushed institutional investors into this market as they sought greater yields, but as their losses mount and interest rates eventually rise, I expect them to pull back and Car-Mart to regain its previous per-car profitability. In the meantime, it continues to open new locations at a rate of 10% per year, establish lasting customer relationships, and make profitable sales and loans. This business is cyclical, and Car-Mart has done well through many cycles over three decades. Earnings per share for the most recent 12-month period were 4% below the preceding one, and its stock returned 4% in 2013.

Armanino Foods of Distinction
Armanino was our star of 2013. At last report, it was on pace to grow its earnings per share 13% as it continued to sell more of its (tasty) frozen pesto sauce. Equally important, management’s behavior demonstrates that they actually like their shareholders, and it paid out a significant portion of its free cash flow via dividends. We started buying Armanino at the beginning of 2013, and our total return so far is 103%. I wish we had found 20 Armaninos. Despite the run-up, the value of the shares remain relatively reasonable, with the total shareholder payout still in the mid-single digits.

Aflac’s core business of providing supplemental health insurance in Japan and the US continued to do well in 2013, but since most of its income comes from Japan, earnings in US-dollar terms were hurt as the yen depreciated 20% against the dollar last year. Through the first nine months of 2013 that have been reported so far, Aflac’s operating earnings per share in US dollars were down 7%, but would have risen 5% without the yen depreciation. The yen won’t slide forever, and Aflac’s cash flows are continuing to accrue to shareholders at an attractive rate. The stock returned 29% last year.

American Express
American Express has been a bit of an unsung hero for Bretton shareholders. It’s been one of our best investments to date. Last year, the stock returned 60%, and its annualized total return since the fund’s inception is 29%. The company increased its operating earnings per share by 12% last year, and its shares, while no longer the screaming bargain they were after the financial crisis, remain reasonably priced.

Apollo Group
Apollo, the company behind the University of Phoenix, finally showed signs of life. Its stock was up 31% during the year as its earnings per share decreased 11%, less than investors were expecting. Overall, Apollo has been a disappointment—in other words, a mistake. New student loan regulations affected Apollo a bit, but the bigger damage was the hit to the reputation of for-profit colleges from increased regulatory scrutiny. Also, while the company saw a surge in demand at the beginning of the recession from the newly unemployed deciding to go back to school, employment has since recovered, and demand is back down. Our approach to Apollo now is one of salvaging our remaining stake, as I believe the shares are undervalued even with its reduced earnings. Including the shares we sold for a profit at the beginning of 2012, the investment is just slightly below break-even for us.

In 2012, CSX and Norfolk Southern dragged down the fund’s NAV as they struggled with declining coal volume, but they rebounded strongly in 2013 as coal fell less quickly and revenue from other traffic more than made up the difference. All three of the railroads, including Union Pacific, achieved record earnings per share. CSX, Norfolk Southern, and Union Pacific increased their earnings per share by 2%, 12%, and 14%, and their stocks returned 49%, 54%, and 36%, respectively.

Big Banks
JPMorgan and Bank of America continue to see much lower loan losses, lower expenses, and modestly higher loan demand. As I see it, litigation and regulatory fines are the remaining hurdles for the large banks. These are unpleasant, but easily survivable, bumps in the road. They certainly reduce the amount of money available to shareholders, but don’t materially impair the banks’ ability to earn money in the future. For example, JPMorgan recently settled with regulators to pay a $13 billion fine for its—and its predecessors—actions leading up to the financial crisis. That’s an awful lot of money, but it’s a manageable amount compared to the $24–$28 billion I estimate JPMorgan can earn in a normal year. Plus, those earnings are going to grow as the bank continues to add customers and interest rates rise; penalties of that size aren’t going to happen every year. JPMorgan’s earnings per share decreased 16% in 2013 due to its legal costs, and its stock returned 37% during the year. Our return so far from Bank of America is 9%.

Small Banks
The small banks did okay in 2013, but not as well as their larger cousins. Shares of Standard Financial and SI Financial, small community banks converted from mutualized thrifts, remain cheap, and while they return capital via dividends and buybacks, they’re not able to grow as quickly as the big banks. New Resource Bank, a relatively young bank focused on environmentally friendly loans, is growing at a rapid pace: Its 2013 earnings are on track to increase 50% over 2012’s. Compared to the rest of the market, the total returns from our small banks were anemic in 2013, roughly flat to mid-single- digit returns.

The fund has trimmed its holding of both Gap and Carter’s over the past two years as their shares appreciated. Both businesses continue to grow nicely and return cash to shareholders. Gap’s earnings per share increased about 13% for the year, and its stock returned 27%. Carter’s operating earnings per share went up roughly 16%, while its stock returned 30%.

Investments Initiated in 2013
Armanino Foods of Distinction, Inc.
Bank of America Corp.
Coach, Inc.

Investments Exited During 2013
Investment                              Internal Rate of Return (Annualized Return)
CapitalSource, Inc.                                             22%

Reading in 2013

I took my time getting around to Sam Walton’s autobiography, Sam Walton: Made In America, which was published in 1992. It has been strongly recommended by no less an authority than Warren E. Buffett, and I thoroughly enjoyed it.

When Sam Walton opened the first Wal-Mart in 1962, one of the country’s largest retailers at the time was S.S. Kresge, which ran 800 variety stores across the US. That same year, S.S. Kresge started its first discount store—a bigger store with lower prices— and called it Kmart. Within five years, there were 250 Kmarts with $800 million in sales and only 19 Wal-Marts selling $9 million a year. Spoiler: Kmart filed for bankruptcy a few decades later, eventually acquired by a recently bankrupted Sears, while Wal-Mart went on to become the world’s largest retailer.

How did it happen? Obviously, Wal-Mart didn’t start out with an inherent competitive advantage over Kmart or anyone else. It had a distinct disadvantage being a tiny, rural retailer in a business where scale is so important. The story of Wal-Mart is fascinating because it covers a long period of time and the gradual evolution of its competitive advantage. In the beginning, Sam Walton ran franchised variety stores, which pretty much sold the same goods, acquired at the same price, as other stores. Team Walton simply worked harder and executed better than the competition. In his words: “Friend, we got after it and stayed after it.” He started their discount stores—inventively dubbed Wal-Mart—in small towns because that’s where he and his wife happened to be from, which inadvertently led to a strategic advantage because Wal-Mart was selling in towns with little competition while Kmart was slugging it out in urban areas against Woolworth, Sears, Target, et al. Eventually, Wal-Mart got so big and so efficient that its competitive advantage became structural: There was very little the competition could do to sell things more cheaply than Wal-Mart. Wal-Mart’s management of its own logistics and the negotiating power over vendors gave it the ability to sell goods at lower prices than just about anyone else. That competitive advantage, which translates into relatively modest price differences, was persistent, and it led to large effects over long periods of time.

Odds & Ends

We’ve been joined recently by Cameron Susk, who’ll be working as a research analyst for us before he departs for business school later this year. Cameron, a fellow San Francisco native, is an alumnus of Williams College and previously worked for a hedge fund in Los Angeles. He played baseball in college (shortstop), and I’ve had to restrain myself from asking arcane baseball questions (“What should one expect on a 2-1 count with a runner on?”) during our working sessions. He was instrumental to our Bank of America investment and has also been quite helpful in our eternal search for underappreciated investments.

As I mentioned in the semiannual report, I did a long interview with the Mutual Fund Observer last May. I finally managed to make a transcript of the call, and you can now find it here (pdf).

As always, thank you for investing.

Stephen J. Dodson
Bretton Capital Management