April 22, 2013

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of March 31, 2013, was $20.43, and the total return for the fund for the quarter was 8.44%. Over the same period of time, the total return for the S&P 500 Index was 10.61%, and the total return for the Wilshire 5000 Total Market Index was 10.91%.

Total Returns as of March 31, 2013

1st Quarter1 YearAnnualized Since
9/30/10 Inception
Bretton Fund8.44%12.33%15.59%
S&P 500 Index10.61%13.96%16.06%
Wilshire 5000 Total Market Index10.91%14.15%16.04%

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%. An investment in the fund is subject to investment risks, including the possible loss of the principal amount invested.

Contributors to Performance

The largest single contributor to performance during the quarter was America’s Car-Mart, which added 1.1% to the fund’s NAV. Sales and earnings continued to increase; its stock price responded in kind, increasing 18%. Bretton Fund stalwarts Ross Stores and American Express each contributed 0.8% to the fund as their share prices appreciated 14% and 19%, respectively.

As a group, the funds’ railroad investments had the largest impact on the fund, adding 2.6% to the NAV. The eastern railroads CSX and Norfolk Southern lagged last year when coal volume dropped sharply. Coal shipments have since stabilized, while traffic from other sectors increased, a trend that I anticipate will continue. The stock prices of CSX and Norfolk Southern were up about 26%, and Union Pacific’s increased 15%.

Perennial Bretton Fund laggard Apollo Group had a slightly negative impact on the fund again, taking 0.2% off the fund’s NAV.


Security% of Net Assets
Wells Fargo & Company8.9%
Coach, Inc.8.3%
America's Car-Mart, Inc.7.9%
Ross Stores, Inc.7.4%
Aflac, Inc.6.2%
American Express Co.5.1%
CSX Corp.5.0%
JP Morgan Chase & Co.4.9%
Norfolk Southern Corp.4.8%
Union Pacific Corp.4.5%
The Gap, Inc.3.9%
Armanino Foods of Distinction, Inc.3.7%
Carter’s, Inc.3.5%
New Resource Bank3.0%
Standard Financial Corp.2.2%
SI Financial Group, Inc.1.7%
Apollo Group, Inc.0.8%

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

The quarter was a relatively active one for Bretton. The fund sold out of its CapitalSource investment. The small bank continues to grow and perform well, but its stock price appreciated to the point where there wasn’t much of a margin of safety left. The total return to the fund was 38%, sold off in two segments over two and a half years, and resulted in an annualized return (aka internal rate of return) of 22%.

In the last shareholder report, I wrote, “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.” This quarter, two opportunities did: Coach and Armanino Foods. The new additions brought the fund’s cash percentage down from around 30% at the start of the year to a little less than 20%. In general, the amount of cash the fund holds is a residual of how many great investments I’m able to find.


Yes, the one that makes handbags. Founded in 1941 in a Manhattan loft, Coach today is the foremost purveyor of fine leather goods in the US, primarily known for its womens handbags and purses that are both chic and accessible.

About 90% of Coach’s sales take place at its own stores or website, and the rest via department stores like Macy’s and Nordstrom. Selling its products directly allows Coach to not only capture the full margin of its products, but also control the retail experience: how the brand is displayed, how it’s sold, and, crucially, how it’s priced. While they may not always be able to articulate it, consumers who are willing to pay a few hundred dollars for a purse do not want to see the same bag a month later with a “70% OFF!” sticker at, say, a Ross Dress for Less. (As Ross investors, we reluctantly recognize the “off-price” channel might not be for everyone.) Coach has been careful to protect the long-term integrity of its brand by not aggressively discounting, which can boost short-term results but have damaging, long-term effects.

Coach’s historical growth has been staggering. Revenue in 2002 was $720 million; by 2012, it was $4.8 billion. That’s a compound annual growth rate of 21% a year, for 10 years. Earnings per share fared even better: 31% a year for 10 years. The return on its invested capital is in the ballpark of 100%, meaning for each dollar it’s invested into its business, it gets a dollar back every year. There are very, very few businesses that can do that.

Finding public company management that’s highly devoted to outside shareholders’ returns can be challenging, but it’s especially rare in high-growth businesses since there’s less shareholder pressure when things are going well. Share buybacks and dividends are generally better for shareholders than acquiring companies, but aren’t nearly as much fun for management. Telling your treasurer to keep on buying back stock just isn’t as exciting as thinking about the next company you could buy, hiring investment bankers, and striking a deal. Coach’s management is a notable exception. When recently asked about acquisitions, management replied, “We’ve talked about this many times…we have [an] enormous run rate organically with the Coach business, and we don’t see acquisitions as a imperative to driving double-digit, top-line and bottom-line growth.” Instead, Coach has used its extra cash to issue significant dividends and buy roughly 20% of its own shares over the past four years, increasing the amount remaining shareholders own of the company by 25%.

Sounds good, but why invest in Coach now? Historically, Coach’s share price has reflected how great a business it is. The ratio of its market value to its earnings has never been particularly attractive, at least not to me. But Coach’s growth in the US has disappointed investors the past year, causing its stock price to drop by over a third, essentially affixing it with a proverbial “35% OFF!” sticker. It continues to grow, but not as fast as it used to. The question for a value investor is not whether Coach can regain its previous growth trajectory and stock price momentum, it’s whether the price at which the market is offering Coach shares provides an attractive return compared to what the business will earn in the future. We emphatically believe the answer is yes. Coach is now the fund’s second-largest holding.

As a mid-range luxury provider, it is less exposed to the fickle vagaries of high fashion than its ultra-luxe brethren—brands like Hermès, YSL, and Chanel, or obscure, high-end brands with hard-to-pronounce names. CEO Lew Frankfort and chief designer Reed Krakoff have run Coach for the better part of the past two decades and have done an outstanding job of cultivating and thoughtfully growing the Coach brand. It’s been fashionable without being trendy, focusing more on “classic” looks than fads, and has become one of the more durable brands in fashion with a mass appeal. They could have achieved faster growth by licensing the brand to third parties or offering steep discounts to clear unwanted inventory, but this would have hurt Coach’s image in the minds of its customers and, eventually, its earnings. They run the business with the long term in mind. Frankfort, 66, will be staying on as chairman and giving up the CEO role next year to Victor Luis, who has overseen Coach’s successful international expansion.

Coach has a decent runway to expand in the US, but its major source of growth is Asia. It’s big in Japan, and it has the potential to be bigger in China. It grew sales in China by 40% last quarter. It’s still in the early phases of building out stores there, i.e., there’s a lot more growth to be had. An emerging class of Chinese consumers who desire to own quality fashion brands, but cannot afford European labels like Louis Vuitton, could increasingly opt for Coach. An interesting cultural fun fact, as well as an enormous opportunity for Coach, is that men make up about half the luxury handbag market in China. “Boundless” is the word management uses to describe the China opportunity, and I suspect they may be right.

As I see it, the major risk to the investment that would cause a permanent loss of our capital is that Coach becomes very uncool, very fast. While possible, I think it’s unlikely. Coach competes with some newer, mass-luxury brands like Michael Kors and Tory Burch, but Coach has always faced fierce competition. It’s managed to maintain a timeless appeal to large swaths of the handbag-buying population. At the price we acquired our shares, Coach doesn’t need to dramatically increase its sales for the investment to work out; it only needs to not deteriorate significantly.

Armanino Foods

Unless you’re a fashion-phobic, pesto-sauce aficionado based in Northern California, chances are you’re less familiar with Armanino than with Coach. Armanino Foods of Distinction, Inc., of Hayward, California, makes and sells frozen pasta sauce, different varieties of pesto, and stuffed pasta. While not as recognizable as, say, Prego, it’s carved out a nice niche for itself on the West Coast as being one of the more popular options for frozen pesto sauce. In a number of different supermarket chains I visited in various parts of California, Armanino was often the only brand of frozen pesto sauce they had. And yes, it’s delicious.

Like Coach and others in the fund’s portfolio, Armanino is a cheap compounder, which is getting pretty hard to find these days. (There are oodles of expensive ones.) Over the past ten years, it compounded its pretax earnings by 27% per year. Its return on invested capital is a gaudy 56%. It’s distributed just about all of its earnings the past five years to shareholders through buybacks and dividends, extending its dividend streak to 51 consecutive quarters. Its dividend yield is now 4.5%, not including its buybacks or frequent special dividends, and they’ve steadily increased dividends over time. Yet the market value of Armanino, including its debt and excess cash, is less than 12 times its after-tax operating earnings. Companies in the S&P 500 or Russell 2000 indices that are similar to Armanino—branded consumer-food companies with high returns on capital—can trade these days for well over 20 times after-tax earnings, and most of these businesses aren’t growing nearly as fast.

But Armanino isn’t in these indices. It isn’t followed by analysts. There are no other mutual funds that own shares of Armanino, according to Morningstar. It’s too small for most funds to own; even a major stake in the company would have no impact on the performance of most funds. But it can with the Bretton Fund. It’s an advantage we’ll try to make the most of while the fund’s at its current size, and with a gem like Armanino, we can report that bigger is not highly correlated with better.

As always, thank you for investing.

Stephen J. Dodson
Bretton Capital Management