October 22, 2013
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of September 30, 2013, was $22.52. The fund’s total return for the quarter was 2.64%, while over the same time period, the total return was 5.24% for the S&P 500 Index and 6.03% for the Wilshire 5000 Total Market Index.
Total Returns as of September 30, 2013
| 3rd Quarter | 1 Year | Annualized 3 Years and Since 9/30/10 Inception | |
| Bretton Fund | 2.64% | 18.26% | 16.55% |
| S&P 500 Index | 5.24% | 19.34% | 16.27% |
| Wilshire 5000 Total Market Index | 6.03% | 20.96% | 16.48% |
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
For the second quarter in a row, the most significant contributor to the fund’s performance was Armanino Foods of Distinction, adding 1% to the fund’s performance this quarter. The investment has returned 74% since our purchase earlier this year, and I believe it remains attractively valued. The other main contributor was good ol’ Ross Stores, quietly compounding away and adding 0.8% to the fund.
The two main detractors to the fund’s performance were Coach and New Resource Bank, each shaving 0.3% off the fund. Not much worth noting happened to the fund’s investments this quarter, and in general, one can’t make too much of three-month stock price movements. What matters is that Armanino, Coach, and New Resource Bank all increased their earnings and continue to have cheap stock prices.
Portfolio
| Security | % of Net Assets |
| Wells Fargo & Company | 11.4% |
| Coach, Inc. | 7.9% |
| America's Car-Mart, Inc. | 7.7% |
| Ross Stores, Inc. | 7.0% |
| Armanino Foods of Distinction, Inc. | 6.0% |
| Aflac, Inc. | 5.8% |
| Norfolk Southern Corp. | 4.9% |
| JPMorgan Chase & Co. | 4.7% |
| Union Pacific Corp. | 4.5% |
| American Express Co. | 4.5% |
| CSX Corp. | 4.1% |
| Carter’s, Inc. | 3.6% |
| New Resource Bank | 2.7% |
| The Gap, Inc. | 1.8% |
| Standard Financial Corp. | 1.6% |
| SI Financial Group, Inc. | 1.2% |
| Apollo Group, Inc. | 0.8% |
| Cash* | 19.9% |
*Cash represents cash equivalents less liabilities in excess of other assets.
For another quarter, the fund did not initiate or eliminate any investments. Stocks have returned 16% a year for the past three, and at the risk of stating the obvious, that rate of return is not, by any means, sustainable. Bargains these days are hard to come by. The market isn’t as overvalued as it was in 1999–2000, but a major difference between then and now is that there aren’t many pockets of hidden value where long-term investors can take refuge. Circa 1999, if you had the foresight to avoid buying General Electric stock at a price of 47 times its earnings, Wal-Mart at 58 times, or Pets.com at any price, you could have found good, solid—albeit boring—businesses for stupid cheap prices. Today, even the boring businesses are going for exciting prices. Financial companies, particularly banks, are probably the most undervalued sector of the market, despite being past the worst of the financial crisis, and the fund has been selectively adding to those positions. Overall, things aren’t crazy, but it’s pretty hard to find low-risk, high-return investments. I love the investments we have now and believe them to be of the low-risk, high-return variety; I do wish we had a few more like them to add to the fund.
The Artificial Intelligence Investor
IBM’s Deep Blue defeated Garry Kasparov in 1997. In 2011, another IBM computer, Watson, defeated Jeopardy! champion Ken Jennings. In 2018, will a new IBM computer—the Graham-and-Dodd 9000?—defeat its company’s largest shareholder, Warren Buffett, at his own game?
Unlikely. But it brings up an interesting question: How will advanced computing affect the staid craft of value investing? The ways in which technological change will affect jobs in general is the central topic of a new book from economist Tyler Cowen, Average is Over, which, along with his blog, Marginal Revolution, I enthusiastically recommend. Average is Over joins Race Against the Machine (by Erik Brynjolfsson and Andrew McAfee) as recent, excellent economics books on how intelligent machines and automation will impact labor markets. (One can safely infer from the titles that their prognosis for unskilled labor in the US is not bright.)
Cowen doesn’t cover investing specifically. He does write about chess and how it’s evolved with sophisticated computing. Traditional chess still gets all the attention, but the most exciting corner of the chess world is Freestyle chess, where players form teams and are allowed to consult books, use computers, call friends, whatever. Human-versus-machine games are no longer interesting because chess applications are now so good they can almost always defeat the greatest chess players in the world. But human-plus-machine versus other human-plus-machine combos is a lot more interesting. As of now, human-computer teams are much more successful than computers by themselves. Intriguingly, the dominant teams are not led by grandmasters, but by those with good-enough chess skills, strong computer knowledge, and the ability to quickly synthesize and appropriately weight data from various sources.
On his own, Cowen uses a chess program called Shredder and plays it against itself, overriding the decisions of one side every once in a while. “In essence it’s ‘me plus Shredder’ against Shredder. The human-computer team usually wins.… For me plus Shredder to beat Shredder, I don’t have to be as good as Shredder, I simply have to understand the game well enough.” And this is a key insight of the book. Computers are powerful tools used by humans; they’re not (at least not yet) sentient beings that are taking over humanity. More of our world will look like Freestyle chess, with the most successful participants being adept at using programs, but more important, being able to accurately gauge both their own and computers’ limitations.
Finance, of course, has already been significantly impacted by technology, particularly in short-term trading and arbitrage. Computers are quite adept at taking advantage of short-term inefficiencies, with their clearly defined parameters, quick feedback loops, and susceptibility to speed. Technology has had an impact on long-term investing as well, though less so, with the main contributions being spreadsheets’ usefulness in quickly projecting future cash flows—and thus value—and database searches that easily identify the cheapest stocks based on simple metrics like price-to-earnings ratios and returns on equity.
It’s hard to say definitively, but I strongly suspect these tools have made the market more efficient in some ways. Benjamin Graham, the godfather of value investing, earned much of his returns through “net-net” investments, which are companies trading for less than their working capital. A bona fide net-net is extremely rare in recent decades, probably in part because of the ease of finding them with computer-generated searches and screens. And while they can occasionally be found, one could not consistently build an investment strategy today based primarily on net-nets. They just don’t exist as much as they used to.
I expect financial modeling and search/screening programs to continue to improve and help value investors identify mispriced securities, but I think there’s somewhat of a limit to their usefulness. Unlike chess, which has very precise data and a strict input-output relationship, investing is simply way too messy. It’s a fair bet to say that, within our lifetimes, no computer will be able to accurately predict what Ross Stores will earn 10 years out. Screens can be useful and can point value hunters in the right direction, but while the investable universe is large, it isn’t endless. There are roughly 3,700 listed US stocks, which may sound like a lot, but the composition doesn’t change significantly year to year. Over time, a diligent investor can at least familiarize himself with them, particularly those in his wheelhouse.
I think the more interesting prospect is technology’s potential to help an investor understand his own limitations better. One of the most underrated aspects of investing is self-awareness: The best investors are excellent at knowing when they know something, when they don’t, and why they made the mistakes they did. Of course, being highly self-aware is easy to say, but it’s devilishly hard to do. I now keep my company analyses in an online system that’s easily searchable and maintain a spreadsheet of the 1,000 or so companies I’ve looked at over the past five years. I can see where I’ve been right—and wrong—and when I’ve missed things I shouldn’t have. The system is helpful, but crude, and I can see how better software would help me understand my own gaps in knowledge and biases.
Overall, I expect technology overall to create more opportunities for thoughtful, long-term investors, not less, situations like net-nets aside. Technology has a bias toward measurable, high-volume, repeating events—in other words, short-term stock-price movements—which aren’t as impactful as long-run events. What matters more: predicting Starbucks’s stock price will be down 2% today, or buying it 20 years ago and seeing an almost 50-fold return? Yet we see an increasing focus on the short-term. Technology has eroded attention spans; average holding periods for stocks continue to decline. This may mean more frequent bubbles and busts, which can reward those with longer investment horizons. There’s much more ambiguity in the long term, which makes it harder for technology to have an impact. There will always be an opportunity for those who know their own limits and can think critically about the ambiguous.
Cowen might agree; he’s said, “Wisdom and modesty will become much greater epistemic virtues in this future scheme.” I try to keep that in mind as I manage your capital.
As always, thank you for investing.
Stephen J. Dodson
President
Bretton Capital Management