April 21, 2015
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of March 31, 2015, was $25.47. The fund’s total return for the quarter was -0.97%, while the S&P 500 Index returned 0.95%.
Total Returns as of March 31, 2015
| 1st Quarter | 1 Year | Annualized 3 Years | Annualized Since 9/30/10 Inception | |
| Bretton Fund | -0.97% | 7.53% | 12.53% | 14.27% |
| S&P 500 Index | 0.95% | 12.73% | 16.11% | 16.57% |
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. Current performance may be lower or higher than the performance data quoted. You may obtain performance data current to the most recent month-end here or by calling 800.231.2901.
All returns include change in share prices, reinvestment of any dividends, and capital gains distributions. 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. The fund’s expense ratio is 1.50%.
Contributors to Performance
The largest impact on the fund during the quarter was Ross Stores, adding 1.0%. Detracting from performance was American Express, which took away 0.9% from NAV; the company unexpectedly lost a credit card partnership with CostCo, which accounted for a decent chunk of American Express’s charge volume. The stock’s return during the quarter was -15.5%. However, American Express continues to grow, benefitting from the ever-moving shift from cash and checks to cards. It also returns a lot of capital to shareholders through buybacks and dividends, and with the drop in the stock price, it’s once again pretty cheap. We think, despite this loss, the business will continue to perform well.
As a group, the railroads took performance down by 1.1%, and the large banks had a negative impact of 0.7% in the quarter. Other holdings with more modest impacts on the quarter’s performance were new addition PGT, adding 0.6%, and Coach, making a bit of a comeback and adding 0.5%.
Portfolio
| Security | % of Net Assets |
| Wells Fargo & Company | 13.0% |
| Ross Stores, Inc. | 9.3% |
| Armanino Foods of Distinction, Inc. | 4.9% |
| American Express Co. | 4.9% |
| Union Pacific Corp. | 4.6% |
| CSX Corp. | 4.3% |
| Norfolk Southern Corp. | 4.2% |
| JPMorgan Chase & Co. | 4.1% |
| Flowserve Corp. | 3.9% |
| Bank of America Corp. | 3.8% |
| Discovery Communications, Inc. | 3.7% |
| IPC Healthcare, Inc. | 3.4% |
| Carter’s, Inc. | 3.3% |
| The Gap, Inc. | 3.2% |
| PGT, Inc. | 3.0% |
| NexPoint Credit Strategies Fund | 2.6% |
| New Resource Bank | 2.1% |
| MasterCard Inc. | 2.0% |
| Aflac, Inc. | 1.9% |
| Community Health Systems, Inc. | 1.5% |
| Coach, Inc. | 1.5% |
| America's Car-Mart, Inc. | 1.3% |
| Standard Financial Corp. | 1.2% |
| Cash* | 12.4% |
*Cash represents cash equivalents less liabilities in excess of other assets.
We added four companies during the quarter, which we describe in detail below. In addition, we made one small purchase of an Australian engineering company, Cardno, which we subsequently sold before the quarter end.
PGT
PGT is a small, Florida-based window manufacturer. After Hurricane Andrew in 1992, Florida strengthened its building code to require houses in high wind areas—essentially the coastal crescent that runs from Tampa on the Gulf side, south to the Keys at the tip of the state, and up north to Daytona on the Atlantic side—to have either metal shutters placed over windows, or, as a much more aesthetically pleasing option, impact-resistant windows that won’t shatter when hit with high-velocity debris. Although a minnow in the nationwide window business, PGT is a giant in this niche, and in the fall of 2014 it bought its largest competitor, solidifying its dominant market share.
The process of making impact-resistant windows, which involves lamination and multiple phases, is more complex than producing regular windows. Perhaps unsurprisingly, PGT’s gross margins are roughly double the industry average. While lucrative, this Florida niche is too small for national window makers to develop an expertise in, leaving PGT with a nice competitive advantage. We also expect new housing starts in Florida to rebound from 2014’s 54,000 to something closer to the ten-year average, a bit over 100,000 per year.
MasterCard
This past quarter we added a company that we should have added years ago: MasterCard. No stranger to readers, or really anyone in the developed world, MasterCard and its bigger corporate twin, Visa, dominate the payments industry worldwide. Originally created and owned by the major banks, MasterCard sold shares to the public in 2006 and the company, along with its stock price, has been on a run ever since. MasterCard, along with the other major card companies including American Express, are the “rails” of our economy: they facilitate the world’s transactions. MasterCard does not take on the credit risk on its transactions; rather it’s a middleman between merchants and banks. For decades, large merchants and dozens—maybe hundreds—of technology companies have tried to circumvent the major payment systems, but no one’s yet to even put a dent in their business. The network effect of vendors and customers being on the same payment systems is just too powerful.
Our hesitancy to add MasterCard in the past was not due to uncertainty about the business; it always seemed just a little too expensive. (MasterCard trades for a price-to-earnings ratio of 24, while American Express’s is about 14.) As we’ve gotten to know the payments industry better, we’ve become more confident that MasterCard’s rapid growth can keep up for a long time, justifying its above-average price. Only 15% of the world’s transactions are done on cards or other electronic means; the rest is cash and paper checks. Think about your own spending patterns: 10 to 15 years ago, you might have been hesitant to pay for a $5 transaction at Walgreen’s with a credit card. Now, that’s the norm. The rest of the world will look more and more like this in the years to come.
Community Health Systems
The hospital industry is an anachronism. Why build a centralized behemoth of a building with tremendous overhead that is difficult to navigate, when so many functions can be miniaturized and distributed? The future belongs to urgent care clinics in shopping centers and stand-alone imaging centers, facilities that exist on a more human scale.
For now, though, the hospital remains the anchor of the healthcare system. It’s often the largest employer in town, the place people turn to when they truly are in trouble. Most hospitals are organized as nonprofits, many of which are run with the efficiency of businesses with no particular sense of urgency. There are a handful of large networks of private hospitals that have grown by buying underperforming hospitals and turning them around. One of these is Community Health Systems.
The hospital stocks have traded at comparatively low valuations because of a pending Supreme Court case, King v. Burwell. This lawsuit, which was argued at the Court in March and will be decided this summer, seeks to block the IRS from providing subsidies to individuals who purchase insurance on the federally operated insurance exchanges created as part of the Affordable Care Act (ACA).
If the Court sides with the plaintiffs, Community will lose some of its ACA benefit. We will be cushioned, at least partially, by our margin of safety: we invested at a low price-to-earnings ratio of roughly 12x current earnings. If the Court sides with the defendants, Community stands to be transformed. The open secret of medical care is that the uninsured usually do not pay. Hospitals can huff and puff, but they have little ability to recover unpaid medical bills. Community writes off 8% of its revenue annually due to this bad debt expense, on top of its explicit charity care program. In states with functional exchanges and Medicaid expansion, bad debt expense is closer to 4%.
NexPoint Credit Strategies Fund
We came across an interesting, and likely one-off, situation this past quarter in NexPoint, a closed-end mutual fund in the process of spinning off a real estate investment trust (REIT) from real estate assets the fund has accumulated. We were able to acquire the security at a discount to its net asset value and a yield of 8%, a rarity in this environment of low rates.
Cardno
We ventured outside the US to invest in Cardno, a civil engineering firm in Australia. Over the past decade, Cardno grew through acquisitions, eventually becoming a midsize, predominantly US company with specialized niche competence in the energy sector. The decline in the price of oil caused the company to revise its estimates and the share price dropped precipitously, leaving the shares very cheap.
The big challenge investing in the civil engineering sector tends to be the opacity of earnings, which makes the ability to trust management a key criterion. Projects can span multiple accounting periods, the timing of revenues and costs can involve some measure of judgment, and performance guarantees and penalties often lurk behind the scenes. We took comfort in the company’s consistent cash flow generation.
No sooner had we invested than the new CEO—who started only six months prior—suddenly retired with immediate effect, which was rather unsettling. There are many innocuous reasons that come to mind, but in an industry that relies so heavily on accounting accuracy and management integrity, we decided we didn’t know enough about the abrupt CEO departure and chose to honor the cardinal rule of hiking in a snowstorm: if you can’t see where you’re going, don’t. We sold.
Team Bretton
As we discussed in the annual report, Raphael de Balmann will be joining the fund as co-portfolio manager on May 1, and so far, he’s been instrumental in helping get new investments into the fund. He and his family are in the process of settling back into the San Francisco Bay Area after a number of years living in New York.
Our analyst, Cameron Susk, recently gained admission to Columbia Business School, Warren Buffett’s alma mater and home of the leading value investing program. He’ll be leaving us in the fall; we congratulate him and wish him all the best. He’s been a great help to the fund.
As always, thank you for investing.
Stephen J. Dodson
President
Bretton Capital Management