October 20, 2015

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of September 30, 2015, was $23.59. The fund’s total return for the quarter was -8.67%, while the S&P 500 Index returned -6.44%.

Total Returns as of September 30, 2015

3rd Quarter1 Year (A)Annualized
3 Years (A)
Annualized 5 Years and
Since Inception (A)
Bretton Fund-8.67%-1.94%8.03%11.03%
S&P 500 Index-6.44%-0.61%12.40%13.34%

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 fund’s performance was hurt this quarter by a number of investments: the Federal Reserve delayed its long-planned increase in interest rates, hurting the fund’s bank investments (Wells Fargo, JPMorgan Chase, and Bank of America) and affecting performance by -1.2%; broader industry concerns about healthcare companies hurt the stock price of Community Health Systems, a -1.2% impact on the fund; new holding HD Supply stock dropped—for reasons unclear other than general market/economic anxiety—a hit to the fund of -0.9%; fears about pay-TV “cord-cutting” affected the whole media sector, including our Discovery Communications holding, a -0.9% impact; and slower rail traffic, particularly coal, hurt our rail investments, an effect of -0.9%.

The bright spot for the fund this quarter was IPC Healthcare, which announced it will be acquired by a larger company in an adjacent sector, TeamHealth, for $80/share, versus our average cost of $42/share. This boosted the fund by 1.2%.


Security% of Net Assets
Wells Fargo & Company8.3%
Ross Stores, Inc.5.8%
American Express Co.5.4%
Union Pacific Corp.5.4%
AutoZone, Inc.4.9%
Google, Inc. (Alphabet, Inc.)4.7%
MEDNAX, Inc.4.5%
MasterCard, Inc.4.4%
HD Supply Holdings, Inc.4.3%
IPC Healthcare, Inc.4.1%
Valspar Corp.3.9%
PGT, Inc.3.8%
Discovery Communications, Inc.3.8%
Armanino Foods of Distinction, Inc.3.3%
Carteru2019s, Inc.3.3%
JPMorgan Chase & Co.2.8%
Flowserve Corp.2.7%
Community Health Systems, Inc.2.7%
Bank of America Corp.2.6%
Nordson Corp.2.6%
CSX Corp.2.3%
Whole Foods Market, Inc.2.0%
The Gap, Inc.1.4%
Centene Corporation1.3%
New Resource Bank1.3%
T-Mobile US, Inc.1.2%

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

We exited four companies in the quarter: Norfolk Southern, Aflac, NexPoint, and HMS. We invested in Norfolk Southern along with our other two railroads, Union Pacific and CSX, at the fund’s inception in September 2010, and it generated an annualized return of 12.8%. The railroad sector has been under significant pressure from the decline in coal volume, with the eastern railroads more exposed to coal than the western ones. As western operator Union Pacific’s share price dropped during the year, becoming increasingly compelling, we reallocated our position in Norfolk Southern to Union Pacific. We also bought Aflac at the fund’s inception, exactly the wrong time (in hindsight) for a firm with 75% of its revenue in Japanese yen. While Aflac’s performance in Japan was fine and the earnings yield excellent, the company was no match for Abenomics, which devalued the currency by over 35%. Our annualized return on Aflac was 6.0%. NexPoint was a brief investment to take advantage of a spinoff; we did not intend to be long-term holders of a REIT, and were not. HMS was an even briefer investment, described more comprehensively below. Both had an immaterial impact on the fund.

The fund initiated five investments during the quarter: Google, HD Supply, Whole Foods Markets, Centene, and HMS.

We have generally been averse to technology companies for a couple of reasons: 1) technology changes so rapidly that it’s hard to tell which company is going to be around and successful in the future, and 2) tech companies have a habit of treating their public shareholders as nuisances instead of as partners, often prioritizing cool deals over shareholder returns.

Like any technology firm, Google (which as of October 1 formally renamed itself Alphabet, Inc.) is only as good as its products. If someone invented a demonstrably better search engine tomorrow, she could well have half the market for search within a year or two. Nokia, MySpace, and Netscape are but three members of the large fraternity of firms that were leapfrogged. Clorox and Colgate can afford to be complacent; Google cannot. That said, Google’s long-held dominance in search and advertising has, if anything, grown stronger in recent years. What was once a static desktop URL that customers needed to visit is now an integrated suite of search engine, browser, mapping, and productivity applications available anywhere there is a screen. Its products are so fully ingrained in people’s lives that it would be difficult for a new entrant to displace Google. If Larry Page and Sergey Brin were young grad students at Stanford today trying to compete against a Google, we don’t think they’d stand much of a chance. They’d face a much tougher competitor than AltaVista.

Google’s product excellence has been obscured in recent years by a rather mixed financial discipline. Its forays into tangential products (e.g., Google Glass, a hoverboard prototype) may or may not pay off, but to date these investments haven’t been huge compared to how much it makes on its enormously profitable search and advertising business. The same can’t be said for its $12.5 billion acquisition of Motorola Mobility, which still seems to be in search of a rationale, and its attempted $6 billion acquisition of Groupon, saved only by the kindness of Groupon’s rejection. Management also missed a big opportunity to boost shareholder returns by using some of its excess cash to buy back its own shares at a fraction of today’s price. Even a highly profitable company isn’t worth much if management isn’t going to reinvest its cash well.

Google recently took two actions that give us hope that its back of house is catching up with the front of house. 1) It announced a restructuring that will separate the core search business from the self-styled “moon shots.” While changes in reporting do not themselves generate value, we suspect the first step to better discipline may be better measurement. 2) Google also hired former Morgan Stanley CFO Ruth Porat, esteemed for her ability to manage costs across a large organization. These changes give us confidence about Google’s desire to control costs and use its cash wisely. It’s an excellent business, and the stock is very reasonably priced.

HD Supply
HD Supply (HDS) is the former industrial distribution business of Home Depot. It comprises several businesses targeting products for maintenance, repair, and operations for different end markets. The facilities maintenance division, which represents the majority of HDS’s cash flow, serves multifamily and commercial buildings. Instead of each superintendent or maintenance crew going to Home Depot and Bed Bath & Beyond each morning, HDS will deliver things like HVAC parts, faucets, and coffee filters. The company has similar distribution businesses focused on municipal water systems, construction equipment, and residential interior goods like flooring and countertops.

Distributors typically suffer from one of two major ailments: low gross margins and weak free cash flow. Low gross margins come with the territory; why should a middleman with no intellectual property be able to mark up someone else’s product? Weak free cash flow often comes from maintaining the large inventory necessary for same-day delivery of a wide range of goods.

HDS has so far managed to avoid both traps by being the largest provider in a business where scale is critical (apartment building managers typically only want to deal with one provider). It has both high gross margins and a fast cash conversion cycle. Plus, each incremental sale on its delivery routes is very lucrative. It’s growing rapidly and trading for a low price.

Whole Foods Markets
As each of us can personally attest, Whole Foods runs a great grocery store: clean and compelling, with a broad selection of prepared foods and organic produce. It’s a far cry from the fluorescent A&Ps and Pathmarks of a few decades ago with their shrink-wrapped meat and shelf-stable cakes. About the only thing better than the shopper’s experience in a store is the investor’s. A typical 40,000-square-foot Whole Foods store costs about $2 million to build out. Including another $1 million of inventory and other working capital, a store ties up about $3 million of its owners’ capital. The store generates $990 of sales per square foot, for total store revenue of $39.6 million annually. The costs of those goods are about $24.4 million, which leaves a gross profit of $15.2 million. Less wages and benefits for store-level employees ($8.6 million) and rent ($1 million), that original $3 million investment throws off close to $5.5 million of cash each year.

These economics are not a secret. For the most part, the market has recognized this value by giving the company a high stock price relative to its earnings. And competitors have recognized this value by entering the market: both new entrants, such as Sprouts and Fresh Market, and established firms, such as Kroger and Safeway, are investing in improvement. Recently, a stream of recent bad news—a slower pace of per-store growth, lower margins from increased competition, accidental overcharging of New York customers—cut the stock price in half, bringing the valuation to within the realm of reason.

The stock price still isn’t quite a bargain, but we found it attractive enough for a small position. Despite the increased competition, we still believe the company holds a strong competitive advantage and, importantly, has a long runway with the opportunity to double its existing fleet of 424 stores.

While Medicare tends to attract the most attention, its sibling Medicaid is actually the nation’s largest health insurance program, with about 72 million enrollees—more than one in five Americans. Indeed, the Affordable Care Act (ACA) increased Medicaid enrollment by 14 million people, 2 million more than the entire population purchasing insurance on the state and federal ACA exchanges. Medicaid programs are administered on a state basis, albeit with heavy Federal regulation. Increasingly, state governments have chosen to outsource these programs, and the associated risk of cost overruns, to private firms. Centene is the largest firm in this sector.

Roughly 90 cents of every dollar that comes in the door goes right back out to medical care providers. Broadly speaking, Centene does not control this money: the plan contracts specify the nature of claims to be paid, and Centene is bound to honor legitimate claims. As a measure of risk, it makes sense to look to the total claims volume and understand that a mispriced contract can do significant damage. However, to understand the drivers of the company, it’s best to focus on the money that is left over after the claims are paid.

After all claims are paid, Centene has about $50 per member per month. It spends close to $35 per member per month running its business—all the costs from recruiting doctors to paying for its IT network to cutting checks. The remaining $15 is shared between the IRS and the shareholders. Nearly all of Centene’s expenses—except, of course, the tax expenses—are fixed, while its revenue scales with the membership. Furthermore, each of Centene’s competitors has the same basic economics. In combination, a potential acquirer can offer a generous multiple of profits and generate enormous savings for itself by avoiding all of the duplicative overhead expenses.

Centene was so eager to grow that it acquired a struggling competitor, Health Net, at a rich price in cash and stock. Investors—many of whom may have expected Centene to sell itself to the rapidly consolidating commercial health insurance industry—reacted by selling Centene. In two months, Centene’s share price fell by more than the entire purchase price of Health Net. This created an opportunity for us to buy Centene stock for a modest price, even though the integration of Health Net should yield close to a 50% increase in earnings in the next two to three years.

HMS is a small healthcare IT business that focuses on “program integrity”: making sure that people who file claims for benefits are actually entitled to them, that the correct insurance policy is debited, and that healthcare providers actually provide the services for which they bill.

The two core customers for HMS had been the Center for Medicare Services (CMS), a federal agency, and the various state Medicaid agencies. Unfortunately, shortly after we invested in HMS, the firm lost its contract for New Jersey’s Medicaid program. The contract loss itself was not the end of the world, but the end of the streak of continuous renewals caused us to reconsider our investment thesis that the Medicaid business was rock-solid. When we are lost, we pull over and ask for directions; we don’t keep driving on hope. We sold and await more clarity.

As always, thank you for investing.

Stephen Dodson ?         ? Raphael de Balmann
Portfolio Manager         Portfolio Manager