This shareholder letter is part of the Bretton Fund 2016 Annual Report (pdf).
February 17, 2017
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of December 31, 2016, was $26.12. For the year, the fund returned 10.68% compared to the S&P 500’s 11.96%.
Total Returns as of December 31, 2016 (A)
| 4th Quarter | 1 Year | Annualized 3 Years | Annualized 5 Years | Annualized Since Inception (A) | |
| Bretton Fund | 8.02 | 10.68% | 4.31% | 10.68% | 10.83% |
| S&P 500 Index (B) | 3.82% | 11.96% | 8.87% | 14.66% | 13.78% |
Calendar Year Total Returns (A)
| Bretton Fund | S&P 500 Index (B) | |
| 2016 | 10.68% | 11.96% |
| 2015 | -6.59% | 1.38% |
| 2014 | 9.79% | 13.69% |
| 2013 | 26.53% | 32.39% |
| 2012 | 15.66% | 16.00% |
| 2011 | 7.90% | 2.11% |
| 9/30/10 – 12/31/10 | 6.13% | 10.76% |
| Cumulative Since Inception | 90.23% | 124.14% |
(A) All 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® Index is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the US stock market, as determined by Standard & Poor’s, and captures approximately 80% coverage of available market capitalization.
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%.The fund’s principal underwriter is Rafferty Capital Markets, LLC.
4th Quarter
The fund returned 8.02% in the fourth quarter, compared to 3.82% for the S&P 500. Our investment in banks, as well as construction supplier HD Supply, surged on investor optimism in those sectors following the election. Bank of America added 1.8% to performance, while HD Supply added 1.6%, Wells Fargo 1.3%, and JPMorgan Chase 1.3%. Visa and new holding Continental Building Products each took away 0.1% from the fund.
In the quarter, we sold our shares in Nordson as its stock price almost doubled from the start of the year, reaching our target valuation. Our annualized return (aka, internal rate of return) on Nordson was 19.4%.
We added two companies in the quarter: wallboard manufacturer Continental Building Products and paint company PPG Industries. We discuss these investments in more detail below.
Contributors to Performance for 2016
For the year, the fund benefited from a rebound in bank and infrastructure stocks. HD Supply added 2.1% to the fund’s performance, and the other main contributors were Union Pacific with 1.9%, Bank of America 1.8%, JPMorgan Chase 1.5%, Valspar 1.3%, Nordson 1.1%, and Ross Stores 1.1%.
We were hurt by two of our healthcare investments, along with our real estate agency investment. They were Community Health Systems, taking -0.7% off the fund, MEDNAX -0.4%, and Realogy -0.3%.
Tax Distributions
The fund made a long-term capital-gain distribution of $0.42651 per share to shareholders on December 22, amounting to 1.6% of the fund’s NAV. There were no other distributions during the year.
Portfolio
| Security | % of Net Assets |
| Alphabet, Inc. | 7.5% |
| Wells Fargo & Company | 6.5% |
| Union Pacific Corp. | 6.5% |
| HD Supply Holdings, Inc. | 6.3% |
| Bank of America Corp. | 6.1% |
| AutoZone, Inc. | 6.1% |
| JPMorgan Chase & Co. | 5.4% |
| MEDNAX, Inc. | 5.3% |
| Ross Stores, Inc. | 5.1% |
| American Express Co. | 5.0% |
| Berkshire Hathaway Inc. | 4.6% |
| Mastercard, Inc. | 4.6% |
| Carter's, Inc. | 3.9% |
| Valspar Corp. | 3.9% |
| Discovery Communications, Inc. | 3.7% |
| Visa, Inc. | 3.3% |
| Continental Building Products, Inc. | 3.3% |
| PPG Industries, Inc. | 2.7% |
| Armanino Foods of Distinction, Inc. | 2.2% |
| Flowserve Corp. | 1.9% |
| Verisk Analytics, Inc. | 1.4% |
| Whole Foods Market, Inc. | 1.2% |
| Cash* | 3.5% |
* Cash represents cash equivalents less liabilities in excess of other assets.
Portfolio Discussion
Retail & Consumer
The retail industry in general is undergoing a tectonic shift as consumers shift their spending online. It’s a whole lot easier to get things delivered to your door than fighting your way through traffic and crowds to get to a Macy’s that may not even have what you want in stock. Much of retail is under pressure from Amazon and others, and that pressure isn’t going to abate, ever. A lot of retail stocks have suffered and are trading at ostensible bargains, yet we’re likely to pass on almost every one of them. Investing in retail today, one has to ask, “Why can’t Amazon eventually replace this business?” Retailers that can thrive in this new environment are ones whose products or shopping experiences are somehow insulated from online competition. Most auto parts purchased at AutoZone are needed right away; many customers are mechanics who can’t afford to wait for even one- or two-day delivery for critical parts. Ross Stores (and its primary competitor, TJX with its T.J. Maxx and Marshalls stores) provides a rapid-fire, “treasure hunting” experience, with thousands of distinct items at enormous discounts; in effect the Ross shopper is staffing her own distribution center, purchasing items with an average price comparable to UPS shipping costs. We believe the retailers we own are set for the internet age.
AutoZone’s steady growth in stores (+4%) and sales per store last year (+2%), combined with buying back 5.3% of the company’s stock, led to a 13% increase in earnings per share. We think the company can continue to do this for years. The stock returned 6.7% last year.
Ross Stores was on pace to increase sales 7% and earnings per share 12%. The market rewarded Ross’s stock price, giving it a total return of 22.9% last year.
Baby clothes producer Carter’s is set to increase its 2016 earnings per share 9% over 2015 levels. Its stock price lagged, in part due to investors expecting even higher growth and general concern about the apparel sector, for a total return of -0.9%. We expect this lull to be temporary; management expects earnings per share growth to return to low double digits this year.
Armanino Foods of Distinction, our maker of frozen pesto sauce, rebounded from a tepid 2015 and hit record sales and earnings in 2016. It has also revamped its production process, doubling capacity and exceeding industry food safety standards. Its stock returned 16.1%.
Whole Foods Markets continued to struggle, increasing its earnings per share by only 4%, due to a 2.5% decline in sales per store. After a rough few quarters, the business seems to be stabilizing, and we still believe the company has a long runway to build stores. Grocery shopping is very much a local activity, and it’ll be many years before Whole Foods reaches saturation. However, competition isn’t likely to get any easier. The stock’s total return was -6.2%. At 1.2%, it remains a small position for us.
Industrial Products & Transportation
Despite an early decline, Union Pacific’s traffic stabilized toward the end of the year, which along with solid pricing gains led to a total return of 34.0% for the stock. Earnings per share dropped 8%, but is expected to gain 12% in 2017.
HD Supply had a good year; its stock price had an even better year. It refinanced and paid down its heavy debt load, sold off an ancillary division, and grew its earnings and free cash flow significantly. The market rewarded the company by boosting its stock price 43.4%, though some of that is based on an anticipated—but yet-to-be substantiated—boon in infrastructure construction spending.
The stock price of new addition Berkshire Hathaway increased 12.8% over our average cost. Warren Buffett’s conglomerate benefited from its large holdings of bank stocks, as well as its broad collection of industrial and insurance businesses.
Flowserve, the maker of industrial-scale pumps and seals—much of it for the energy sectors—also saw a sharp stock price rebound, producing a total return of 18.3%, based on higher oil prices and increased investor optimism about infrastructure spending. Earnings per share was on pace to drop 30% from the previous year. We sold around half our position, as we became less enthusiastic about the timing of a significant turnaround and took advantage of the share price rally.
Banking
It took a little longer than we thought it would, but we’re beginning to see the benefits of higher interest rates on our bank investments. The Federal Reserve raised its benchmark interest rate target toward the end of the year, after almost a year of no changes and a decade pushing zero, and indicated it will raise rates a few more times in 2017. JPMorgan Chase and Bank of America are more sensitive to short-term rates than Wells Fargo and thus saw a more immediate benefit, but we expect all three to benefit significantly from higher rates combined with low loan losses and tight cost control. Furthermore, the regulatory environment is more pro-bank than we (or the market) would have expected a quarter ago. Despite their run-ups, the stocks remain fairly cheap relative to the companies’ abilities to grow earnings per share.
Wells Fargo had a mixed year, to put it mildly. Regulators discovered that branch staff members at many Wells locations opened thousands of accounts without authorization— sometimes going so far as to forge signatures—to meet overly aggressive sales goals set by management. Despite the headlines and public antipathy, the immediate financial hit to Wells wasn’t very large, but could eventually be meaningful if customers defect en masse (so far, they haven’t) or if this issue is the tip of a larger compliance iceberg. Wells has since replaced both its CEO and retail banking chief, and we are watching closely to see how well they do in restoring their customers’ trust. Earnings per share declined 3% for the year, while its stock’s total return was 5.8%.
JPMorgan Chase benefited from the higher rates and greater trading activity, particularly toward the end of the year. Earnings per share increased 3%; its stock returned 34.9%.
Bank of America also benefited from higher rates and continued to cut its legacy costs stemming from the financial crisis. Earnings per share increased 15%, and its stock returned 35.4%.
Payments
Our three investments in the payments sector all have what we look for in long-term compounders: a long runway for healthy growth (the world is rapidly moving from cash to card), a defensible business (it’s very difficult to create a payments network from scratch), and the ability to return excess capital to shareholders (all three companies issue dividends and buy back stock).
After coming off a tough 2015—losing its largest card partner in Costco—American Express spent the year trying to make up for that lost business. Helped by a one-time gain from the sale of its Costco-related loans, earnings per share increased 12%. It spent much of that gain on promotions and marketing, trying to woo back old customers, retain its most valued customers from increased competition, and add new cardholders with large incentives. Its stock returned 10.1% last year, and it remains a bargain compared to its earnings.
Mastercard increased its adjusted earnings per share by 19%, and we expect future growth to be be close to its historic rate of low-to-mid teens for a long time.
We added Visa last year as we felt the market was significantly underestimating the ben- efits of its reunion with Visa Europe, which had been separately owned and run by its European bank partners. We also didn’t think investors were fully appreciating for how long the company will continue to see high growth. Like Mastercard, Visa isn’t cheap based on its current earnings, but given its growth, we think we’ll see a nice return from it. Our return to date on the stock is -2.5%.
Media & Technology
Alphabet, Inc., aka Google, became our largest holding this year. Though the stock only returned 3.6% for the full year, we loaded up on shares during a handful of weak spells; our overall gain to date is 17.5%. Despite its large size (it’s one of the world’s largest companies by market capitalization), earnings per share grew 22% last year and would have grown even more if not for the unfavorable currency swing. Unlike earlier in its history, the company seems to be increasingly considerate of outside shareholders and maintaining spending discipline. Despite this very fast growth rate and capital restraint, it trades at only a slight premium to the market.
Discovery Communications, proprietor of its eponymous Discovery Channel and other channels, had an outstanding year, which unfortunately was obscured by broader industry concerns. Earnings per share, before currency fluctuations, increased more than 20% last year, and management believes they can grow cash flow and earnings per share in the low teens for the next few years. Despite this performance, the stock rose only 4.8%. More US subscribers are “cutting the cord” from traditional providers and watching video online. More video subscribers are buying “skinny bundles,” with fewer channels at a lower cost, and some of these bundles don’t include all of Discovery’s channels. Discovery’s programming blend is well-suited for linear programming—it is fun to watch and has devout viewers the company calls “superfans”—but unlike, say, Disney’s iconic movies, Discovery’s content doesn’t do as well in an on-demand world. We share these concerns. However, the market is offering us a growing, globally distributed platform of original content for a 9% free cash flow yield. Management has been a good steward of capital, buying back stock and making prudent acquisitions, and controlling shareholder John Malone has a history of seeking value-maximizing deals for shareholders. Discovery’s overhead is roughly similar to its operating income, which would mean tremendous synergies in a combination with Fox or another content owner. And we can’t help but notice that both Netflix and Amazon have been pushing hard to own their own content. We are cautiously optimistic that the low valuation and strategic value balance the industry risks.
Verisk, the provider of data and software for various industries including property insurance, was on pace for 9% earnings per share growth from its core business. The stock returned 5.8% last year.
Building Products
Valspar announced its acquisition by larger paint company Sherwin-Williams early in the year, which led to a 26.7% total return. We sold a large portion of our position after the announcement, though we continue to hold some remaining shares. There’s a small gap between the current share price and the eventual acquisition price, and we gain some favorable capital-gains tax treatment for the shares we end up owning for longer than a year.
We like the paint business so much that we decided to invest in another one. We added PPG Industries, the world’s largest maker of paints and other coatings, to the fund in the fourth quarter. Based just outside Pittsburgh and originally known as Pittsburgh Plate Glass Company, the company has been around since 1883. Over time it has transformed itself from a glass and chemicals maker—both poor, volatile businesses—to a higher-return, higher-margin coatings company, patiently selling off its legacy businesses and opportunistically buying up smaller paints and coatings companies at attractive prices. Organic growth in the business is relatively modest (the phrase “watching paint dry” comes to mind), but PPG has been able to grow its coatings revenue by 12% a year for 10 years through good acquisitions. The coatings business has high returns on capital since it’s such a defensible industry. Given the economies of scale of both manufacturing and distribution, there aren’t really new entrants. We’ve acquired PPG at a reasonable price and expect to see a nice return from a high return of capital combined with smart acquisitions. We have a gain of 2.9% to date.
Also in the fourth quarter, we added Continental Building Products, a maker of wallboard. Made out of gypsum and thick paper and often known as drywall, wallboard is used by builders for most residential walls built in the US today. Like many building products, the wallboard industry saw rough times after the housing bust, but has slowly rebounded with the housing market. New home construction is still way below its 50-year average, so there’s a lot more room to grow. More important, the wallboard industry has consolidated and is much more rational about pricing. The product essentially is a commodity, but the combination of its low price and high relative shipping cost leaves each region with only a few competitors. Due to a wrinkle in accounting standards, Continental’s free cash flow is considerably higher than its reported earnings—which are usually similar for most companies—and we think the market is missing this important detail. Continental’s management is taking advantage of its low stock price and high free cash flow by buying back as much stock as it can, acquiring 10% of its own shares the past 18 months. We are down 2.6% on the investment so far.
Healthcare
Doctor-staffing company MEDNAX had a mediocre year, with roughly flat earnings per share growth and a stock price decline of 6.5%. MEDNAX grows mostly through acquisitions, buying private doctor groups in its core historic verticals of anesthesiology and neonatology. As the company has expanded its scope to teleradiology (remote doctor assessments of X-rays and CT scans) and other fields like hospital billing software, it’s had growing pains in achieving the same economics with these acquisitions. Management maintains these are short-term speed bumps (e.g., there’s a decent lag time between when you hire and start paying a radiologist and when she passes multiple states’ board examinations to be able to start working), and we’re inclined to agree. Revenue grew 15% last year, and we think earnings will catch up eventually.
Investments Initiated in 2016
Berkshire Hathaway
Continental Building Products
PPG Industries
Realogy Holdings
Visa
Investments Exited During 2016
| Investment | Internal Rate of Return |
| PGT Industries | 3.7% |
| Community Health Systems | -66.9% |
| Nordson | 19.4% |
| T-Mobile | 4.5% |
| Centene | 11.2% |
| Realogy Holdings | -32.2% |
As always, thank you for investing.
Stephen Dodson Raphael de Balmann
Portfolio Manager Portfolio Manager