This shareholder letter is part of the Bretton Fund 2018 Annual Report (pdf).
February 19, 2019
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of December 31, 2018, was $30.01, and the total return for the year was –1.94%.
Returns as of December 31, 2018 (A)
| 4th Quarter | 1 Year | Annualized 3 Years | Annualized 5 Years | Annualized Since Inception | |
| Bretton Fund | –13.51% | –1.94% | 8.65% | 5.64% | 10.05% |
| S&P 500 Index (B) | –13.52% | –4.38% | 9.26% | 8.49% | 12.33% |
Calendar Year Total Returns (A)
| Year | Bretton Fund | S&P 500 Index |
| 2018 | -1.94% | -4.38% |
| 2017 | 18.19% | 21.83% |
| 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 | 120.47% | 161.10% |
(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
In a rough fourth quarter for the stock market, the fund was hit hardest by the decline in Continental Building Products, which took 2.0% off fund performance. The company reported great earnings growth, but its stock price was hit by the negative sentiment surrounding the broader housing and building products sector. Like Continental, Alphabet announced positive earnings, but the market downturn pulled the stock down, taking 1.5% off the fund. TJX Companies hurt performance by 1.3%.
The only significant positive contributor in the quarter was AutoZone, which added 0.5% to the fund as both sentiment and earnings rebounded for the auto-parts retailer.
We added auto insurer Progressive to the fund, which we discuss below.
Contributors to Performance for 2018
For the year, the largest positive contributor was Mastercard, adding 1.3% to performance, as it keeps up its rapid growth. After a weak 2017, AutoZone had a nice rebound in 2018, adding 1.1%. TJX also had a bounceback year and added 0.8%.
Carter’s, a business we’ve owned since the fund’s inception, had the biggest negative impact on the fund last year, pulling down performance by –1.6%. Wells Fargo and Bank of America pulled performance down by –1.2% and –1.0% as investors became more concerned about a weakening economy toward the end of the year.
Taxes
The fund issued a long-term capital gains distribution of $0.259457 on December 19, which amounted to 0.9% of the reinvested NAV of $29.81. As a reminder, the fund did not pay any tax distributions in 2017, despite an 18.2% return that year, and 2016’s distribution was relatively modest as well. We don’t have a singular focus on reducing taxes (the easiest way to reduce your taxes is to stop making money), but we do try to minimize the taxes our shareholders face. The fund’s taxes over the past three years were about 90% less than the average fund in its category, according to Morningstar.
Portfolio
| Security | % of Net Assets |
| Alphabet, Inc. | 10.5% |
| Union Pacific Corp. | 7.6% |
| Ross Stores, Inc. | 6.4% |
| Mastercard, Inc. | 6.3% |
| Bank of America Corp. | 6.0% |
| American Express Co. | 5.6% |
| Berkshire Hathaway, Inc. | 5.5% |
| Visa, Inc. | 5.5% |
| The TJX Companies, Inc. | 5.4% |
| JPMorgan Chase & Co. | 5.4% |
| AutoZone, Inc. | 5.2% |
| Wells Fargo & Company | 4.9% |
| Canadian Pacific Railway Limited | 4.7% |
| Continental Building Products, Inc. | 4.5% |
| Carter’s, Inc. | 4.1% |
| NVR, Inc. | 3.5% |
| Discovery, Inc. | 3.0% |
| Armanino Foods of Distinction, Inc. | 2.5% |
| The Progressive Corporation | 2.5% |
| Cash* | 0.9% |
* Cash represents cash equivalents less liabilities in excess of other assets.
Consumer
Ross Stores and TJX continue to be two of the few bright spots in the retail business. In a year that saw Sears file for bankruptcy and other mainline retailers deteriorating, our “off-price” retailers flourished yet again, both growing earnings per share an estimated 25% last year. Ross’ stock returned 4.8%, while TJX returned 18.9%. Like most of our companies, 2018’s earnings figures were boosted significantly by the corporate tax cut, which, all things being equal, increased domestic net incomes by 22%.
A year and a half ago, investors were wringing their hands over the supposed imminent demise of AutoZone and the auto-parts retail sector due to online competition, despite no real signs of that happening. Mechanics require same-day delivery, often within 15 minutes, and do-it-yourself customers frequently rely on store personnel to help select and install the right part, often borrowing specialized tools. Sentiment can take a while to turn, and it finally did for AutoZone in 2018. More favorable weather also helped. AutoZone’s stock price increased 17.9%, while earnings per share increased 11%. We had added to the position when the stock took a sharp fall and have since trimmed a bit as it’s risen back to its all-time highs.
Carter’s stock price was hit hard, returning –29.3%, and earnings per share rose an estimated 5%, not a great number in a year in which most companies saw double-digit increases just from the lower tax rate. A handful of headwinds hit the company: operational stumbles in China, larger spending on long-term initiatives, and most of all, the liquidation of Toys “R” Us, one of its largest customers. Management expects to recapture at least 80% of that lost business, which represented 6% of its earnings, though it may take some time for customers to adjust. At a modest 12.5x earnings, the stock is the cheapest it’s been in almost eight years.
Our acquisition of NVR was poorly timed: even as NVR’s earnings increased, the stock dropped 17% below our purchase price in a matter of months as the overall housing market cooled from higher mortgage rates. While we expect increased mortgage rates to reduce house prices (or at least slow the rate of growth), we also think the US is significantly under-building new houses, particularly in the markets NVR serves, and we think they’ll be building an increasing number of new homes for a long time. Equally important, we think the stock’s a bargain.
Discovery completed its merger with Scripps, bringing on HGTV and Food Network, and has started to see the benefits of the merger. In addition to significant cost cuts, Discovery used its increased content heft, which now represents 20% of TV viewership, to push its way onto online subscription video platforms, most notably Hulu and Sling TV, easing its transition from cable TV to online video. Viewership patterns are changing as the world switches from organizing content by channel and time to organizing by show, and the cozy ecosystem where networks and the cable companies were sharing an endlessly increasing pie of subscription dollars is gone. That said, Discovery is still growing, and the current share price offers us something close to a 15% free cash flow yield, which we find fair compensation for the challenges. The stock rose 10.6% last year, and earnings per share was up an estimated 5%.
We’ve owned Armanino Foods of Distinction since 2013, and along with Ross Stores, it might be our most consistent, under-the-radar grower. On track to increase earnings per share 36%, the stock returned 15% last year including its large dividend. And their frozen pesto sauce continues to taste great.
Financials
After two really strong years, our banks stocks dropped a bit last year on lower optimism about the global economy, despite generally good earnings growth and cheap valuations. Bank of America increased earnings per share by 43% (!), while its stock returned –15.0%. JPMorgan Chase’s earnings per share increased 30%; its stock returned –6.6%. Both benefited from 1) higher interest rates, 2) loan growth, 3) fewer defaults, 4) larger payouts to shareholders, and 5) a lower tax rate. Both stocks have done really well for us, and we think they’re still good investments.
Once labeled “best in class,” Wells Fargo’s recent performance has been awful in comparison. It continues to deal with the fallout from employees creating fake accounts to meet management’s unrealistic sales targets, and to compound matters, revenue has been flat and costs have crept up. Earnings per share increased only 6% (pre-tax earnings shrunk 3%), and its stock returned –21.8%. Longtime shareholders may remember when Wells Fargo’s “best in class” performance contributed regularly to the fund’s performance, while our Bank of America and JPMorgan investments struggled with regulatory problems and inflated costs. While Wells’ problems aren’t the same, we think the core business remains pretty good and will eventually work past its problems in a similar way the other two banks did.
The turnaround at American Express continues. Competition among card issuers for big spenders has eased, and American Express has more than replaced its lost Costco business. Earnings per share increased 24%, with the company seeing both healthy revenue growth and controlled costs. The stock returned –2.6%.
We added Progressive toward the end of the year and are down a modest 5.9% so far.
Information Technology
Alphabet’s stock was essentially flat last year (–0.8%), despite earnings per share increasing 37% on continued fast growth and lower taxes. The company does face a few challenges: a tougher regulatory environment, particularly in Europe; declining ad rates for certain types of ads; and weaker economics on its search-engine deal with Apple. Yet, its core business of search remains dominant and still grows fast, with even developed markets like the US and Europe growing around 20% a year. If it can maintain anywhere close to its historical growth, we think we’ll do pretty well in the stock in the years to come.
Consumers around the world keep using their Visas and Mastercards. Despite being up almost 50% in 2017, the duo’s stock prices rose sharply again, Mastercard up 25.3% and Visa up 16.5%, which was especially impressive in a down year for the market. Earnings per share rose 42% and 32% for Mastercard and Visa, respectively. The steep rise in their share prices has put them in the upper bounds of what we usually consider “reasonably valued,” but their earnings have also increased so much that we still find them relatively compelling.
Industrials
“Precision railroading” has reached a tipping point in North America. A couple decades ago, Canadian National Railway was the first large railroad to implement the relatively radical operating philosophy that relies on tighter adherence to schedules while running fewer, longer trains. The result is faster and more reliable delivery times for customers and significantly reduced operating costs for the railroad. It’s a superior operating model, but isn’t easy to do. CSX was the first to implement precision railroading at scale in the US a couple years ago, and after some hiccups, the results have been great. Last year Union Pacific announced it’s going to give it a go as well and hired a new chief operating officer away from precision-railroading pioneer Canadian National. For 2018, Union Pacific increased its earnings per share by 37%, and its stock returned 5.3%.
Canadian Pacific, long since colonized by precision railroaders, increased its earnings per share 27%, and its stock’s total return was 6.6%.
Berkshire Hathaway, which owns the BNSF Railway (for now a precision railroading holdout) among a wide range of businesses, increased its book value per share by an estimated 6%, and its stock returned 2.8%. (Given that its earnings fluctuate widely based on changes of its stock holdings, we find book value per share a little more relevant.)
Wallboard-maker Continental Building Products had a great 2018, increasing earnings per share by an estimated 53%, but negative sentiment on the housing market dragged down its stock by 9.6%.
Progressive
Progressive is the third-largest auto insurance company in the US, behind State Farm and GEICO (part of our very own Berkshire Hathaway). It is an old saw that insurance is sold, not bought, and most insurance companies work with an army of independent agents who go out and find customers. The agents receive a commission (typically 12–15%) for each customer they bring in and continue to clip renewal commissions (typically 5%) for each year a customer stays with a carrier. From the insurance company’s perspective, it’s a low-risk way to grow a business; the company only pays for the customers who actually sign up. But it’s an expensive and unwieldy tool for a sticky product like auto insurance, where customers often remain with a carrier for six to eight years. The direct companies—largely GEICO, Progressive, and USAA—pay for their own sales efforts, which requires a greater upfront investment, but then allows them to keep more of the lifetime value of the customer relationship. The direct companies have steadily, if slowly, taken share from the companies that use agents.
From a financial perspective, it is helpful to think about Progressive as two different companies: an insurance company that writes policies and pays claims and an investment company that handles the money put up by the policyholders.
On the insurance side, we expect Progressive to write about $35 billion worth of insurance next year. Roughly $25 billion will go back out the door in claims, and about $7.5 billion will go toward overhead and marketing, including almost $1 billion to bombard TV viewers with “Flo.” That leaves $2.5 billion in underwriting profit, which, adjusted for taxes and the 585 million shares outstanding, is about $3 per share net.
On the investment side, Progressive’s $35 billion portfolio is split between roughly $27 billion of debt and $8 billion of equity. The conservative bond portfolio should yield at least 3.5% for $950 million, and we’d expect its equity portfolio to earn at least 6% for another $480 million. All told, we expect the investment portfolio to yield about $2 per share after taxes over the medium term. However, it is important to note that accounting rules can introduce tremendous volatility in reported results: e.g., a rise in interest rates is reflected as a sudden loss in the investment portfolio, even though the company benefits from investing new funds at higher rates.
As a combined entity, we are looking for Progressive to generate slightly less than $5 per share in earnings next year, which means that at a share price of $60 we hold it for 12x. Progressive has consistently generated double-digit policy, revenue, and earnings growth, and while the top line may slow over time, we note that a slowdown in newer, more expensively acquired customers would increase profitability and earnings.
Investments Initiated in 2018
NVR. Inc.
The Progressive Corporation
Investments Exited During 2018
| Investment | Internal Rate of Return |
| Verisk | 14.9% |
| PPG Industries, Inc. | 9.5% |
Investing Climate
Ten years into an American economic expansion with steady growth and unemployment levels as about as low as they can get, there are risks on the horizon. There are nascent signs of inflation after a decade of price and wage stability. Interest rates are rising. The Federal Reserve is unwinding its balance sheet. The corporate tax cuts have increased the deficit. The high-yield market, which in the middle of 2018 was offering pre–financial crisis terms to borrowers, has seen massive outflows. There are trade tensions and tariffs with major trading partners. China just published its lowest annual growth rate since 1990. The UK flirts with a “hard exit” from the EU, the EU has yet to fully resolve the euro crisis, and Brazil limps from crisis to crisis. There is plenty of ground for pessimism.
At the same time, stock market multiples have contracted considerably. For people who are looking to buy earnings streams inexpensively, this is a major development. After years of struggling to find enough investments with a margin of safety to protect against economic shocks, we find ourselves in the somewhat unusual position of being modestly sanguine about the market. We’ve taken the opportunity presented by the market volatility to become fully invested and make upgrades to the portfolio. Of course, we have no idea what will happen over the short and medium terms, or if there will be a market crash or a recession in 2019, but we are quite optimistic about our current collection of good businesses at reasonable prices and think they’ll do well over the long term.
As always, thank you for investing.
Stephen Dodson Raphael de Balmann
Portfolio Manager Portfolio Manager