Many Happy Returns In 2013: Expectations And Reality

April 28, 2014

Dear Fellow Shareholders:

The Bretton Fund’s net asset value per share (NAV) as of March 31, 2014, was $23.70. The fund’s total return for the quarter was 1.11%, while over the same time period, the total return was 1.81% for the S&P 500 Index and 2.04% for the Wilshire 5000 Total Market Index.

Total Returns as of March 31, 2014

	1st Quarter	1 Year	Annualized 3 Years	Annualized Since 9/30/10 Inception
Bretton Fund	1.11%	17.98%	15.61%	16.27%
S&P 500 Index	1.81%	21.86%	14.66%	17.69%
Wilshire 5000 Total Market Index	2.04%	22.42%	14.43%	17.83%

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

Wells Fargo had the largest impact on the fund this past quarter, adding 1.4% to performance. As a group, our three railroad investments (Union Pacific, Norfolk Southern, and CSX) contributed 0.9%. The two main detractors from performance were Coach and America’s Car-Mart, which each took away 0.8% from our returns.

The fund did not add or eliminate any investments this quarter.

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

Many Happy Returns

After five years of great stock market returns, investors as a whole are feeling a little richer. I hear more and more sentiments like, “Let’s hope this market can keep going, eh?” “Wouldn’t it be great if we had another year like 2013?” “Dow 36,000!” “NASDAQ 5,000!!!”

Okay. Let’s take a step back. The market has produced 20% annualized returns the past five years. Where did those returns come from? Where do return numbers come from in general? When thinking about this, it’s helpful to break down the various components that make up investment returns, which over the long run, come from two sources: 1) companies increasing their earnings, and 2) companies distributing capital to shareholders (either through dividends or stock buybacks). The aggregate of companies’ earnings tends to increase steadily over time, but the amount that investors as a whole are willing to pay for these future earnings fluctuates, often wildly, and can have a substantial impact on day-to-day market values. E.g., in 2008, the market declined 37%, even though the economy shrank by only 3% in ’08–09. How aggregate investors “decide” to discount future earnings drives most of the short-term fluctuations in the market. You can think of this willingness to pay for future earnings as essentially an interest rate, and like interest rates, it tends to stay within an historical range, but with larger swings. If the market is way outside its historical average, you could reasonably assume a reversion to the mean, but in general, the rate at which investors discount the future is not an inherent source of sustainable returns. The amount companies distribute to shareholders tends to grow at the same rate as earnings since businesses can’t pay out more than they make in the long run. So, the key variable that determines stock market returns is how fast its underlying companies grow, which is essentially based on the growth of economy. In the short run, market fluctuations impact economic activity, but over the long run, it’s better to think of the stock market as an output of our economy, not an input.

(It’s worth noting that profit margins and corporate profits as a percentage of GDP are at an all-time high. It’s not fully clear why. Some believe it’s a cyclical dynamic, that companies, in the wake of a near-catastrophic financial crisis, are valuing profitability over growth and are reticent to hire and invest. The argument is that corporate profit margins are more cyclical than not, and eventually they will come back down to historical averages. Others believe this is a secular trend, that companies today are more profitable due to several macroeconomic factors: better technology requiring less people, the influence of labor unions is weaker, private equity and activist investors have forced companies to be more efficient. My feeling is that it’s a little of both, though I’m not necessarily basing our investment strategy on that presumption.)

The combination of earnings growth plus corporate distributions historically generates a rate of return of about 7%, adjusted for inflation. This has held true for as far back as the data goes (1871), and recent decades are in line with this average. (Nominal returns are roughly 10% the past century, which includes ~3% of inflation.) Today, the dividend rate on the S&P 500 is 2%, net stock buybacks are maybe another 1–2%, and long-term, real GDP growth is in the neighborhood of 3%. In other words, future returns as we stand here today don’t look to be different from that 7% average. If anything, the market feels a bit pricey right now as the willingness to pay for future earnings appear to a bit on the high side of the historical average. If that’s the case, medium-term returns (~10 years) could be below that 7% real-return average. (This seems like a good place to note that, as your portfolio manager, I strive to deliver returns greater than that average, with less risk, through a full stock market cycle.)

When the market delivers a return significantly above that 7%, as it did last year when the S&P 500 returned 32%, one of two things is happening: 1) investors are catching up on past returns from previously under-recognized earnings growth, or 2) investors are pulling future returns into the present. In the first few years after the global financial crisis, it seemed pretty evident that the market was recovering lost ground from its sharp drop in 2008. But over the last couple years, it’s no longer clear the market is still catching up, and it seems like it might have started dipping into future returns. There’s no way to tell for sure, but even if the market was fairly valued, one can’t assume the market will deliver 20% returns for the next five years.

The fund has appreciated significantly since its inception, and we’ve been fortunate enough to still have a number of great investments that I believe will continue to appreciate at an attractive rate. The bad news is that when markets rapidly rise, there’s less to choose from, something we’ve had to deal with the past few years. In an environment like this, it’s best to be cautious—avoiding some of the excessively overvalued sectors like biotech, master limited partnerships (MLPs), and some areas of consumer Internet—while keeping our eyes open for the occasional great business selling for an attractive price.

Bretton in the Media

In a profile of longtime Bretton Fund holding Carter’s, Reuters’s David Randall quoted me on the Atlanta-based company’s success. On the durable appeal of the Carter’s brand for baby clothes, I noted, “Toddlers don’t tend to be fickle about their fashions.” Carter’s has been a beneficiary of this since its founding in 1865, which, as a friend notes, was “quite the time to start a company in Atlanta.”

As always, thank you for investing.

Stephen J. Dodson
President
Bretton Capital Management

Bretton Capital Management

870 Market St, Suite 417

San Francisco, CA 94105

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