Bretton Funds 2014 Annual Letter – Big BanksVW Staff
Bretton Fund annual letter for the year ended December 2014.
Dear Fellow Shareholders:
The Bretton Fund’s net asset value per share (NAV) as of December 31, 2014, was $25.72, and the total return for the fund for the fourth quarter was 6.91% compared to 4.93% for the S&P 500 Index. For the year, the fund returned 9.79% compared to the S&P 500’s 13.69%.
The fund’s cash balance muted returns again, but the volatility in the fourth quarter allowed us to put more of our cash to work by adding, what we believe, are three great businesses whose stock prices went on sale: Discovery Communications, Flowserve, and IPC Healthcare. We discuss these in more detail below.
Note: In previous reports, we had shown the Wilshire 5000 Index in the above performance tables, with the goal of showing the broader market beyond the 500 largest companies that comprise the S&P 500 Index. But since those 500 companies dominate the market-capitalization-weighted Wilshire, the difference in those indices isn’t material. Going forward, we’ll just show the S&P 500.
Bretton Fund: 4th Quarter
During the fourth quarter, the largest contributor to the fund’s performance was Ross Stores, adding 1.8%. Ross Stores, the company, continued to chug steadily along nicely during the year, selling even more discounted clothes and adding stores, and in our estimation, steadily increasing its value. ROST, the stock, on the other hand, saw wide swings in its perceived value by the market, starting the year at a value of $16 billion, hitting a low of $13 billion in July, then recovering to almost $20 billion by the end of the year. The business hardly changed.
Car-Mart also made a significant contribution of 1.6% in the fourth quarter. The company continues to open stores and managed to significantly improve its per car profitability, getting back to its historical average as the fierce competitive environment waned a bit. Wells Fargo added 0.9% and CSX added 0.6%.
Bretton Fund: Contributors to Performance for 2014
For the full year, the main detractor from the fund was Coach. As predicted, its sales grew overseas quite nicely, but its appeal in the US deteriorated much more than expected, with sales per store declining 24% last quarter. We have since sold some shares as our assessment of its value wasn’t quite what we thought it was. This mistake cost the fund 2.4% in 2014. Fortunately, there were no other significant detractors from performance this year.
Wells Fargo and Ross had the biggest impact on the fund, adding 3.1% and 2.5%, respectively. The railroads continued to charge ahead, adding 4.1% to the fund as a group, with Union Pacific having the largest impact, 1.9%.
Bretton Fund: Taxes
The fund made a tax distribution to shareholders on December 23 for $0.01427 per share, representing 0.06% of the fund’s NAV at the time. While minimizing taxes isn’t the fund’s raison d’être, we strive to reduce the amount of taxable distributions to shareholders. The fund managed to avoid making a capital gain tax distribution during the year, and for the third year in a row, the fund avoided incurring any short-term capital gains, which are taxed at a higher rate than long-term gains.
Bretton Fund: Portfolio
Each quarter, we disclose which investments had the largest impact on the fund’s performance for that quarter, and in the annual and semiannual reports, the attached financial statements contain gain-loss information for each security. This time, we thought we’d break out more detail on each investment to give you a sense of the companies we own and how they performed to date. To date, none of our investments has led to a net realized loss, and excluding the investments we made in the last weeks of the year, only Coach is in a net loss position. Including our fully exited investments, about two-thirds of our investments have outperformed the market.
Bretton Fund: Portfolio Discussion
Our three large banks, Wells Fargo, Bank of America, and JPMorgan, comprise our largest position both individually, with Wells Fargo, and the fund as a whole. While each of these companies has distinct qualities, the common theme has been the tremendous resurgence in earning power of the banking sector. In 2009, Wells Fargo-broadly considered the best managed and most transparent of the large banks-earned $1.75 per share after writing down over $22 billion of assets, which, at the time, was not clear would be enough. Last year, earnings were up to $4.10 per share in an environment where ultra-low interest rates have materially depressed its interest income. We expect Wells to earn at least $4.20 per share next year, which, we believe, is a bargain compared to its $55 year-end share price.
Bank of America and JPMorgan have had slightly more complicated stories, thanks to crisis-era liabilities that have not been fully resolved. Bank of America made what, at least in hindsight, was an ill-advised acquisition of Countrywide and its problems during the subprime mortgage crisis, and it is still digging out. It also wildly overpaid for Merrill Lynch when it was at death’s door and failed to terminate its purchase contract in the face of a material adverse event: a worldwide financial crisis centered on these investment banks. Despite the circumstances, Merrill turned out to be a strong franchise and now represents close to half of Bank of America’s earnings. As its elevated legal and credit costs fade, the underlying earning power of Merrill Lynch’s wealth management operation and BofA’s enormous deposit and loan franchise will accrue to us as its partial owners. We estimate it can earn about $2 a share within a few years compared to its year-end share price of only $18.
JPMorgan has spent nearly $30 billion on legal settlements since the financial crisis-an amount that could buy Whole Foods and Safeway, with enough left over for E*TRADE-and it is unlikely that the regulators are finished with it. Yet, the bank earned nearly $22 billion just in 2014, an amount that’s likely to increase in the coming years with higher rates, increased loans, and lower legal costs. For all of the unwieldiness of the universal bank model, JPMorgan is, in an important sense, a combination of Wells Fargo, BlackRock, and Goldman Sachs, trading for a lower ratio of price to earnings. At current prices, we have an earnings yield slightly above 10%.
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