PERIOD FMR* Taxable RCP L.P.** S&P 500 DOW JONES Russell 2000
2nd Qtr 15.10% 8.00% 14.89% 12.43% 22.99%
The extreme volatility and pessimism surrounding the economy and the impending war with Iraq in the first quarter gave way to an impressive stock market rally of about 25% from the March low. Much of this relief rally was due to the success of the war in the very first days of this campaign, but the sustained upward move in stocks is explained by the growing consensus that we are in fact having a slow but steady economic recovery that is likely to improve with time because of the enormous injection of monetary liquidity into the economy by the Federal Reserve. Moreover, corporate profits for the first quarter were favorable on balance and exceeded low expectations. On top of this change in investor psychology was added a very beneficial and significant tax cut and economic stimulus package and the acceleration of the decline of the dollar. Each of these important factors helped significant amounts of cash that was sitting on the sidelines earning 1% gravitate into the equity market on expectations that improved corporate profitability would continue and economic growth would move to the 3% range for 2004 without the threat of inflation. However, perhaps one of the most unappreciated factors that hopefully has lasting long term significance for equities was the significant reduction of income taxes on dividends! Putting dividends on an equal footing with capital gains from taxation has dramatic long-term implications for corporate America and investors as stocks with high, sustainable, and growing dividends have already begun to rise, but more importantly, growth companies who have been hoarding cash and heretofore would only consider buying back stock, not increasing or instituting a dividend, are in fact raising their existing dividend at an above average rate or starting a dividend for the first time (e.g. Kinder Morgan, Microsoft). This new trend is good news for all investors, and is particularly positive for the stocks in your Five Mile River portfolio, as we have emphasized companies that pay and increase their dividend along with companies that are generating substantial free cash flow that can be used to buy in stock or pay a dividend. The trend of recent dividend announcements by companies who were unlikely candidates to dramatically raise or even pay a dividend, is proof positive that putting real cash into the hands of investors has been raised to a higher priority by the management's and board's of our companies. Our estimate is that S&P 500 dividends will be up 20% over 2002's level in 2004 and still only represent a 33% payout ratio of estimated operating earnings for 2004 and 38% of after write-off earnings, assuming a 10% write-off, as has been the past average. The important observation here is that this payout is well below the past average of 50% in earlier years and now there is every incentive to return real money to shareholders in what is likely to be an 8-10% return for the broad equity market. It is also worth noting that even with the S&P 500 dividend yield at approximately 1.7%, while below the 1982 6% peak, adjusted for inflation it is the same as 1982. And finally, the dividend yield minus the 10-year Treasury yield is the highest since 1967, and relative to the 3-month Treasury Bill yield, the highest since 1964! So put us in the camp that says dividends do matter to long-term equity returns, and it looks to us like they will become even more important in the future.

How are equity market valuations? On balance, the equity market is at the higher end of its historical price to earnings valuation range, but looking at that number alone could have caused one to miss the very nice returns available from equities rebounding in the face of overwhelming pessimism at the March low. Significant monetary stimulus and the relatively puny returns available elsewhere were far more important factors than P/E's as economic momentum is just getting underway. The equity market's rise during the second quarter was fueled by net inflows of cash into the market. In April, a reported $16.1 billion was injected into US equity mutual funds, followed by another $12.1 billion in May. While these inflows are significant, they represent only 1.4% of the $2 trillion sitting in money market accounts! Clearly not all of these funds are destined for the equity market, but the Federal Reserve is making it clear with its low interest rate policy that consumers should be taking on more risk in their asset allocation and is accommodating such a shift with massive injections of liquidity into our banking system.

While we are somewhat cautious after such a large upward move, the stock market continues to prove that it is resilient even in the face about lingering doubts about the durability of an economic rebound. The Fed wants corporate pricing power to improve which is bullish for stocks. The Fed has provided the monetary fuel and that is bullish. Tax policy has been shifted towards encouraging investment and that is bullish. This combination probably means the stock market will grind higher but selectivity will become more important going forward than what we watched in the second quarter. To this end, we continue to look for companies that are priced at a discount to what their businesses would sell for in a private transaction, companies with dividends that can grow and companies that generate substantial free cash flow that will be used to increase shareholder value.

Five Mile River Investment Management is off to an excellent start with competitive performance and strong administrative leadership from Martha Robbins who has been appointed President. We are pleased to report that Five Mile River has accepted over a dozen new account relationships during the second quarter and we thank you for your confidence and support. Please do not hesitate to call us, or Martha, with any questions you may have about your account.

Sincerely

Lee Garcia - Managing Member

Todd Robbins - Managing Member

*FMR account # 118-17545. Results are net of management fees and are not audited.

**2003 results for RCP L.P. are net of management fees and are not audited.

Disclaimer

This letter is not meant as a general guide to investing, or as a source of any specific investment recommendation, and makes no implied or express recommendation concerning the manner in which any client’s accounts should or would be handled as appropriate investment decisions depend upon the client’s investment objectives. Any offer to sell or the solicitation of an offer to buy any interests in any securities may be made only by means of delivery of a Five Mile River Investment Management Agreement and or other similar materials which contain a description of the material terms and various considerations and risk factors relating to such securities or fund. Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be either suitable or profitable for a client’s or prospective client’s portfolio, and there can be no assurance that investors will not incur losses.