PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (1.0%) (2.2%) (8.6%) (5.6%)
The first quarter of 2005 got off to a disappointing start with the S&P 500 down -2.2%, the NASDAQ off –8.0% and small stocks, the Russell 2000, down -5.4%. Five Mile River’s portfolio was down 1.0% because we owned companies in two of the three strongest sectors for the quarter, energy and utilities. The markets’ decline was classic because stocks always struggle as long-term interest rates rise. And in this case, rates finally began to rise (4.6%) after surprising everyone in 2004 by staying flat at around 4%. The Fed tightening, along with inflation scares from the surprisingly strong rise in industrial commodities and materials, especially oil, caused an extremely volatile and nervous quarter for the stock market. Our year-end forecast for this year, that market returns will be more subdued in the 6-10% range, is unchanged following the events of the first quarter.

Fed tightening has always created some degree of fear and a lot of uncertainty until it is over, or until the prospect of the last tightening is in sight. When might that be? The Fed has signaled at its last meeting that they were aware of increased pricing power in a broad cross section of businesses, and were prepared to be more vigilant in keeping inflationary pressures from getting out of control. When the Fed begins to finally have an impact on long rates there is always the possibility of unintended consequences and they almost always have the effect of producing a slowdown or a recession depending on what other financial crises pop up on the radar screen. In the past, these crises included everything from the dot-com bubble and the collapse of the NASDAQ in 2000, to the S&L Crisis of 1990 that pushed us into recession. Alternatively, the crises in Mexico and the Pacific Rim from the devalued Peso only resulted in slowdowns.

While it is always difficult, if not impossible, to predict what the next crisis will be, our current environment offers significant but not widespread troubles in the insurance industry (AIG, Berkshire Hathaway, March & McLennan), and, of course, the prospect of unintended consequences from high levels of speculation in oil and gas. We do not discount the serious implications of both of these mini-crises in 2005, but our estimate is that the insurance problems are narrow and focused, and are not sufficient to cause the U.S. economy to tip into recession. The speculation in energy is serious and widespread. Nonetheless, the environment in 2005 is significantly different than 1980 because energy costs are a much lower percentage of our economy and our budgets. Our estimate is that higher energy costs will contribute, along with higher interest rates, to a slowing of the economy and corporate profits, but not push us into a recession unless oil prices were $80/barrel or higher (the inflation adjusted equivalent of what oil prices were in 1980). Our forecast, therefore, is slowdown, not recession.

So, back to the question we posed, when will Fed tightening be over, or at least the end in sight? Our best guess is that the Fed should have completed the bulk of its tightening by the end of the third quarter of this year, at which time the Fed Funds rate should be in the range of 2.75-3.5% and the l0 year Treasury at 5-5.5%. The duration of this tightening cycle is of course uncertain because of unintended consequences we cannot now foresee, but we think the good news for stocks and bonds is that it will be over sooner than the consensus now expects. The parallel to last year is quite illustrative in that stocks struggled for three quarters in anticipation of the long bond yield rising, and when it did not, stocks went up 10% in the fourth quarter. What the market worried about last year is now finally happening. The anticipation of the end of rising rates should produce moderate equity appreciation.

Where do we stand with Five Mile River’s portfolio strategy and stock selection in 2005? We have emphasized in our past quarterly letters that we have been looking for and investing in companies that have free cash flow after capital expenditures. Companies that can increase their dividends at an above average rate should provide lower volatility than the market. Additionally, due to the historically low taxation of dividends, companies which pay dividends should outperform those without dividends. In fact, in 2004 the S&P dividend payers rose 18.4% while the total S&P 500 rose 13.8%! The other reason we want dividends is that in times of volatility and uncertainty, our clients, receive a steady stream of cash from these companies which can either be paid out and spent as needed, or reinvested back into the same or similar companies to grow your portfolio.

We expect dividends will continue to contribute importantly to Five Mile River’s portfolio total return. The various sectors we own include: electric utilities (one of three groups to outperform in a tough first quarter); REIT’s which underperformed in the first quarter and pay out high and rising dividends; and a cross section of energy stocks that outperformed the market (including pipelines like the Williams Companies, coal in the form of Natural Resource Partners and/or Peabody Energy, and Halliburton, the latter two recent additions). We also have invested in smaller natural gas exploration and development companies like XTO Energy and Cimarex that performed better than the market. Our energy investments are not short-term opportunistic investments, but long-term commitments to managements who are growing their businesses through both strategic acquisitions and divestitures as well as strong internal growth.

We expected energy prices and commodity prices would be coming down this spring and they have not to date. We still expect this speculative surge to abate which will help the rest of the stock market. In the meantime, your energy investments, your real estate investments, and your timber investments benefit when there are inflation scares because their property/tree/reserve values are growing faster than the underlying inflation rate for goods and services. These hard assets can and do outperform in this kind of cycle as they have liquidity, cash flow distributions, and real operating businesses that have stood the test of time, and are not going away as happened in the dot-com bust of 2000-2002. We expect these “inflation hedges” to continue to provide an important part of your portfolio’s total return over the next several years.

As always, we thank you for your interest and we welcome your questions regarding Five Mile River Investment Mgmt. We encourage you to share your thoughts with us by phone or email at any time.

Sincerely,

Todd Robbins Lee Garcia CFA *

Results are unaudited.

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.