PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (1.0%) (2.2%) (8.6%) (5.6%)
2nd Qtr 5.5% 1.4% 0.7% 4.0%
3rd Qtr 9.5% 3.6% 7.2% 4.4%
YTD 13.6% 2.8% 1.1% 2.5%
The third quarter of 2005 produced a decent positive return for the broad market as represented by the S&P 500 of +3.6% compared to the virtually flat performance for the first half of the year. The NASDAQ, which was down 8% in the first half, rebounded +7.2% in the latest quarter and the small stock index Russell 2000 was up 4.4%. Five Mile River’s portfolio outperformed the market again because of strong momentum in the only sectors that have shown significant superior performance for the year, namely utilities and energy. This dichotomy between these two groups (utilities +20% YTD and energy +40% YTD) is unsustainable in our opinion and clearly not representative of a healthy market. As we begin the fourth quarter, evidence of the accuracy of this observation has become crystal clear with profit taking and price corrections in both groups. The twin realities of the impact of higher interest rates and painfully higher energy prices on the real economy are giving investors a better understanding of how one-sided this market has become in 2005. While very good fundamentals remain in place for our companies in these two sectors, there is no doubt that we will give back some portion of these outsized gains experienced in the third quarter. We have cut back weightings in some of our energy and utility positions as they have grown throughout the year and expect to moderately reduce the weightings further in the fourth quarter to give us flexibility when the end of Fed tightening of interest rates is in sight.

What has changed this Fall? As you may recall, our expectation for 2005 had been a flat market in a tight range until we could see the last Fed tightening of short term interest rates. Our assumption had been that we would be there by now, but, we are not because of the inflationary fears caused by the hurricane induced spike in energy prices to levels never before seen in the U.S. Natural gas is up almost 150% year over year, gasoline is up almost 60% year over year, jet fuel up 80% and there is absolutely no doubt that these prices are an extra tax on the economy and on the consumer that will be a drag and slow us down from growth and profitability we otherwise would have expected in 2006. Consider this - the gasoline price increase alone is almost equal to $160 billion of additional consumer expenditures just to keep our cars functioning! This number combined with significantly higher electric utility bills and heating bills (both oil and natural gas) this winter will result in an added burden on our economy and the impact this Fall is probably underestimated as these price shocks always work with a lag of at least six months and can last a year. Net result - slower growth, margin pressure on any businesses that have a significant component of energy costs in their products or services, lower corporate profits for those companies that cannot pass on 100% of their higher energy costs, and an economy that should look like it is not growing in the first half of next year (maybe 1-2% growth versus consensus right now of 2-3%).

How will this gloomy scenario play out for the next six months? While the headlines are full of angst over all of these negative impacts our economy has been hit with over the last month, the market is a discounting mechanism that looks to the future even as today’s stock prices react to old news. While these energy and hurricane induced negative factors capture the media’s attention and pound away at frightful scenarios day after day, we do not want to lose track of what it takes to be a successful long-term investor even in an economy that is facing all of these headwinds. Namely, we look at good business models and managements that can execute value-creating strategies, even in turbulent times. We invest in businesses that maintain good flexibility with solid balance sheets, and continue to generate free cash flow for enhancing shareholder value from any one of the following three avenues: 1) reinvesting in projects they know well where the return on investment is higher than their cost of capital, 2) repurchasing their own shares, and 3) paying out real cash in the form of higher dividends or special dividends to us as shareholders. Companies that are doing all three today, with discipline, are being valued higher in the marketplace than those doing only some or none of these value enhancing actions. In virtually all of our companies, our managements have a significant portion, if not a majority, of their net worth invested in the shares of the company they are managing. They own their stock in size and it makes all the difference in the world as to how they execute their role as CEO versus those companies where the senior management owns token amounts of actual common stock relative to their net worth.

Why has this emphasis on ownership mentality for senior management been working in the stock market over the last several years? We have beaten the drums constantly in our quarterly letters stating real world evidence from stock market performance demonstrates categorically that companies who announce and execute buybacks, and increase their dividends outperform those which do not. Both of these actions are consistent in their message that management is confident about their business model, as there is no way to fool the investing public when you actually pay a cash dividend. With personal taxes now equalized between capital gains and dividends, dividend income will increasingly become a more important portion of an investor’s total return in a market that has not been undervalued for the past two years, and is not particularly undervalued today. Standard and Poor’s work shows that the first six months of 2005 has witnessed the greatest number of dividend payout increases since 1998. There were 1,055 payout increases in the first half out of the 7,000 publicly owned companies reporting. From 1972 through 2004, companies with dividends were up 10.2% a year versus 4.4% a year for those without dividends from a study by Ned Davis Research. We continue to look for and invest in solid business models that generate free cash flow giving management several different paths to enhance shareholder value.

Finally, a few quick comments about interest rates and housing - subjects that are unavoidable in our busy day to day lives. Short term interest rates are going up perhaps a bit further (4.5%) and a bit longer (January) than we thought in the Spring because of the inflationary implications of this energy price spike. The yield curve is flattening and long rates (ten year Treasury bond) will also move up (5%), but these rates are still historically low. Many observers of the Fed’s gradual and persistent rate increase process thought we would have seen higher long term interest rates at the 5% level a year ago. If the Fed can manage the economy into a low inflation soft landing early next year (2% GDP growth), then as the evidence builds that this outcome is most probable, the market can and will react more positively on the upside for a broader cross section of sectors and industries than the narrow performance we have seen this year. Accompanying this favorable scenario will be rising mortgage rates, stricter bank lending standards, less mortgage equity withdrawal by consumers to fund personal expenditures, and cooling of the housing “bubble” talked about incessantly in the press. We said in our last letter that housing is regional, that some markets were already cooling and pricing was going flat.

There is also further evidence of a plateau in that the total dollars for existing houses for sale in August was up almost 30% year over year. Affordability is down in many newly popular areas and, therefore, with energy costs taking up a larger part of the consumer’s budget, housing speculation and huge price gains will self-correct market by market around the U.S. as inventory builds and demand subsides. The end game of this process is not similar to the end game we watched when the dot-com internet bubble burst because homes are real assets that we live in and use. Speculators in housing will make less money or no money and some will even lose money, but this phenomenon is simply the healthy discipline of free market forces at work bringing specific regional housing excesses back to equilibrium.

In closing, we would like to highlight one of our holdings (usually we have discussed some of our more obscure companies, so we thought it might be enlightening to talk about one of the largest and best known companies in the world that resides in most, if not all, of our portfolios) – that is Proctor & Gamble! P&G just got bigger, and will grow faster with higher profitability on the recent acquisition of Gillette, the dominant personal care men’s shaving company in the world. P&G will now have 22 brands each with more than one billion dollars in revenue and another 14 brands between one half and one billion dollars that include Tide, Ariel, Pampers, Always, Whisper, Tampax, Bounty, Charmin, Pantene, Vidal Sassoon, Clairol, Wella, Crest, and now Gillette. EPS growth for the past three years has been 19%, and with the Gillette acquisition, P&G can grow revenues 5-7% and earnings from low double-digit to mid teens with expanding margins for the next several years, generating substantial free cash flow. Dividends have compounded at 11% a year and should continue at that pace. Share buybacks since the Gillette announcement will total between $18 and $22 billion to reduce dilution from the acquisition. Growth opportunities, through product innovation and increased emphasis on health-care and beauty products, plus enormous expansion opportunities in China, set this consumer products company well ahead of the competition. CEO A.G. Lafley is an extraordinary leader and motivator for this very large multi-national company, who like most of our managements, has a significant personal financial interest in the success of his company. Lafley owns approximately 600,000 shares worth $35 million and has options to acquire another 2.4 million shares. His interests are aligned with ours as shareholders. We expect to make 10-15% a year in total return from our P&G holding as the integration of this important combination realizes its full potential.

As an SEC registered company we file an ADV II form annually describing our business. Please contact us if you would like a copy. As always, please do not hesitate to call or email us with your questions and observations. We are available for conference calls at your convenience.

As always, please do not hesitate to call or email us with your questions and observations. We are available for conference calls at your convenience.

Sincerely,

Todd Robbins Lee Garcia CFA

* Results are net of management fees and 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.