PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 5.0% 4.3% 3.6% 13.7%
2nd Qtr 2.5% (1.4%) (7.5%) (5.3%)
1st Half 7.5% 2.7% (4.3%) 7.6%
The second quarter of 2006 started off with broad optimism that May would mark the last month of Federal Reserve Board tightening as the Dow Jones Industrial Average was within 4% of its prior peak set back in January 2000. We commented in our first quarter letter that the market could give us 10% - 15% total returns by year end once the end of FED tightening was in sight, but not to expect much in the second quarter except sideways to a 5% correction with inflation and interest rate uncertainty still on the front page. Concerns about the mixed messages coming from the FED in the second quarter as to whether they were almost done, along with a higher core inflation rate report, dashed the earlier hope of an early end to rising interest rates with the Dow Jones -8.3%, the Russell 2000 (small companies) -14%, and the NASDAQ (technology) off -13% for the five weeks ending June 13th. Since that date, the market has recovered with evidence that the economy is slowing, inflation is not out of control, and we have, in fact, a decent probability of a soft landing in the third and fourth quarters of this year. Bottom line to the quarter is much as we thought starting out, flat or sideways, -1.4% for the S&P.

With that brief synopsis as an overview, Five Miler River portfolios navigated fairly well despite the increased “noise” and “volatility” in the second quarter with our accounts up +2.5% in the quarter versus a negative or flat quarter for most other indices. Year-to-date, FMR accounts are up +7.9%, which given the continuation of Fed rate increases (now 17 and still counting), is somewhat better than we thought coming into what was shaping up as difficult transition year. While we cannot know in advance when the FED will know it’s work is done to contain inflationary expectations in the economy, our view is that it is much too late to sell into this correction. This pullback and remaining “noise” this summer provide an ideal opportunity to buy both high quality growth companies now selling at half their former price earnings multiple of 2000 (15x vs. 30x) as well as many of our free cash flow, dividend growth names that have significantly less downside risk than the non-dividend paying stocks. From January 1972 through the end of 2005, dividend-payers have returned about 10% per year while non-payers returned a low 4%. With the recent extension of the lower 15% tax on dividends, we expect companies who grow their dividends will continue to outperform those who do not or cannot. As you have seen in the recent correction of the second quarter, dividend-paying companies are not as volatile on the downside relative to the overall stock market. We have a solid core of high-dividend growth names in every portfolio that serve as an anchor in market corrections. With the leading edge of 76 million Baby Boomers starting their retirement in 2006, and continuing for at least the next 20 years, we expect this large and influential investor class to continue to look for ways to increase current income in tax-aware and tax-advantaged ways. Managements hate to cut dividends and they are unlikely to increase them unless they are confident in their future. Rising dividends and higher payout ratios, contrary to the “dot-com” technology bubble era thinking that dividends were old news, actually signal that management is bullish about their company’s future growth prospects.

A quick update on the Kinder Morgan family of companies that we own and discussed in last quarter’s letter (KMP) includes news that the parent corporation, Kinder Morgan Inc. (KMI), is being taken private at $100 a share by a group of private equity investors and Rich Kinder, Chairman and CEO. Almost every account owns KMI, KMP or KMR (depending on whether it is a qualified account), and we have enjoyed substantial capital gains and growing dividends from this major pipeline company, parent of the master limited partnership known as Kinder Morgan Energy Partners. We will continue to own KMP and KMR where appropriate for FMR accounts and expect continued appreciation and dividend growth of 10% - 15% annually from this holding. KMI holdings will be held unless funds are needed for new investment ideas. We expect to receive a couple of more dividends from KMI prior to the 4th quarter close of this transaction, and possibly, a sweetened buyout price of as much as $105. Thus, we are content for now to make about 10% from here to the end of the year with virtually no downside risk.

Another segment of our core dividend growth group has been our electric utilities. Over the past three years, we have owned two to four names for most of our accounts and they have produced steady and sometimes huge returns for our portfolios because of the consolidation and restructuring now taking place in the electric utility industry. These are safe monopolies that every one of us needs and uses every day. Currently, Duke Energy, Exelon, and TXU Corp report yields of 2.7% - 4.0%. While electric utilities have significantly outperformed the S&P 500 since early 2000 (+100% vs. -4% for the S&P), these are recession-proof companies that have a guaranteed rate of return on their investments. The three companies we have chosen have some combination of reasonable or favorable state regulation, higher demographic growth, low cost generation, and restructuring opportunities. In addition, they have other assets such as coal reserves, transmission and distribution, as well as gas pipeline and processing assets where new initiatives (MLP’s) and spin-outs can create value for shareholders. Duke Energy serves 2.2 million customers in North and South Carolina and, as a result of its merger with Cinergy, has extensive assets in natural gas liquids, pipelines, storage, processing and trading that are very likely to be spun out in a new gas company in the first quarter of 2007. Exelon (EXC) provides electric/gas utility services to 5.6 million customers in Illinois and Pennsylvania and is the largest nuclear plant operator in the U.S. EXC is in the process of acquiring Public Service Enterprise Group that serves 3.8 million gas and electric customers in N.J. The combined savings and expertise at running the best nuclear operation in the U.S. will create significant future earning power and position EXC to be a dominant player in the expected new generation of nuclear plants to be built starting in 2010. Finally, TXU Corp. is the largest Texas utility providing electric utility service and power generation to 2.6 million retail customers. TXU has undergone major divestment of assets and restructuring in the last two years under new management and plans to spend $10 billion in Texas primarily on new coal-fired generation over the next three years to take advantage of its low-cost lignite reserve position. Spin-out possibilities of their extensive transmission and distribution network also exist and continue to make this an intriguing work-in-progress and a value creation opportunity. Rather than thinking of electric utilities as “old fashioned” businesses, these three companies are industry leaders in this market segment which is simultaneously undergoing major deregulation, restructuring, and consolidation under dynamic new leadership. We will continue to highlight some of our positions and encourage you to forward any questions to us that you might have about your portfolio.

Thank you for your continued support.

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.