PERIOD FMR*
Taxable Estimated
FMR*
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 4.67% 2.56% 0.70% 1.02% 1.95%
The first quarter of 2007 did not surprise us with our year end forecast of increased volatility in U.S. markets. However, it did surprise us with a quicker bounce back in March, and thus a very good quarterly return of 4.67%* for the taxable accounts and 2.56%* for the qualified (IRA, pension) accounts versus a flat S&P 500 return of .70%. Contributing to the relatively good first quarter performance was strength in the energy and utility sectors once again. On February 27th the market plunged 3.5% as bearish news appeared simultaneously from several sources. Our former Fed Chairman Greenspan made a speech where he thought it was “possible” that the U.S. would see a recession before year end, and the Chinese market in Shanghai dropped 8.8% overnight. These two somewhat ephemeral events coincided with a more tangible negative, namely the meltdown in the “subprime” lending market for residential homes. Since the S&P 500 had gone up for eight months in a row through January, a down 2% month for February should not have been a surprise. There have been only nine streaks of this length or longer since 1928, with the last one ten years ago in 1996. The surprise to us was the immediate recovery in March, which on the surface, seemed too quick because a normal correction after such a long up phase is 5%-7% over at least a couple of months, not a few weeks. Since 1945, the S&P 500 has gained on average 18% in the third year of a president’s term versus an average of only 9% for all other years. We are not too fond of making predictions based on presidential cycles, and believe 18% is too high unless the Fed cuts rates by at least 50 basis points in the second half of the year. We are sticking with our year end forecast of making 10%-12% for calendar year 2007, where the trigger point for further gains will be the Fed’s acknowledgement that inflation is at 2%, thus allowing them room to cut the Fed funds rate.

Typically, financial crises appear well into an up cycle and it is virtually impossible to predict in advance what they will be, let alone the extent of their impact on the economy. In 1995 Mexico blew up and in 1997 it was the spreading Thailand crisis. We now know what the 2007 financial crisis is, namely, the subprime mortgage crisis. What we do not know yet is the severity and duration of this housing finance crisis, but we can put some wide parameters on the probable impact and draw some conclusions as to its effect on the economy and our markets. What normally happens in these financial crises is that the Fed Chairman comes to the rescue and says either the Fed will not tighten monetary policy further, or that you should anticipate future rate cuts to soften the impact on the economy. What we heard this time was somewhat different which creates uncertainty. One definition of uncertainty that we like is “when you don’t even know what you don’t know.” We believe that definition pertains in the case of subprime lending. Nevertheless, Chairman Bernanke and his cohorts said we do not see a recession coming as a result of the housing sector and subprime lending, and that the Board will remain vigilant against the higher risk of increasing inflationary pressures. This Fed double-talk has been interpreted in many ways over the last several weeks. The highest probability interpretation is that this statement is the beginning of the Fed’s shift in policy towards an eventual rate cut in the second half of 2007, or sooner if the housing downturn seriously threatens the economy.

The uncertainty in 2007 is clearly two-fold: how big and how “bad” is the housing problem, and is inflation going to run above 2% for an extended period of time. On the first issue, my definition of uncertainty is quite valid, and on the second issue the probability of tame inflation due to moderate wage inflation and global competition is high. Projected mortgage defaults in the range of $300 billion are unlikely to bring down the U.S. economy into a recession. These defaults, representing anywhere from 1.5-2.0 million housing units will be significant in the softest housing markets. At these levels, the consensus of the experts analyzing the subprime market is that this will not develop into a contagion that spreads to the prime loan market. The unfolding of the evidence from the contraction of this subprime market is clearly “uncertain” and will dictate what kind of market return investors receive in 2007. While we did not forecast the subprime meltdown, we still believe that housing prices will bottom this summer in the worst markets. In essence, we are making that bottom, market by market beginning now and continuing through this summer. Recessions usually occur when the Fed is trying to stop inflation caused by a wage/price spiral - that is not the case today. Our best case forecast continues to be that we are having a mid-cycle slowdown with a manageable financial crisis. We anticipate that a Fed response this year will help the stock market, as was true in 1995 and 1997. While first quarter returns were higher than expected, 10%-12% for the year is not an unreasonable forecast given the “uncertainty” of 2007’s financial crisis in mortgage lending.

Dividends and more dividends.
We have perhaps talked too much about total return investing but after all of the macro discussion above, long-term wealth creation comes back to stock selection and risk control. While the recent “volatility event” of February 27, when the market plunged, was difficult to understand from a fundamental perspective, it was much easier to understand as a very nervous, very short-term change in sentiment. Short-term momentum investors and derivative traders tried to outguess short-term market cycles and that is a very difficult game to play and win. When volatility picks up, as we have seen so far this year, focusing on fundamentals and anchoring many of our investments with a base of solid and growing dividends allows us to focus on what we want to own for the long-term. This prevents being flushed out of good companies that are executing value building strategies. The latest dividend numbers for the S&P 500 counted 1,969 payout increases in 2006 from about 7,000 public companies. While that is a modest gain from 2005’s 1,949, it is 13% better than 2004’s 1,745 companies. It is also the most hikes since 1998’s 2,047. Extra dividends were notable in 2006 with 622 companies, up 14% from 544 the preceding year. This gave shareholders an extra bump of cash in their pockets.

Last quarter we talked about the multiple benefits that accrue to a portfolio from owning trees in the form of a real estate investment trust (REIT’s). In the quarter’s letter we thought it would be interesting to highlight the rationale for owning hotels in the form of a REIT. REIT’s are pass through corporate entities that by law have to pay out approximately 90% of their taxable income directly to shareholders. Almost all of our normally diversified portfolios hold a hotel REIT called LaSalle Hotel Properties (LHO), based in Bethesda, Maryland. LHO specializes in owning upscale and full-service hotels and resorts; it owns 27 hotels with about 8,500 rooms. LHO is a pure real estate ownership vehicle as it neither manages nor franchises brands. Most of LHO’s hotels are operated under management agreements with independent third parties such as Kimpton, Noble House, and White Lodging. Over 80% of the management contracts can be terminated upon a change in control. This gives the company flexibility with respect to selling a hotel property, and purchasing an undervalued hotel property that they can upgrade and improve profitability. LaSalle owns a combination of urban hotels (39%), convention facilities (29%), and resort properties (32%) with concentration in Washington, D.C. (20%). Some of their properties that you may have heard of include: San Diego Paradise Point, Lansdowne Resort, Hilton San Diego Gaslamp, Westin Boston Copley, Westin Michigan Avenue, Harborside Hyatt in Boston, and the Hotel Viking in Newport, RI. LHO’s strategy has been to upgrade their hotel portfolio by buying underperforming, well located properties that can be renovated, commanding higher room rates, and selling hotels that have reached their full potential. Given the favorable supply and demand characteristics of the upscale sector over the past few years, revenue per available room (REVPAR) has been growing at 8% or better and occupancy has been strong. LHO has been able to increase its dividend from $1.08 in 2005 to $1.68 in 2007, up 60% in the last three years with good prospects for continuing future dividend growth. Current yield is 3.5%, and CEO Jon Bortz owns 228,000 shares along with options to buy another 135,000 shares. Management’s objective is to create shareholder value by providing a reliable stream of income with moderate long-term earnings growth by being opportunistic in buying and selling hotel properties to create value. With diversity in their hotel holdings by type and location and with a nice base of dividends, LHO represents another long-term asset that we are comfortable owning in your portfolio. Please let us know if you would like a complete list of their properties as we can always use direct input from the field if you should happen to stay in any of their locations.

We welcome any questions you might have at any time.

Thank you for your continued support.

Sincerely,

Todd Robbins Lee Garcia CFA

* The foregoing information is not audited and has not been otherwise reviewed or verified by any outside party. While Five Mile River Investment Management, LLC endeavors to furnish accurate information, investors should not rely upon the accuracy or completeness of this information. 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 securities may be made only by means of delivery of a Five Mile River Investment Management Agreement. 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.