PERIOD FMR*
Taxable Estimated
FMR*
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr +8.03% +4.62 % +5.92% +7.06% +7.64%
2nd Qtr -0.40% -1.11% +0.09% +1.41% -1.91%
3nd Qtr -13.05% -15.29% -13.87% -11.50% -12.91%
4th Qtr +14.17% +13.68% +11.80% +7.80% -15.05%
YTD +6.56% -0.16% +2.09% -1.80% -5.45%

Unchanged: The S&P 500 ended the year just where it started, closing at 1257.60 versus 1257.64 a year ago. The total return for this index finished 2011 at +2.1%, and that return all came from dividends! The fourth quarter was +11.8% after being -13.9% in the third quarter, completing an extremely volatile year of big up days and big down days in a nerve-rattling trip to nowhere. The S&P moved more than 2% in a single day 21 times, helped and abetted by short-term high frequency trading (now 50% to 75% of daily volume). The S&P rarely finishes a calendar year at virtually the same price it began, and the index’s total return has only been between -5% and +5% nine times since 1928. The years following those flat years have averaged +26%. While that number offers some positive consolation, we expect another volatile year right through to the November elections as the serious problems in the European Union are not fixed, and the political rhetoric is guaranteed to get worse before the elections. Five Mile River portfolios performed in line with the market, with taxable portfolios moderately performing better than the qualified IRA accounts. This was due to master limited partnerships in the portfolios of taxable accounts, which are not allowed in IRA portfolios.

For the past two years we have been trying to ignore the whipsawing psychology of market volatility in managing your portfolios for long-term total return. We have focused on market dominant companies managed by shareholder friendly managements with dominant business models that generate free cash flow, and most importantly, pay dividends and grow their dividends. Dividend paying stocks give conservative investors an edge, not only for their defensive value in volatile markets, but in their outperformance over the long-term. For a broad index like the Russell 3000, dividend paying stocks were +11% versus +8.5% for the non-dividend stocks over the past 20 years, with significantly less volatility.

Dividends are much easier to predict than price earnings ratios and short-term movements in stock prices. Most of the companies we own have well established dividend policies approved by their board of directors, and few want to cut their payouts to shareholders once they have established this shareholder friendly policy. As we emphasized in our third quarter letter, for the kind of business models we hold in your portfolios, we get paid whether or not the market is up or down. We continue to believe that predictable quarterly cash dividends are the best way for long-term investors to overcome the uncertainties of this volatile market.

WHAT IS FREE CASH FLOW (FCF) AND WHY IS IT IMPORTANT TO DIVIDENDS?

We have frequently discussed in our past letters the importance of dividends to your total return from investing. Dividends come from “free cash flow.” Free cash flow (FCF) is the cash left over after a company makes all planned capital expenditures (plant and equipment) and taxes. That cash can be used for buying back their common shares, paying down debt, acquisitions in new or existing product lines, new growth capital expenditures, or dividends. Over 90% of our holdings repurchase their shares and/or pay growing dividends to increase shareholder value!

Over the past two years we have emphasized that dividends provide about 40% of total return for long-term investors. Furthermore, since 1962, the dividend yield of the S&P has averaged about 40% of the 10-year Treasury Note yield. Today the stock market dividend yield is above the government benchmark bond yield. This phenomenon is rare (7% of the time over last decade) and reinforces the portfolio emphasis on dividend paying stocks. Dividends from companies producing free cash flow can grow, the 2% interest on 10-year Government Notes cannot! As all long-term investors know, a 2% return does not protect assets from inflation, given inflationary increases in personal expenses for medical care, energy, or food.

The vast majority of companies in your portfolios are generating and retaining record amounts of cash. The uncertain political climate for both personal and business taxes, as well as, the unknown and rising costs from new financial, medical, and environmental regulations, have restrained U.S. companies from aggressive hiring and expansion. However, we remain optimistic about potential dividend growth because the dividend payout ratio (percent of earnings) for the stock market is a little under 30%, whereas, historically, the payout ratio has been closer to 50%. Corporate profits have rebounded nicely over the past two years, and while global growth is projected to slow this year, interest rates are so low that it makes sense for managements with free cash flow to increase their dividends to reward shareholders who are patient. We expect the majority of our portfolio holdings to increase their dividends again in 2012. The table below shows the positive dividend history and forecasts for a few of our companies.

FREE CASH FLOW EQUALS GROWING DIVIDENDS:

(IN ORDER:  IBM, KINDER MORGAN ENERGY PARTNERS, MAGELLAN MIDSTREAM PARTNERS, SCHLUMBERGER, MCDONALDS, COCA COLA)

COMPANY 2010 DIVIDEND 2011 DIVIDEND                   2012 DIVIDEND (E)
IBM $2.50                             $3.00                                $3.45
KMP $4.32                              $4.64                                $4.96
MMP $2.91                               $3.20                                $3.44
SLB           $0.84                            $1.00                               $1.15
MCD    $2.26                           $2.80                                 $3.00
KO $1.76                            $1.88                               $2.00

(IN ORDER: IBM, KINDER MORGAN ENERGY PARTNERS, MAGELLAN MIDSTREAM PARTNERS, SCHLUMBERGER, MCDONALDS, COCA COLA)

WHERE IS THE STOCK MARKET AND THE U.S. ECONOMY?

Fortunately, we spend most of our time studying our existing company holdings, listening to managements, and researching potential portfolio replacements instead of trying to predict the market. In other words, our mission is to find the companies that possess strong business models, generating free cash flow, with managements focused on creating shareholder value. A year ago we forecast that higher corporate earnings on a modestly higher price earnings valuation could produce a 1350-1425 range for the S&P 500, or +9% to +15%. The market was flat and that forecast did not happen in 2011, not because of earnings, but because of no confidence in the U.S. and no confidence in the European Union. So for 2012 we are going to use 12x $105 of earnings (S&P 500) for the low end of our range or 1260 (another flat market) and 14x $105 for the high end at 1470 (+17%). WHY?

Corporate profits are likely to be up again in 2012 but at a more modest rate (+5 to +10%) compared to +15% last year.  Interest rates will continue to be repressed by the Federal Reserve at artificially low rates.  The Fed printing more money has not worked to spur the economy and real GDP is likely to again be anemic in 2012.  There is nothing magic or necessarily concrete about what the appropriate price earnings ratio should be for the stock market.  Stock market investors did not want to pay a higher valuation (price earnings ratio) in 2011 and whether or not investors pay higher valuations in 2012 are likely to be answered by how effectively the European Union manages the “endgame” of too much debt and too much government spending.

As all of us continue to watch Europe struggle along with our historic political confrontation, our recommendation continues to be to stop waiting for “normal” economic growth and “normal” unemployment and “normal confidence” and collect our quarterly dividends while we wait for sanity and solutions.  We should expect more grinding market days in 2012 like we had in 2011, and we truly understand these days only increase investor aggravation and frustration.  We encourage all investors to not overreact to the daily assault of negative stimuli when facts and logic go out the window.

We know much more today about the nature of the serious negatives facing the U.S., Europe, China, and the Middle East.  We do not know the timing or the magnitude of their impact in 2012, but we do know that it helps to have a steady framework for making informed decisions coolly and objectively.  We have such a framework in our focus on free cash flow, share buybacks, and dividends.  Forecasting these three metrics is easier than forecasting global confidence.  We expect that inevitably, definitive solutions to our seemingly intractable problems will come into focus because the status quo is not a viable option.  Patient stock market investors in high quality dividend paying companies will benefit over the next several years.

Sincerely,

Lee Todd Martha Colleen

*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. Fourth quarter and YTD approximate performance ranges are due to the conversion to Royal Bank of Canada (RBC) in June. Individual performance reporting will be available shortly from RBC.

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.

Please remember to contact Five Mile River Investment Management if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations. Please also advise us if you would like to impose, add, or to modify any reasonable restriction to our investment advisory services.