PERIOD FMR* Taxable RCP L.P.** S&P 500 DOW JONES Russell 2000
2nd Qtr 15.10% 8.00% 14.89% 12.43% 22.99%
3rd Qtr 2.86% 5.97% 2.20% 3.22% 8.77%
The U.S. stock market reached its low for this cycle just over one year ago, on October 9, 2002. Pessimism was rampant and money was pouring out of stocks to the safety of cash and bonds. Despite the sizable gains in all indices since then, we fortunately hear from many individuals that this market still does not feel like a bull market. As value investors we are encouraged by the continued skepticism as it gives us confidence that 2004 is likely to be another up year for equities. Many investors were hurt both financially and psychologically by the bubble and longest market downturn in sixty years, so it is only natural to find the consensus cautious.

Two positive quarters in a row for the market was not a high probability event for most investors at the beginning of the year as investors worried about the possibility of a fourth down year. We thought that outcome highly unlikely at the time, and encouraged investors to swap out of bonds and cash (“safe assets”) into stocks (“risky assets”). We continue to believe that with over two trillion dollars side-lined in money-market funds, the downside is protected from significant erosion as these funds earning less than 1% return to equities. Money flowing into stocks during the rally of the second and third quarters amounted to less than 3% of the money market cash! Pension funds, the biggest class of stockholders, have made one of the largest sector bets ever in bonds. With bond yields unlikely to approach the actuarial hurdle (7-9%) demanded of these pension accounts, the probability exists that this class of investors will return to being net buyers of stocks.

While this recovery has been uneven, business conditions and profitability are improving. S&P 500 earnings are estimated to be up 15-16% for the third quarter, and fourth quarter analyst estimates have earnings growing 20-21%. This outcome would put the dollar level of earnings at almost $60.00 and above the 2000 peak. Since profits drive stock prices in the long run, these profits provide a solid base for increased equity returns. Meanwhile, industrial production, retail sales, and even capital spending are picking up; a harbinger of the long awaited upturn in employment growth for 2004. These positive trends, coupled with the FED’s easy money policy and commitment to keep short-term rates low, should provide the fuel for the continuation of an asset reallocation to stocks from bonds.

In our second quarter letter we talked about the growing importance of dividends as a source of investment returns with the reduction of the tax rate on both capital gains and dividends to 15%. In the short-run high dividend stocks have underperformed the low dividend paying companies as the NASDAQ is up over 30% this year with renewed speculation in many of the small technology stocks. Historically, dividends have accounted for almost 75% of the gains during low return periods (1940’s and 1970’s) and only 30% of the total return during the 1982-2000 bull market cycle. What is the implication of this data? Simply, in the lower return environment for the market we see over the next 3-5 years of 8-10%, we expect the new tax policy will cause more and more companies to reassess their dividend payout policy. This will lead to increased payout ratios, increased absolute dividends, and increased share repurchase. Large rewards will accrue to those companies generating free cash flow above their reinvestment requirements. Those kinds of companies are good examples of what we are looking to invest in for the clients of Five Mile River Investment Management. Predictable returns from growing tax protected or tax deferred dividends like Plumb Creek Timber and Kinder Morgan with yields of 5%+ are examples of opportunities in the subset of stocks that offer attractive absolute dividends and total returns in the 10-15% range. The FMR portfolio is full of good businesses providing attractive up front dividends that are growing at above average rates. If we are right that long-term capital market returns will be more modest in the years ahead than what we witnessed in the 1990’s, then yield and growing payouts will become increasingly important for successful stock selection.

Five Mile River Investment Management continues to perform well in its first year and is meeting our objective of generating low double-digit long-term returns with low volatility. We continued to grow in the third quarter with the addition of several new account relationships. We thank you for your referrals and your support.

Enclosed you will find the Third Quarter Performance Sheet, as well as, the Five Mile River Quarterly Statement of management fees paid. As an SEC registered company we file an ADV II form annually describing our business. Please contact us if you would like a copy.

Please do not hesitate to call me, Martha, or Todd with any issues you would like to discuss about our company or your account.

Sincerely,

Lee Garcia - Managing Member

Todd Robbins - Managing Member

*FMR account # 118-17545. Results are net of management fees and are not audited.

**2003 results for RCP L.P. are net of management fees and are not audited.

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.