PERIOD FMR* Taxable RCP* L.P. S&P 500 DOW JONES Russell 2000
1st Qtr 5.62% 2.94% (1.29%) (.92%) 6.00%
The S&P 500 is up over 50% from the October 2002 low to its recent peak in March. Risky assets (stocks) were quite cheap and the preference was clearly for bonds not stocks eighteen months ago. Our view remains that the vast majority of this under valuation has been eliminated by the uninterrupted up cycle and that the market was long overdue for at least a 5% correction to shake out the short-term momentum players who joined this bull-run quite late. We have witnessed many corrections within bull markets, and feel that a decline of as much as 10% is not out of line, given the huge straight-line advance we have just experienced. This pullback or correction of the "animal spirits" is healthy, was needed, and should run its course before the end of April. Does this mean the market will be ready for another 50% move? Unlikely in our view as most of the current good earnings comparisons are already reflected in price earnings ratios that are the most volatile element in valuing stocks. While interest rates are still extremely low by historical standards, we expect the lows have been reached as the bond market has begun to anticipate faster economic growth and "potential" price pressures either late this year or early in 2005. The yield on the 10 year Treasury Bond was unduly depressed (below 4%) due among other factors to the huge inflow of foreign surplus funds to this market as well as the supposedly "riskless carry trade" of borrowing short and investing long to capture the yield spread. Both of these factors should diminish throughout 2004, leading to gradually rising interest rates and this factor alone will keep a lid on stock valuations as reflected in the price/earnings ratio for the market. However, the market is still healthy with stronger corporate profits, margins, and cash flow which will support moderate total returns from equities this year. Because the market valuations are relatively full and unlikely to expand, a large gap exists between what investors expect and what the market is offering. Broad market returns are unlikely to be in the double digits for the next few years so focusing on total return (appreciation plus dividends) in our active stock selection will be critical to earning 10-15% returns we targeted in our year-end letter.

How is our economy doing? The economy is strong, and we believe stronger than most forecasts. The recent blowout 300,000 jobs created for March is a precursor for both strengthening capital spending by businesses and finally an expansion of employment which has been delayed by both strong productivity gains and long-term permanent structural changes in many manufacturing industries. Indications from the transportation sector evidence strong trends in rail, air freight, trucking and shipping. Whether inventory building alone is the cause seems doubtful, yet it certainly is helping. Corporate profit estimates continue to ratchet higher, with Q1 estimated now to be up almost 20%! Surely, the breadth and strength of corporate profit growth will lead to improved employment growth in the months ahead. While the twin deficits are not pretty, current trends are not that bothersome. The rate of federal spending has been flat for over 6 months, and given stronger tax receipts, we may get some breathing room on the budget deficit. The trade deficit will improve as the lagged effects of our currency decline help U.S. exports. I believe the trade numbers are difficult to interpret since companies which manufacture a component offshore must account for this as an import even if it is part of a manufactured good assembled in the US. As in the case of GE (portfolio holding generating free cash flow, spinning off lower growth assets, acquiring higher growth assets, raising dividend), their annual report cites the boom in China as a duel benefit; it is a high growth economy into which they export, and a low cost manufacturing region where they build component parts.

Inflation is always the most important ingredient for any forecast since its effects can be so pernicious. While there is plenty of anecdotal evidence that most purchased goods cost more now than a year ago (i.e., oil and housing), a corporation's largest expense is labor, weighing in at an average of 70%+ of total corporate costs. Labor is in excess supply, and should not be a source of cost pressure for corporations for a number of years. Although energy gets a lot of attention, all commodity costs (including energy) within an average corporation, are less than 5% of total costs. The data we analyze suggest that inflation will most likely not be a 'problem' for possibly another three to five years. Clearly the recent increase in bond yields of 65bpts (US Government 10 year note went from 3.6% to 4.25%) has spooked parts of the bond market, and interest rate sectors of the equity market (some REITS are down over 20% in the last 10 days). We feel inflation is a late business cycle phenomenon and there is only 'anecdotal' evidence of it representing a current problem. The business cycles of the '80's and '90's only saw inflationary pressures after five and seven years respectfully. History suggests this problem is overblown in investors' minds but it is important to remember that P/E ratios on stocks are unlikely to increase from current levels.

Five Mile River Investment Management LLC had a positive return this quarter primarily because of good performance in the energy sector along with the contribution from significant and growing dividends in many of our portfolio holdings. We have advocated investing in companies with above average dividends and the capacity to significantly grow those dividends. Despite the rhetoric about rolling back tax cuts by the Democratic party, we think it is unlikely that the reduction in tax on dividends and capital gains would be successfully rolled back if there were a change of party holding the White House. Over the last two weeks, the higher a company's yield, the poorer the stock has performed relative to the market. There has been a knee jerk reaction to the first large employment report in almost three years as a precursor of higher inflation. We disagree and still believe dividend yield and rising dividend payout ratios make for a long-term conservative winning strategy over the next few years of moderate total stock market returns. Companies started to act this way as well in 2003, with more and more companies increasing their dividends or starting one for the first time and very few actually suspending or decreasing their dividend. The facts are compelling: 229 companies of the 500 in the S&P raised their dividends by a average of 26% in 2003 and 33 companies (including one of our significant holdings, Kinder Morgan) increased their dividends more than once. Finally, 21 S&P companies, the largest number in 24 years, initiated dividends for the first time in 2003.

Our investing themes for 2004 will emphasize both quality and free cash flow generation as we believe it will be those companies that will most be able to increase their dividends, their dividend payout ratio, repurchase shares, and create shareholder value from using this excess cash flow wisely. Consistent with our philosophy, we continue to search for corporate assets selling at a discount from their true business value, and in addition we look for a catalyst to unlock those values. The combination of these strategies will generate above average total returns with moderate risk over the long-term.

This month we welcome our new Office Manager Colleen Bucknum. She has valuable experience in the investment management business and we expect she will make early and significant contributions to the success of our company. As always we welcome your comments and insights. Please inquire if you would like to visit our web site.

Sincerely,

Lee Garcia - Managing Member

Todd Robbins - Managing Member

* Results 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.