PERIOD FMR* Taxable S&P 500 DOW JONES Nasdaq
1st Qtr 5.62% (1.29%) (.92%) 2.17%
2nd Qtr .74 1.30 .75 (0.001)
3rd Qtr 14.73 (1.87) (3.40) (3.10)
4th Qtr 6.60 9.23 7.00 13.70
YTD 30.12 10.88 3.10 17.00
Last year we forecast that the S&P would increase between 10-12%. The assumption was that rising interest rates correlate with a contraction in P/E’s. Our forecast of 15-20% earnings growth in 2004 would therefore generate low double digit market returns. The surprise for all was that the 10-year Treasury bond started and ended the year at 4.20%. Recycling of excess dollars into U.S. Treasuries from our trading partners kept the benchmark 10 year paper unchanged versus our year-end expectation of 5% yield for these bonds. This contributed to top performing returns in many interest rate sectors: utilities, REITS, and housing related stocks.

Five Mile River’s portfolio continued to perform well in the fourth quarter and our performance in 2004 at about +30% was clearly higher than we expected given our outlook that the economy would slow as the FED tightened. With the exception of a broad rise in the market for the fourth quarter, the first nine months of 2004 were flat as the market stagnated over concerns about corporate profits, interest rates, the war in Iraq, and the outcome of the November elections. We performed better than the market for two reasons. One, we focused on companies with free cash flow that pay dividends. This portion of the portfolio included: companies that initiated new dividends (Microsoft), companies that increased their dividends at a faster rate than expected (Texas Utilities, Kinder Morgan), and companies that paid special dividends (Microsoft, Redwood Trust, Citizens Utilities). Secondly, we invested in the energy and utility sectors with a significant weighting in our portfolio. When 2004 ended, these two sectors were the best performers with energy +28% and utilities +20% for the year. REITs were also up significantly for the year at +37%.

Our forecast this year is that market returns will be in the 6-10% range. We do feel that higher rates on the 10 year benchmark bond will continue to pressure price earnings ratios as S&P profit expands at an 8-10% pace. The primary difference in 2005 is the economy is likely to slow as the consumer feels the pinch of higher interest rates (on variable mortgages and credit card debt), higher energy prices, the absence of any significant home refinancing activity, and the lack of fiscal stimulus (tax cuts). While much of this forecast would have been true six months ago, now the consumers’ primary asset (housing) is unlikely to appreciate further, and in fact will probably stagnate in some of the over-built and over-heated markets. This has the dual penalty for the consumer of a negative wealth effect restraining spending in general and the inability to pull cash out of one’s home. The fact that real interest rates have been negative for over a year has contributed to a record level of debt issuance and refinancing activity. Historically low borrowing costs also fostered speculative buying across a number of asset categories in 2004. This was evident in select commodities, housing, and some sectors of the stock market. In 2004 housing prices advanced over 13%, the largest annual price increase since 1979! The Federal Reserve has increased short rates five times (125 bpts) bringing Federal Funds rates to 2.25%. It is highly likely that the Federal Reserve will continue increasing short rates to between 3-3.5% this year. This would achieve positive real rates, and dampen much of the financial inducement for speculation. Does this activity unwind gradually or abruptly? We are expecting the former.

Corporate profit growth (8-10%) will be one of the positive contributors to GDP increasing about 3.5% in 2005. The issue, however, will be the sustainability of earnings growth. Bears will point to historically high profit margins, likely a peak because of cost pressures from wages and commodities. Absent from this concern is the fact that corporations have achieved remarkable liquidity, both from refinancing debt and managing working capital. Cash held by corporations has doubled over the last three years and now stands at $2 trillion! While profit growth will slow as 2005 progresses, there is good reason to suspect that 2006 will be another year of growth in the economy and corporate profits. This should provide a positive bias for the stock market, particularly given the $5 trillion of cash yielding less than 3%!

We highlighted in our third quarter letter that the reduction of tax rates on dividends was more significant than most investors initially thought and the evidence of this was the wide disparity in the performance of dividend versus non-dividend payers in 2004 (+10%e). In a recent National Bureau of Economic Research paper; “Evidence from 2003 Dividend Tax Cut” by Chetty and Saez, University of California at Berkeley, the percentage of companies that paid dividends increased from 20% in the fourth quarter 2002 to 25% in the second quarter 2004. This reversed what had been a long-term decline in companies paying dividends. Furthermore, the 2003 reform also increased the number of companies that raised regular dividends by at least 20% from 19 companies per quarter before reform to 50 companies in the post-reform period. The study also revealed that the number of one-time special dividends rose from 7 companies per quarter pre-reform to 18 companies post-reform. The study also concludes that the companies most likely to take increased dividend action were those where the senior management owned significant shares in their company (Bill Gates and Microsoft most notably). This evidence confirms that actual stock ownership by management remains one of the important criteria we look at in making new investments.

The American Jobs Creation Act of October of 2004 provides corporations with a year- long window for bringing cash back to the US at 5.5% taxes versus 35% normally. This new law will force corporations to reexamine their 2005 cash uses. The current level of corporate cash plus this new tax holiday suggest that 2005 will see significant M & A activity (consolidation) in some industries, such as health care, technology, and energy. Additionally, our emphasis on investing in free cash flow generating companies, suggests that a number of our investments should benefit directly from these trends.

We welcome those investors who have joined us this year, and encourage all to share your thoughts and suggestions.


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.