PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (1.0%) (2.2%) (8.6%) (5.6%)
2nd Qtr 5.5% 1.4% 0.7% 4.0%
YTD 4.2% (0.8%) (7.9%) (1.8%)
In the second quarter of 2005, the S&P 500 performance improved to positive territory at +1.4% versus the –2.2% in the first quarter of the year. The NASDAQ was up almost +3% and the small stock index Russell 2000 was +4%. Five Mile River’s portfolio was +5.5% and outperformed the market for the same reasons as we experienced in the first quarter, namely above average weightings in the three strong sectors of energy, utilities, and real estate. In addition to those sectors, healthcare and telecommunications were good performers for this quarter. The S&P 500 has been virtually flat over the last 18 months and the Fed has been tightening for the last year with the federal funds rate now at 3.25%. Our expectation since the end of last year has been that the market would trade in a tight range with virtually no progress until the Federal Reserve’s last tightening was quite clear. We have not changed our opinion that the end of this tightening phase would be this Fall. The Federal Reserve’s policy goal is to move interest rates to where they have a neutral effect on the economy that constrains what they describe as a “frothy” housing market without pushing the economy into a recession. Mid-cycle slowdowns are basically good for stocks as they take the edge off higher inflation expectations. Both the 1985 and 1995 mid-cycle slowdowns were accompanied by significant positive equity returns. Against this background, we are still on course for year-end market returns of +6-10% and the potential for higher returns in 2006.

What is going on with oil and gas pricing? The simple explanation is that oil demand exceeds supply because of large incremental demand coming from China. Furthermore, the supply side is constrained by the gradual peaking and decline curves for most of the major petroleum basins in the world ex the Middle East. The micro factor affecting gasoline prices in the U.S. is the shortage of refinery capacity as no new refineries have been built on U.S. soil in over 20 years. In our first quarter letter we said that the speculation in energy was potentially a serious catalyst for exacerbating the mid-cycle slowdown, but that the energy component of our economy is much less today than 1980 and therefore the impact of high oil prices was more likely to induce a slowdown, not a recession. We still feel that way but the pricing has been higher for a longer period of time than expected, and there is little doubt that our economic growth will be negatively impacted by -.5 to -1% from what it would have been without this 50% spike in energy prices. With the economy growing at 3.5% versus 4.5% last year, this is clearly a hit to the U.S. economy, but not a fatal blow. Typically, oil leads GDP by about one year which means that the economy is now slowing and should continue to slow at least into the first quarter of next year. The positive in these high prices is that they help slow the economy along with the Fed’s interest rate hikes sooner rather than later and thus get us to a neutral fed funds rate that may not be as high as the most bearish forecasts. Our thinking is that another 25-50 basis points, or 3.5% to 3.75% by this Fall, will be the peak for this cycle because of the incremental slowing effect of high energy prices. Further evidence that we are witnessing a global slowdown from the price of oil is the peak in the leading economic indicators for Europe in early 2004, and the continuing decline in the growth rates for those economies. Recent evidence from China also points to some slowing in their unsustainable domestic growth rate. We expect a pullback from the $60 level for oil prices this summer supporting the mild slowdown scenario. Your portfolio has benefited over the past year from our significant energy weightings and the important fact to know is that the companies you own, whether they are pure natural gas exploration companies, oil service companies, pipelines, or coal producers, do not depend, for their continued growth and success, on $60/barrel oil and $7.00/mcf natural gas. None of the managements of these companies have priced in these levels in their capital expenditure decisions, hiring decisions or acquisition strategies. Most energy companies are using oil prices around $30/barrel in their planning and when you see recent reserve acquisitions, most of these are being made at $2.00/mcf in the U.S. We like these companies for their internal organic growth prospects to create shareholder value, and for their management’s interest being strongly aligned with ours through substantial insider holdings of common stock.

Before closing with a few portfolio comments, we wanted to touch briefly upon the so-called “housing bubble” and consumer net worth. It is clear to many of us that in certain markets around the U.S., speculative investment in housing has risen to levels that are not sustainable in the long-run. These markets will certainly correct by going flat and possibly down in pricing where the supply of housing exceeds the underlying demand. However, this is not a national issue, but a localized issue that we feel will sort itself out by the free market pricing of homes until a better equilibrium is reached. Good examples of markets that have seen unsustainable levels of speculation include several cities and towns in California, Florida, and Nevada. A market like Phoenix that we know first hand does have about 20% of home purchases by investors, but it also has reasonable prices compared to California and thus is attracting about 120,000 new people a year, 25% of whom are from California. Demand exceeds supply and the builders in Arizona are successfully managing demand and not over building. In a broader context, home prices in the U.S. are approximately 3.5x incomes compared to other countries which are 4.0x and up. As a point of reference, home prices in Japan in 1990 reached their peak at 10.0x income. We do not foresee a “national” housing bubble. Finally, a few aggregate consumer net worth numbers are supportive of our conclusion. Consumer net worth in the second quarter of 2005 is about $49 trillion, helped considerably in the last two years by increases in the value of real estate. However, consumers have $5 trillion of cash reserves in savings, which represents over 50% of personal income. We have made the point in the past that there is ample liquidity in the U.S. economy for further investment in common stocks, particularly with the 10-year Treasury Bond yielding about 4.0%.

We are invested in solid business models that produce free cash flow with managements whose interests are aligned with ours because of their substantial common stock ownership in their own companies. Their incentive to create shareholder wealth is strong because of that ownership and manifests itself in asset sales, spin-offs, growing dividends, special dividends, and share buy-backs. We have been investing in companies with growing dividends for three years now as the impact of 15% taxation on dividends, equal to the long-term capital gains tax rate, becomes more apparent as a winning strategy for creating value with lower volatility. As an example, Steven Malcom, CEO of The Willliams Companies since 2002, owns over 1.8 million shares of common stock and options, and the officers and directors of Williams own over 5.6 million shares of stock and options. At a recent price of over $19 per share, that represents over $110 million dollars of net worth for the team leading this remarkable turnaround of a natural gas company. Williams explores for, produces, gathers, processes, and transports natural gas; and manages a wholesale power business. They focus on the Pacific Northwest, Rocky Mountains, Southern California, and the Gulf Coast. Their gas reserves and pipelines are among the highest quality assets in the U.S. Our three year price target is $30.00 per share as the Williams’ management team continues to create value from restructuring steps and internal organic growth opportunities. This is but one example of the kind of real assets and solid management we invest in for our clients and ourselves.

As a registered investment advisor, we are required annually to send our investors a copy of our privacy policy and our proxy voting policy, which is enclosed with this mailing. In addition we will be glad to furnish, upon request, copies of our ADV filings Part I and Part II, or our code of ethics.

While this epistle is somewhat longer than normal, we wanted to cover a range of current topics affecting the markets and hope you find these comments of interest. Please do not hesitate to call or email us with your questions and observations.

Sincerely,

Todd Robbins Lee Garcia CFA

* Results are unaudited.

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.