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%
3rd Qtr 9.5% 3.6% 7.2% 4.4%
4th Qtr (4.2%) 2.0% 2.7% 0.8%
YTD 9.63% 4.88% 1.49% 3.32%
The stock market in 2005 ended the year just about where it started twelve months ago with most of the indices recording very modest gains on the year. The S&P 500 was up +4.9%, the Dow Jones Industrials +1.7%, the NASDAQ 100 +1.5% and the Russell 2000 (small companies) +3.3%. We had expected a basically flat market for the year because once the Federal Reserve starts to tighten interest rates, the stock market typically becomes range-bound. Corporate earnings were up nicely this year with the S&P 500 operating earnings running at about an $82 annual rate in the fourth quarter, up 13% year over year, but also typical was the decline in the price earnings multiple to about 15 times earnings. At the beginning of the year we thought it would be difficult to produce much more than +8-10% returns for the year and we were not far off that mark as Five Mile River’s portfolio was up +9.63% for 2005. The final quarter of the year for FMR was –4.2% vs. +2.0% for the S&P 500 as modest price corrections took place in previously strong groups such as energy, utilities, and real estate investment trusts that have significant weightings in our portfolios, and had outperformed in the first three quarters of the year.

What do we see as the key variable for 2006? Clearly, we view 2006 as the time frame for the end game of the Federal Reserve’s cycle of tightening. Past quarterly letters have stated that once the market perceives the last Fed tightening and once the Fed actually stops tightening, the stock market can rally nicely even though the economy slows and earnings slow while price earnings multiples can expand once again. The cycle is not new and equity investors are likely to begin to anticipate two to three years of non-inflationary rising growth starting in the fourth quarter of 2006 and into 2007-2008. After thirteen consecutive quarter point increases in the Fed Funds rate, our best guess is that we get no more than two, and most likely just one more to 4.5% at the end of January when the new Chairman takes over.

At the end of the third quarter we commented on both energy prices and housing; and our expectation that both would moderate from over heated levels in the short-term. This expectation started to be realized in the fourth quarter and will keep going in the first half of 2006. Housing is continuing to slow as we enter the New Year as the number of new and existing homes for sale is up 18% year over year, and new home prices have gone flat in many markets around the country. Existing home sales have declined 4% over the past two months and existing home price increases have slowed. Our view of an orderly unwinding of speculative home markets around the country is unchanged as this market has always been self-correcting and this time is not any different. Mortgage equity withdrawal is estimated to have been about $800 billion dollars, with half of that amount being spent representing about 4% of consumer spending. As home prices flatten out and mortgage interest costs rise, mortgage equity withdrawal (MEW) will decline significantly in 2006, helping cool the speculative psychology that has surrounded residential real estate for the past several years. This is not a collapse in housing but is a healthy long-term trend for the residential real estate sector of our economy. Post-hurricane Katrina speculation in energy prices was also over done, unsustainable and not healthy for the U.S. economy. Inflationary fears from the impact of significantly higher energy costs filtering through our economy are beginning to subside due in part from the high of $70 per barrel of oil this past Fall to trade in a more normalized band of $45-55 per barrel of 2006 production. Gains from non-OPEC producers along with OPEC supply increases should rise faster than world oil demand despite the huge growth in China. Demand substitution (coal, nuclear, wind, solar) and demand destruction (coal for natural gas) will continue for the next few years as the shock of these prices filters through energy decision makers at all levels of the economy. Prices will be higher to be sure, but this new normalized level will not derail our economy, nor lead to an out of control inflationary spiral. All energy consumers, whether individuals or businesses or governments, will learn to adapt, substitute, and become more energy efficient as we have done in past energy price shocks.

Dividend increases and stock buybacks continue as one of the hallmarks of the kind of companies we are researching and buying for Five Mile River portfolios. We have commented in almost every quarterly letter on the importance of finding companies whose business models generate free cash flow (FCF) after operating expenses, maintenance and growth capital expenditures. Free cash flow provides managements with the flexibility to increase shareholder value by both buying in their existing shares and by increasing their dividends to shareholders. With dividend taxes and capital gains tax rates equalized, we have focused on finding companies that have this key characteristic and it has paid off in better performance than the broad market over the past three years as price earnings multiples contracted from rising interest rates. Companies continued to adopt the secular trend of initiating dividends and increasing them in 2005. They also ramped up share repurchase plans, because their shares have not looked expensive relative to alternative uses for their cash. Over the past year 1,012 U.S. based publicly traded companies declared over $450 billion worth of stock-repurchase plans, up from 728 companies and about $300 billion in 2004. Furthermore, actual stock buybacks increased substantially as the largest 100 public companies bought an estimated $400 billion of their own shares last year. Cash takeovers last year were also at a record level of $277 billion, eclipsing 1999’s previous record of $231 billion. Corporate America, along with billions of dollars of liquidity in private equity funds, demonstrates continued bullishness about the reasonable equity values in the U.S. stock market.

How do we see the opportunities in 2006? We are absolutely more positive about the prospects for the U.S. equity market than we were one year ago when the end of interest rate increases was not clear, nor in sight. After watching the end of the Fed’s cycle and digesting the economy’s mid-cycle slow down, we believe the stock market will anticipate and begin to discount rising, non-inflationary growth in 2007-2008 during the back half of this year, if not before. In contrast to last year’s market returns of +1-5%, we expect the broad indices to deliver 10-12% in 2006.

We have commented many times in the past year about how unhealthy such a narrow market (energy, real estate, utilities) was and that a broadening of industries and sectors was necessary before a healthy rise in the market could take place. That broadening started in the fourth quarter with technology, transportation, health care and other sectors improving and looks to carry forward in a good start to 2006. While we continue to want to own natural gas reserves and hard assets throwing off cash, we expect to keep on diversifying our names into other sectors with free cash flow business models. We maintain a positive view of the hotel sector, and have added to our existing LaSalle Hotel Properties holding where appropriate, and are researching other names in this attractive industry. There is a global glut of both labor and capital, but not of real estate and other scarce commodities. Land is attractive to own, especially when incremental capital can enhance the value of this real asset. We expanded our media holdings last year in both Viacom and Time Warner, both of which underperformed the market and provided us with attractive entry prices. Viacom split into two companies on January 1, 2006: CBS, a slower growing value play with the CBS network (TV and radio stations, billboards, publishing and over $1 billion of free cash flow) and new Viacom, a growth play with the movie studio and the cable networks. We thought the old combined entity was under priced by 30% and wanted the opportunity to sell the growth piece upon split up and reinvest in the value piece. We expect the value play, CBS, to increase dividends substantially over the next several years, buy in stock, and manage a more focused “old” broadcasting portfolio to the advantage of us as shareholders. Our price target is $35 from the post split price of about $25 over the next two years. We will continue to look for this kind of opportunity in the year ahead to supplement our core dividend growth companies that we expect to deliver 10-15% total returns in the year ahead.

As always, please do not hesitate to call or email us with your questions and observations. We are available for conference calls at your convenience.

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.