PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 5.0% 4.3% 3.6% 13.7%
The first quarter of 2006 gave us a broad and robust stock market, somewhat surprising the consensus that continues to worry about rising interest rates after two more Fed Funds increases to 4.75%. Small stocks (+14%) outperformed large stocks (+5%) by a wide margin in the first quarter, continuing a long-term trend over the past three years. Long-term bonds (30-Yr Treasury Bonds) declined (–4.35%), as rising short rates pressured the long-end but not as much as expected as the yield curve flattened, and then modestly inverted towards the end of the quarter. Our Five Mile River accounts were up +5.03%, with our energy and utility holdings correcting after a strong 2005; and our REIT holdings up significantly. We said at year-end that the broadening of the market in the fourth quarter was the beginning of a healthy trend for the whole market that could give us total returns of 10-15% by year-end once the Federal Reserve stopped tightening the Fed Funds rate. While the new Chairman, Ben Bernanke, speaks more clearly than former Chairman Greenspan, the recent language from this Chairman and other members of the committee leave open the possibility of a move to 5% at the May meeting, if needed, to keep any inflationary creep out of the economy. Clearly Chairman Bernanke wants to be seen as decisive and strong at the beginning of his reign. The odds of a 5% Fed Funds rate seem quite high right now, and then we think there might be a pause into the summer to assess the incoming economic data points that will govern any future tightening. These next couple of months of further uncertainty about interest rates could cause the market to go sideways, perhaps back track as much as 5% if any negative news on the inflation front surfaces, but generally this would be a disappointing waiting game after the strong gains in the first quarter. Price earnings multiples across large and small companies are compressed and there are no glaring pockets or sectors of severe undervaluation. In such an environment, plain old bottom-up stock selection and research pays dividends.

No prior pun intended, but as we have expressed many times in our letters, dividends and real cash matter in successful total return investing more than ever today. Contrary to what most investors think, around 65% of overall stock returns have come from the compounding of reinvested dividends (without reinvestment, 40% of total return). From 1985 through year-end 2005, dividend paying stocks in the S&P 500 returned about 10% versus about 2.5% for non-dividend stocks over the same period. Since the tax rates were equalized on capital gains and dividends two years ago, companies have been increasing their dividends at a record rate. Standard and Poor’s said there were 1,949 payout increases among the approximate 7,000 public companies, up almost 12% from 2004’s 1,745 increases. Last year marked the fourth consecutive year of dividend improvement, and Standard and Poor’s estimates we could see roughly 2,000 dividend increases in 2006. The aggregate dollar numbers are very big. The S&P 500 companies paid a record $202 billion in dividends last year up 11% from 2004. In addition, these companies spent $315 billion on stock buybacks, up 60% from the $197 billion spent in 2004. If looked at on a combined basis, cash plus buybacks produced yields on year-end values of 4.6%. These numbers show both how profitable and how liquid corporate America is right now, and auger well for positive stock market performance in the year ahead. We have talked in the past about some of the company characteristics we are looking for in our investments and free cash flow has been at the top of our list for some time. Free cash flow is what is left over after all expenses of running the business are deducted, including required capital expenditures to sustain a company’s growth. Free cash flow is desirable because it can be used to acquire new assets or companies that are accretive to earnings; it can buy back stock which increases the value to existing shareholders; and finally, it can be used to pay out cash in dividends to shareholders, a most positive action increasingly in evidence across corporate America today.

I thought it would interesting to talk about one of our core holdings that has been and is today a total return dividend machine for it’s investors, Kinder Morgan Energy Partners (KMP). KMP is the largest ($10 billion+ market capitalization) publicly traded energy master limited partnership (MLP) that provides petroleum (oil, gasoline, jet fuel) and natural gas services over 24,000 miles of pipelines across America. The company also produces and transports carbon dioxide through pipelines to oil fields where it is pumped into the ground to enhance recovery of petroleum reserves. KMP also owns and operates 75+ bulk storage terminals and more than 55 rail transloading and materials handling facilities in the States. As an MLP, Kinder Morgan is not a taxable entity for federal income tax purposes as all income are distributions passed onto shareholders of KMP (limited partners) where approximately 90% of the distributions are non-taxable as a return of capital and reduce the tax cost base of your shares. Upon selling the shares, the gain that is taxable (assuming held for one year) is taxed as a long-term capital gain. Led by the founder and very capable CEO Rich Kinder, KMP has the best reputation in the now well developed MLP energy sub-sector. The company is focused on free cash flow and acquisitions that add to earnings. Using the cost effective MLP equity as currency in these acquisitions has led to some 24 dividend rate increases since KMP came public in 1997. The success of KMP and much of the MLP sector that evolved following KMP came from Rich Kinder’s ability to transform what was a low-growth, yield-oriented investment into a growth vehicle by focusing on fee-based assets (transporting and storing gasoline, jet fuel, and natural gas) in growing population markets (Las Vegas, Phoenix, California), increased asset utilization (more products through the pipes), cost cutting, earnings growth through acquisitions that fit the pipeline network, and minimizing commodity price risk (KMP gets paid the same for transporting a barrel of oil whether it is $70/barrel or $35/barrel). Today KMP is at critical mass where it can generate most of its own organic growth prospects without resorting to as many acquisitions. KMP’s long-term distribution objective has been to grow the dividend 8-10%/year and it has delivered on that commitment over the past eight years. While distribution growth will slow in 2006-07 from this pace, KMP has recently announced a $4 billion Rockies Express system that will be the largest natural gas pipeline built in over 20 years. It will extend 1,500 miles from Wyoming to eastern Ohio and be capable of transporting up to two billion cubic feet of gas per day. Shipper support has been quick and substantial, and the financing is already lined up to begin this enormous project which is likely to be completed by June 2009. Ninety percent of the pipeline route will parallel existing utility corridors, reducing the environmental impact. The economic leverage to the KMP master limited partners is significant and reinforces our desire to maintain an above average weighting in KMP for our clients over the next three years. KMP currently trades at approximately $48.00, yields 6.7% on a projected $3.20-$3.25 dividend in 2006, growing to an estimated $4.30 by 2010 from already announced projects and growth initiatives. Most of our accounts also own the parent corporation of KMP, Kinder Morgan, Inc (KMI), a tax paying entity (C corporation) whose ownership interests include an investment in KMP master limited partnership units, and two other major pipeline companies. This investment is a unique vehicle and warrants separate discussion in a future quarterly report which we will be sure to spend some time on for our clients.

We hope this rather extended explanation of one of our core investments is helpful in understanding the kind of assets we are looking for, and in explaining the financial characteristics that are attractive for long-term holdings.

We welcome your comments or questions. Please feel free to phone or email us at any time. Thank you for your continued support.

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.