PERIOD FMR*
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 5.0% 4.3% 3.6% 13.7%
2nd Qtr 2.5% (1.4%) (7.5%) (5.3%)
3rd Qtr 1.3% 5.7% 5.0% 0.1%
YTD 8.5% 8.5% 0.5% 7.8%

The third quarter of 2006 started off with the Federal Reserve pushing the Federal Funds rate to a five year high and its seventeenth consecutive increase for this short-term borrowing cost. Oil prices pushed to their highest level in history at about $78/barrel, and we continue to watch housing weaken across the country with existing home prices likely to show a decline for the full year for the first time on record. If these concerns were not enough, the controversy over the Iraq war will undoubtedly raise the level of political rhetoric to uncomfortable levels as the November elections approach. Among all these negative factors and concerns, the S&P 500 just put in its best quarter of the year, and the big cap stocks of the Dow Jones Industrial Average have taken the Dow to a new high in early October. As we have said in our earlier letters, this midterm election year was going to look weak until the majority of investors believed that the Fed was done raising interest rates. While it took longer than we expected for the Fed to reach the promised land of a soft landing for the economy without inflation, the mitigating factors in the length of this unprecedented interest rate cycle were really two-fold. First, the Fed had instigated an extraordinary low level of interest rates (1%), thus artificially over stimulating housing to the point of creating speculative bubbles in at least a dozen hot markets around the country; and second, the timing of the change to a new Fed chairman contributed to lengthening the cycle because he needed to create an aura of credibility about his willingness to be an inflation fighter for bond market investors.

While inflation may have looked ominous this summer and early fall because of rising energy and commodity prices, our expectation is for a cooling of what has been demand pull and energy/commodity created inflation. Prices of basic commodities should continue to moderate into the fourth quarter as speculation subsides. The 2006 mid-cycle slowdown should prove to be just that, not a recession, led down by housing and autos, with compensating support from the consumer as gasoline prices decline and capital spending and commercial construction continue to get stronger. The bond market has already signaled that it is not upset with the outlook, as this slowdown is very unlikely to play out as a recession with rapidly rising labor costs. Emerging economies of substance like Brazil, India, China, and Russia are growing at above average rates and are big enough (collectively larger than Japan, for example) to make a difference in demand for both industrial and consumer goods. With gasoline down (3.7% of consumer spending versus 7.2% twenty years ago), ten-year bond yields down from over 5% to 4.6%, and the stock market beginning to discount the prospects for rate cuts in 2007, the outlook for stocks is excellent projecting into 2007-2008.

While your Five Mile River portfolio outperformed this narrow trading range market in the first half, the FMR portfolio trailed the S&P 500 index in the third quarter as our oil, gas and natural resource positions underperformed the resurgent large cap growth stocks in the S&P 500. Technology stocks, as represented by the NASDAQ, were up 4.7% in the quarter and are now almost flat, or .5% year-to-date. Smaller capitalization companies, as depicted by the performance of the Russell 2000 index, were flat for the third quarter at .1% and are now up 7.8% for the year. While we are clearly not traditional technology investors and have no representation in this higher volatility sector, we are significant natural resource investors through our investments in pipelines, natural gas, coal and timber. We believe that the oil and gas cycle remains in tact because slower demand growth in developed countries will very likely be offset by growth in developing economies. These developing economies have accounted for 85% of world energy demand growth since 2000 with China alone responsible for one third of the increase in oil consumption. The other side of the picture is the supply response, and while higher prices will increase energy supplies from deep-water fields and Saudi Arabia, these sources are not likely to be sufficient to make a big difference in the overall supply balance for many years to come.

We are particularly oriented towards U.S. natural gas in many of our investments as annual demand growth ranges between 1-3%, but supply will be the critical variable. We have only been able to keep natural gas production in the U.S. flat over the last three years even with doubling of the rig count looking for natural gas. New gas is hard to find in the U.S. onshore and when found it is more expensive than ever to extract because of its depth and the higher cost technology and equipment required to bring this clean fuel to market. In spite of this, onshore growth in natural gas supply looks very positive over the next few years from some of the deeper geology in the Rocky Mountains and particularly in many of the tight gas shale formations. FMR portfolios have investments in two to three strong organic growth natural gas exploration and development companies (XTO Energy, Ultra Petroleum, Williams Companies). These onshore gains will be offset completely by offshore production declines in the Gulf of Mexico because of very rapid production decline curves from reserve depletion. The bottom line for us, as natural gas investors, is simply that the supply side of the gas equation in the U.S. will be difficult and challenging for the foreseeable future. Global gas demand will continue to grow outside the U.S. as electricity demand is driving natural gas consumption.

With the recent correction in energy stocks over the past six months, the valuations of our companies at under four times cash flow makes these companies extremely attractive, once the psychology of the declining oil price subsides. Many of these companies will use a significant part of their free cash flow to buy in shares at current levels. Frankly, natural gas corrected off its post Katrina spike from $15.00/mcf last winter to $6.00/mcf by the spring, while oil did not correct during this period. Now that oil is correcting from its speculative bubble price of $78/barrel to the $50-60/barrel range, and speculative hedge fund energy contracts are being unwound, U.S. natural gas companies will be attractive buys in the fourth quarter heading into the winter heating season. The last point we want to make is that our pipelines (most of which are in the corporate form of master limited partnerships) are not commodity price sensitive as they get paid on the volume flowing through their pipes and those earnings are, for the most part, passed through to us in the form of tax deferred dividends as return of capital. We continue to like these MLPs and will add them where valuations are reasonable and dividend growth prospects are strong (Kinder Morgan Energy Partners, Williams Partners, Crosstex Energy, Magellan Midstream Partners). In an earlier letter this year, we talked about Kinder Morgan Inc. which we have owned for some time in our portfolios and is being taken private early next year at $107.50 per share. KMI is the parent corporation of one of our core master limited partnerships, Kinder Morgan Energy Partners (KMP) and owns about 15% of the KMP shares outstanding. While we have discussed KMP previously, we wanted to reiterate our continued enthusiasm for this kind of investment, even in the face of volatile energy prices.

KMP is one of the largest public pipeline limited partnerships in the U.S. that we own for all taxable accounts. KMP owns or operates 27,000 miles of pipelines and 145 petroleum storage terminals. Their pipelines transport more than two million barrels per day of gasoline and other petroleum products, and up to 8.4 billion cubic feet of natural gas. Their terminals handle over 80 million tons of coal and other dry-bulk materials annually with liquids storage capacity of about 70 million barrels for petroleum products and chemicals. Also, KMP is the largest transporter and marketer of carbon dioxide for enhanced oil recovery projects in the U.S., transporting over 1 billion cubic feet/day of CO2 through 1300 miles of pipelines. KMP has 222 million shares outstanding, 157 million shares actually floating in the marketplace, with a market capitalization of approximately $9.6 billion. The stock trades at $43-44 with an estimated dividend payout this year of $3.28, or about 7.5% yield (90% of the $3.28 non-taxable until sale of the shares). Chairman and CEO Rich Kinder owns approximately 6mm shares of KMP indirectly through his 20% ownership in KMI, worth over $250 million. He also owns 325,000 shares of KMP directly, worth another $14 million and takes $1.00 year in annual compensation. Two major organic growth projects on the calendar for 2008-2010 are the $4 billion Rockies Express Pipeline that will transport 1.8 billion cubic feet per day of natural gas from Wyoming and Colorado to Ohio; and a $500 million Louisiana Pipeline project that will move 3.2 billion cubic feet of liquefied natural gas from a plant in Louisiana. These two major projects will allow the projected distribution to KMP shareholders to reach $4.20 by 2010. If the yield environment is similar to today, KMP shares would trade at $60 per share in 2010, or about 40% above today’s price of $43. Combined with an average yield of 7%, that price target would provide an approximate 17% per year total return over the next four years. KMP is a core holding because of this projected outlook and because of the safety and stability of the fee generating assets owned by this entity. We hope this somewhat more detailed discourse on one of our master limited partnerships helps explain our enthusiasm for this type of asset in taxable accounts.

We are positive on the outlook for stock returns in 2007 and expect total returns for FMR portfolios to be in the 10-15% range. Valuations on many large cap quality stocks are at their lowest price-earnings ratio of the past ten years. From the fourth quarter of a midterm election year to the last quarter of the presidential election year, the S&P 500 has risen over 35% on average since 1945. There undoubtedly will be bumps along the way as politicians and our ongoing war on terrorism are entirely unpredictable, but stocks look poised to outperform fixed income securities over the next two years.

As an SEC registered company we file an ADV II form annually describing our business. Please contact us if you would like a copy. We welcome any questions you might have at any time. Thank you for your continued support.

Sincerely,

Lee Todd Martha

* Results are net of management fees and 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.