Taxable Estimated
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 4.67% 2.56% 0.70% 1.02% 1.95%
2nd Qtr 3.63% 1.31% 6.26% 9.13% 4.12%
1st Half 8.42% 3.87% 6.94% 10.09% 5.85%
The second quarter of 2007 continued to demonstrate both positive performance and the increased volatility we experienced in the first quarter. Second quarter total return for our taxable accounts averaged 3.63% and 1.31% for the qualified (IRA, pension) accounts versus +6.26% for the S&P 500. First half performance was 8.42% for taxable and 3.87% for qualified accounts versus 6.94 % for the S&P 500. Higher than expected second quarter earnings growth along with some price earnings multiple expansion provided the impetus for the large capitalization S&P 500 index to outperform in the second quarter versus a flat performance in the first quarter. Energy stocks provided strong leadership for the index as well, and contributed positively to FMR’s portfolio performance in this year’s first half. Real estate investment trusts (REIT’s) corrected on average 15% in the quarter as interest sensitive, higher yielding sectors reacted to the sell off in the ten-year Treasury Note. Since qualified retirement accounts have a higher weighting in this sector they underperformed the taxable accounts which had a smaller REIT exposure.

While China’s stock market provided the short-term downside fireworks in the first quarter, an unexpected interest rate spike for the ten-year Treasury Note from 4.5% in early March to 5.25% on June 12th sent the Dow Jones Industrials down 400 points in only three days in June. Once again, the market bounced back quickly from this latest volatile event. As with the February sell-off from the China market, the 5%+ yield on the Treasury Note and subsequent dumping of these bonds is hardly a significant reason to turn negative on long-term equity investments. What really matters in this current environment is inflation and the direction of inflation. If rates are rising because of an uptick in inflation we would have real cause for worry, but wage inflation has not been a significant problem and corporate profit growth has been relatively strong. The Federal Reserve has been tough on inflation and will continue to be tough on inflation as reflected in almost all of their formal public comments and policies. They raised the Fed Funds rate from 1% to 5.25% during the time span from 2004 to 2006 which brought about a slow down of inflation over the past year despite the rising price of energy. Inflation has not topped 4% during any year since 1991. The FED’s comfort range for inflation is 1%-2%, and inflation has remained in that range. Typically, the Fed Funds rate slows the economy with a lag and we have seen that result with the 0.7% first quarter 2007 real GDP annualized growth rate. Previously we wrote that we expected that the FED could cut short-term rates in the second half of the year as they became more confident that inflation was under 2%. We now believe a rate cut is unlikely. There are two reasons for this change in forecast. First, rapid economic growth in China, India, and other Asian countries has created a huge demand for credit. The GDP’s of developing economies now equal about 30% of World GDP and they collectively are growing faster than 6%. This puts upward pressure on commodity prices and interest rates while at the same time we are experiencing downward pressure on labor costs and consumer product prices. Second, unless the sub-prime mortgage market and housing market significantly worsen, the FED is very likely to stay put for the remainder of the year at 5.25%. We said in our last letter that our definition of uncertainty was the current sub-prime mortgage debacle. To date nobody has been able to get their hands around the unintended consequences of the eventual write-offs of these mortgages that now reside in something called Residential Mortgage Backed Securities (RMBS); and collateralized debt obligations (CDO). Twenty percent of the mortgages originated in 2006 were sub-prime mortgages (Inside Mortgage Finance), which means they are less creditworthy, and thus charge higher interest rates for first time owners. The problem is complex but simply summarized: investment banks and brokers put these sub-prime non-investment grade mortgages into pools with other mortgages. Then they divide them into various sub-groups of RMBS’s and CDO’s and sell them to insurance companies, hedge funds, and other institutions looking for high yields. The problem with this financial alchemy is that 80% of these new RMBS’s are now rated AAA. Quite obviously, there is no way that these securities are of remotely the same quality as one of the very few AAA corporations that issue debt, such as Exxon Mobil, General Electric, or Johnson and Johnson. As many of these mortgages default over the next two years, no one can tell for sure whether the risks are spread wide enough across the financial marketplace to absorb anywhere from one to two million home foreclosures. If the diversification in these pools of mortgages works like the bankers planned, then the FED is unlikely to have to step into this housing bubble scandal. If not, then we would almost certainly have the reason for FED Chairman Bernanke to cut the Fed Funds rate.

Discussing our current portfolio is always more pleasant than trying to speculate about some of these amorphous issues that have no clear answers. What should matter most to long-term investors is that the fundamentals of our companies are strong and underlying business conditions supporting our companies are very good. While many of our higher dividend yielding companies (utilities, real estate investment trusts) have corrected as the ten-year Treasury Note sold off to 5.25% last month, what is important is that the income produced from these companies has not dropped. In fact, it is growing anywhere from 6%-10% per year as dividends and payouts are increased. Inflation destroys the value of paper assets (equities), not a 75 basis point rise in the Treasury yield.

Guessing the course of interest rates is extremely difficult in the real world. The stocks in our portfolios that are producing substantial free cash flow from which to grow, repurchase shares, and increase dividends still offer much higher total returns than long-term bonds where the interest rate payout does not change. The earning power of the companies in our portfolio has not gone down with the rise in long-term government bond yields, and the dividends are safe and growing. As most of our clients who have been with us for a while know, we have been bullish on certain kinds of energy stocks which have a sizeable weighting in most portfolios, whether taxable or qualified. As we have discussed in the past, we own hard energy assets like pipelines, storage tanks, and natural gas processing facilities, and we own pure exploration and production companies that specialize in natural gas, not oil. Natural gas prices have recently traded at a 20%+ discount to oil on a BTU energy equivalent basis, because natural gas is not as freely tradable around the world as oil. Over time, natural gas prices will trade more closely to oil prices as we believe that natural gas demand in the U.S. will increase more rapidly than oil demand. U.S. oil production peaked in 1970, where as U.S. gas production peaked in 2001 as depletion rates from producing wells have accelerated. Finding and development costs have been increasing steadily and single well productivity has dropped in half over the last nine years. We have had to drill three times the number of wells over the past ten years just to hold production flat. Production has peaked or will peak in every state but Texas (Barnett Shale, Bossier, Cotton Valley trends). Wyoming production may be able to grow again from its current decline with accelerated deep gas drilling in prolific finds like the Pinedale Anticline. The current available universe of attractive and growing natural gas resource plays in the States is small and mostly concentrated in the tight gas shale basins like the Barnett and the deep Rocky Mountain gas reservoirs in Wyoming and Colorado. The Five Mile River portfolios have been invested since inception in anywhere from two to four of the best exploration and production companies focused exclusively on natural gas in these best plays. We have not tried to trade in and out of these natural gas companies based on whether it is a warmer than normal winter or the short-term fluctuations in the commodity. We have trimmed positions when the percentage of portfolio has risen too high from a risk control perspective.

At the end of the day the U.S. will need anything that produces electricity: we will need oil, nuclear, coal, liquefied natural gas, hydro-electric power, solar, and all the natural gas we can find. One of our holdings in this important space is XTO Energy, Inc. (XTO). XTO Energy was formed in 1986 as Cross Timbers Oil Co., and came public as XTO in 1993 as an independent exploration and production company of domestic natural gas with long-lived, high quality U.S. properties. Production and reserves have grown at a compound annual rate of 24% and 30% respectively, and the stock price has compounded at over 30% per year since going public in 1993. Enterprise value is now over $20 billion and the company produces over 1.5 billion cubic feet of gas per day from 11,000 wells. Proven reserves are almost nine trillion cubic feet and the rate of production decline from first year wells is only 15% compared to 30% for the industry. XTO’s exploration and production expertise has allowed it to maintain production with only 30% of its cash flow, leaving the remaining 70% to invest in organic growth opportunities and complementary acquisitions of both acreage and reserves. XTO is a leader from a geo-scientific perspective in unconventional basins that produce gas from rock, such as that tightly held in sands, limestone, shale, and coal bed methane. Finally, assessing corporate management is always key for us. Bob Simpson, the Chairman and CEO of XTO, owns outright 6.7 million shares and requires his senior management to own specified amounts of the company’s stock as a multiple of their base salary. Their interests are clearly aligned with shareholders’ interests. We expect XTO will continue to be one of the few pure natural gas Exploration & Production companies able to prosper in the years ahead.

We are enclosing our Privacy Statement and our Proxy Voting Procedures in this letter. As always we welcome your comments and questions, and we wish you an enjoyable summer.


Lee Todd Martha

*The foregoing information is not audited and has not been otherwise reviewed or verified by any outside party. While Five Mile River Investment Management, LLC endeavors to furnish accurate information, investors should not rely upon the accuracy or completeness of this information.

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.