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%
3rd Qtr (3.34%) 1.52% 3.74% 8.12% (3.99%)
YTD 4.80% 5.45% 9.15% 19.02% 2.26%
The cyclical increase in stock market volatility experienced in the first half of 2007 continued with a vengeance in the third quarter. The U.S. stock market initially rose to a new peak on July 19th (1553 on S&P 500), and then suffered a short, painful correction of about 8% in less than four weeks to its low on August 15th (1407). FMR portfolios underperformed the S&P 500 index during this volatile third quarter primarily for two reasons. First, as the yield on the benchmark Ten-year Treasury Bond surged from 4.5% to 5.25% at the beginning of the quarter, bond prices dropped. However, the high-yield stocks, which we own in our portfolios, also went down in price. This move was simply a sudden and irrational aversion to risk, as opposed to any change in the fundamentals of our companies. The subsequent decline in yield on those same Ten-year Treasury Bonds to 4.5% has not been matched with a dividend rally and many of our dividend-paying stock prices have remained flat, or only up a little. Early October has given us more upside in many of our dividend stocks. As long-term value investors, we view this anomaly as a buying opportunity to purchase free-cash-flow businesses paying out high and growing dividends (6%-8% growth) at a discount. Total returns over the next twelve months from these depressed levels should run 12%-15%.

The second reason that FMR portfolios underperformed in the third quarter was the same as what we saw beginning in the second quarter, namely the out performance of the largest multinational growth stocks in the S&P 500. The largest growth companies continued their good performance in the third quarter for three reasons. First, larger companies are more liquid and seemed safer as the mortgage crisis unfolded. Second, multinationals with large overseas exposure should be more insulated from a U.S. slowdown. And third, the price earnings ratios of these largest companies are reasonable at 16-18 times 2008 forecast earnings. These stocks had underperformed for most of the past five years as the market focused on value stocks, small stocks, and mid-cap stocks.

No summer doldrums occurred this year as the sub-prime mortgage contagion spread across the credit markets and around the world in lightning fashion. Every Fed tightening cycle in modern times has ended with a financial crisis and this cycle is now no exception. Some of these financial crises end up in recession and some do not, but clearly the inflation fighting Federal Reserve of just three months ago was no where to be seen in late August and early September. They rode to the rescue in mid-September with massive injections of liquidity into the banking system, with discount rate cuts, and then a 50 basis point Federal Funds rate cut with a clearly implied promise to do more should the economy slip into a recession. The jury is still out but early indications are supportive of a soft landing without recession as the employment numbers for September came in better than expected and August numbers were revised dramatically from a loss of jobs to a significant gain in jobs. However, these data points are notoriously unstable from month to month and we have not yet reached the apex of this housing meltdown.

Our best guess has been, and still is, that this will be a mid-cycle slowdown but the odds on this outcome have been coming down all summer as the extent and severity of this housing collapse unfold. The housing market issues today are much worse than the 1990 collapse following the savings and loan crisis that saw home prices decline for three years in a row (1991-1993). Today in the U.S., we have over 4.5 million homes in existing inventory for sale, up more than one million since March. This is a ten-month supply and it is headed higher, with over 500,000 homes in the process of foreclosure. Existing condos for sale number over 660,000 and rising; this represents at least a twelve month supply.

This fifteen year housing bubble has come to an end with a resounding thud. Belatedly, the FED has recognized that asset prices (homes) are likely to be down on average 5%-10%, and in the most overbuilt areas as much as 15%-20%. Furthermore, the credit markets that serve this housing sector and the asset backed commercial paper market stopped functioning for much of this past summer. We discussed this issue in our one page August update on the illiquidity problems with collateralized debt obligations or CDO’s. The reason the jury is still out is because it is waiting to see what the U.S. consumer does as a result of this very negative news on his heretofore untouchable rock solid asset, his home. Total home equity cash out (mortgage equity withdrawal) is estimated to have been over $1 trillion in the five years ending in 2006. This is equal to 45% of personal consumption expenditures. The home as a source of extra cash to sustain consumption is dropping rapidly and will be neither a pillar to support real economic growth through the end of this year, nor for most of next year. This is the reason for at least a mid-cycle slowdown, where real GDP growth is likely to range from zero to + 2% for several of the next four to five quarters. Whether this number turns negative will be highly correlated to what the consumer does and particularly how employment growth holds up through the fall and winter. If employment holds up reasonably well, as seen in August and September, then retail sales will be weak but not collapse and the potential for a recession will diminish.

While that covers much of the gloomy scenario, what about the positives and why is the stock market back at new highs? What are the implications for the kinds of stocks we own in the Five Mile River Portfolio, and how are we positioned for this uncertain economic environment? Our one-page, August 15th letter argued that the FED would not stand by and watch the banking system melt down and become the cause of a recession. The $1 trillion market value decline from July to August seemed out of proportion to the strong fundamentals of corporate America. We recommended that long-term investors increase their commitments at this correction low point and we continue to stand by that judgment as we have watched the market bounce back to new highs in early October. We are by no means 100% out of the woods of negative shocks to our financial system. We expect continued violent reactions to further revelations of the true impact of this sub-prime mortgage crisis. Nevertheless, as serious as this housing and mortgage derivative mess truly is, there are numerous positives to keep this black hole in perspective. First and foremost, the world is flooded with huge amounts of liquidity as broad money growth has accelerated to over 10% around the world. This liquidity is present in corporate balance sheets with record cash levels, large foreign central bank reserves, and enormous sums of petrodollars from the $80/barrel oil price. The latter is being recycled back into productive assets, and there is no way that most of these oil dollars can avoid U.S. assets, whether bonds, stocks, or real assets. The second important positive is that inflation is under control in the U.S. and we do not have a wage-price spiral. This excess money is creating excess supply (with help from a glut of cheap labor), not excess demand. Cyclical inflation can pop up, but these secular forces of technology, competition, and the impact of large, inexpensive, global labor pools should keep down any trend to rising inflation. Third, global growth prospects are very good, particularly in the rapidly growing BRIC (Brazil, Russia, India, China) countries. Developing economies are growing at 6% and account for 30% of world GDP. They have 85% of the world’s labor force, which is why prices of manufactured goods are down yet commodity prices are up. What they sell, they deflate and what the buy, they inflate.

The outlook for both our taxable and non-taxable FMR portfolios for the remainder of this year is consistent with our beginning of the year forecast. We stated that 2007 would be a more difficult year to achieve above average returns because we were likely to see increased volatility and risk aversion that had not been present over the past few years. We still forecast that 10%-12% returns are possible if the U.S. economy is not rocked by a full-blown recession following this sub-prime financial crisis. As we said earlier, the jury is still out and there is more difficult news yet to come on the housing and credit derivative front through the end of the year. We believe that preservation of capital when uncertainty and volatility are high is important. Our portfolios deliberately have been defensively positioned in structure with an emphasis on dividends and companies producing free cash flow. Consequently, they have the option of both buying in their shares and paying us out more in dividends. We do have long-term solid commodity exposure with natural gas that we continue to believe will be a scarce and more valuable resource. We have also selectively added three to five names that represent anywhere from a 5%-10% weighting in larger capitalization growth stocks. They have great balance sheets as well as substantial free cash flows from their dominant business models. These companies include Zimmer Holdings, Inc. (ZMH), the number one pure-play orthopedics company in the world, with a market cap of $20 billion and sales of $3 billion in replacement hips, knees, spine, and dental products. A second name is Paychex (PAYX), the number two payroll processing company in the U.S. with 10% of a $12 billion dollar market. Market cap is $15 billion with $2 billion of sales focused on employers with fewer than 100 employees (99% of the nearly 8 million U.S. businesses). Paychex has a below average business risk with free cash flow equal to 25% of sales, no debt, a growing dividend and a $1 billion stock repurchase authorization.

Finally, we would like to mention one of the very largest multinational growth stocks that we have held in our taxable accounts from the inception of Five Mile River, specifically the Proctor and Gamble Company (PG). PG is a mega cap at $220 billion and sales of $76 billion with 54% of its sales international and large representation in Asia and developing countries (31%). PG, under the brilliant leadership of A.G. Lafley since 2000, has repositioned its huge product line of beauty care products, cleaning products, diapers, tissues, healthcare, toothpaste, snacks, and beverages with strategic acquisitions (Gillette) and dispositions. The focus over the past several years has been to add higher growth and higher margin products (cosmetics, men’s shaving products) and dispose of slower growth products with lower profitability. A very recent announcement of the next big strategic step for PG includes the potential divestiture of the Duracell battery business that came with Gillette, as well as its remaining food assets (Pringles chips and Folgers coffee). PG stock has out performed our more defensive dividend stocks in the portfolio during the third quarter and we expect it can continue to do better with their recent restructuring announcement of early October. Their goal has been to grow sales in the mid single-digit range and earnings in the 10%-15% range; they have done just that in the past five years with dividends growing at 11%. We expect PG stock to be able to trade 20% higher than its current price of $70 over the next eighteen months as this strategic repositioning is completed. We intend to add new companies like ZMH and PAYX to companies like PG and Disney to provide balance to our core dividend yield names. However, it is not intended for them to become the majority weighting in our portfolios, although we recognize that value can be found in selective large cap growth stocks.

We welcome your questions and comments about our companies, industries, sectors, or our strategic approach to portfolio construction at any time. As an SEC registered company we file an ADV II form annually describing our business. Please contact us if you would like a copy. Thank you for your continuing support.


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.