Taxable Estimated
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (6.40%) (5.81%) (9.44%) (14.53%) (10.19%)
2nd Qtr 3.61% 4.33% (2.67%) 3.10% 0.25%
3rd Qtr (15.79%) (13.74%) (8.36%) (13.20%) (1.46%)
YTD (18.34%) (15.24%) (19.27%) (23.52%) (11.29%)
What went wrong? The last three months of trying to safely navigate U.S. equity markets has been equivalent to entering a “Perfect Storm.” What started in 2007 as a sub-prime lending calamity has become a worldwide financial crisis that will now be called a full scale recession. It probably started in the first quarter of 2008 and will most likely last through mid 2009. While we have expected a no-growth, no-recovery scenario for the past year, we expected that it would be self correcting and inflict mild damage on the U.S. economy. This assessment was clearly too optimistic as the process of taking debt out of America (banks, investment banks, consumers, and businesses) has turned out to be self-reinforcing, not self-correcting. Over the past three months this has led to an accelerated decline in asset prices (homes, land, and mortgage backed securities). Falling asset prices have led to further forced liquidations, mergers, bailouts, and takeovers (AIG, Merrill Lynch, Lehman Brothers, Washington Mutual, Wachovia, IndyMac, Fannie Mae, Freddie Mac) by both private and government entities (JP Morgan, Citibank, Wells Fargo, Bank of America, FDIC, Federal Reserve, the U.S. Treasury, and now TARP, our recently approved Troubled Asset Relief Program). We did not anticipate the extent of this perfect financial storm, and how long this cycle will continue remains uncertain. What we do know is that the scope and number of aggressive policy responses has exceeded any other financial crisis post WWII and that more will be forthcoming to prevent the worst case scenarios from playing out in our economy. The Federal Reserve and the U.S. Treasury have the scale, the resources and the willingness to use them to halt this slide. They have the tools to restore confidence on Wall Street and Main Street and stand behind the mortgage obligations that have brought our credit markets to their knees. This crisis began with housing and it can only end with housing. Mortgage rates must come down and availability to qualified borrowers must increase.

What happened to our equity portfolios?
The S&P 500 declined 8.4% in the third quarter to bring its year-to-date performance to -19.3%. As of the date of this letter, the market is now down approximately 43% since its peak in October 2007 and certainly is classified as a bear market. While FMR taxable and non-taxable accounts were only down 2%-3% in the first half of the year, outperforming the S&P 500, our third quarter performance was disappointing with the average account off 11%-13% (includes both the taxable and qualified). The defensive sectors that had helped us stay ahead of the market in the first half turned negative to bring our year-to-date performance for 2008 to approximately a 15%-18% decline in the market for taxable accounts and a 17%-18% decline in the non-taxable accounts. Specifically, our energy infrastructure Master Limited Partnerships, our natural gas exploration and production companies, our two oil service companies, and one problem (due to the company holding Lehman paper) in a 2% holding of a utility called Constellation Energy (sold) all contributed to the underperformance of the portfolio in the third quarter. We avoided financials except for the well managed JP Morgan Chase, and we have avoided investing in overly economically sensitive sectors such as consumer discretionary (retail and autos). We have continued to favor and hold our energy names, and we will discuss why in the following paragraph. We also continue to hold companies that have free cash flow and pay growing dividends to shareholders.

Why do we still hold energy and why do we like dividends? FMR portfolios hold basically three kinds of energy companies: Master Limited Partnerships (MLP’s), oil service companies, and domestic natural gas exploration and production companies. MLP’s in our portfolio like Kinder Morgan Energy Partners (KMP) own and operate pipelines that transport refined petroleum products (gasoline, diesel, jet fuel, heating oil, natural gas, and natural gas liquids like propane). They also own terminals that handle coal, store these petroleum products, and process and blend these liquids into various products for end use. Some also produce and ship carbon dioxide that is used to recover crude oil. Our MLP’s are not very sensitive to the actual price of oil and natural gas (the oil price decline in the third quarter from $147/barrel to $91/barrel does not significantly affect our MLP’s because they are transporting and storing products and getting paid a recurring fee for the volumes they move and the volumes they store or process). However, in the third quarter, short-term investors sold virtually all energy related stocks indiscriminately on the mistaken assumption that because oil and natural gas prices were going down from unsustainable peak levels, that all companies would suffer equally with earnings estimates cut. That is patently not true for most participants in the energy patch, particularly our MLP’s. In addition, leveraged investors such as hedge funds had to sell holdings because they had borrowed too much money from the investment banks who have now become commercial banks. These banks basically sail to these overleveraged hedge funds that they had to bring down their debt, period!

While the volume of gasoline transported can go down in the short-term due to less driving, the growth in our population driving cars continues to increase, and oil and natural gas demand should continue to grow 1%-2% even with more fuel efficient hybrid electric cars after this correction. What happens in these pipeline companies is that total volumes of energy products do not decline for long periods of time because other demands take up the slack. For example, demand for natural gas is growing as an increasing percentage of new power plants are being fueled by natural gas to build adequate electricity reserve margins during peak demand periods. Mandated blending of ethanol into our gasoline (a subject for another day) at increasing percentages also increases demand for energy infrastructure assets. Our country remains short on critical energy infrastructure, much of which has scarcity and franchise value. Our asset base is old so the demand for new and expanded pipelines and storage to serve a growing population will continue to be strong for the foreseeable future. The MLP structure was created in 1987 to specifically encourage building these kinds of assets. The MLP’s owned in Five Mile portfolios pay out large distributions that at today’s depressed prices represent yields of 8%-12%, most of which is tax deferred until the individual sells the MLP shares. Moreover, these distributions are growing at anywhere from 6%-9% per year from new organic projects coming on stream over 2009-2012. MLP’s like KMP (Kinder Morgan) are undervalued after the indiscriminate third quarter correction.

The oil service companies we own such as Schlumberger (SLB) are truly worldwide suppliers of energy technology to the exploration, drilling, and production of hydrocarbons in virtually every country producing oil or gas. They have proprietary technology positions with sophisticated R&D programs to help the industry find and develop increasingly more difficult and remote reserves. They have strong balance sheet liquidity and substantial free cash flow which they reinvest in high return projects that produce double digit earnings per share growth. These industry leaders have three to five years of visibility in their growth backlog and are equally undervalued. Finally, while oil supply is significantly influenced by production levels of OPEC member countries and demand driven largely by worldwide economies, natural gas prices are mostly determined by North American supply and demand. Weather has a significant impact on demand for natural gas since it is a primary heating resource. However, its increased use for electricity generation has kept natural gas demand elevated through recent years, reducing the seasonal swing. We expect that trend to continue as it is increasingly difficult to site coal plants and new nuclear plants whose benefits are seven to ten years away at best. While wind and solar power sources are important, cost and available locations are limiting factors and these two sources will only make a small contribution to our overall growing energy demands in the U.S. economy. Natural gas is relatively clean and unlike oil, we have ample reserves available in the U.S. Owning those companies that can find and develop natural gas in the U.S. will be rewarding. We own three to four companies who are smaller to medium size independents that specialize in natural gas and control acreage in the most prospective natural gas basins in the U.S., including the much discussed shales you may have read about from South Dakota to Wyoming, to Texas and to Pennsylvania. The third quarter selling in these natural gas stocks has been overdone with many selling at half their net asset value which is based on their proven and probable reserves.

Furthermore, our conviction that dividends do make a difference is not swayed by the recent markdown of virtually all market segments, including those with above average dividends. While our dividend paying stocks went down along with all other sectors, our investors should look at time frames longer than a single month or quarter. Historically, dividend income has accounted for about 40% of the market’s total return, but in the 1980’s that fell to 28% and in the 1990’s it was only 16%, according to the S&P. But (if you are startled at the next statement, so were we) dividends since the end of 1999 have accounted for ALL of the market’s gains! While some have called the last nine years the “Lost Decade”, without dividends, you would have lost money by investing in the S&P 500 blue-chip stocks. FMR portfolios are up since the inception of the company, even in this difficult environment. While these facts may provide little solace in the current environment of fear, companies that both pay dividends and increase them, normally help reduce the volatility of an all domestic stock portfolio and we expect that outcome again in the future. With a predominantly fully invested domestic equity portfolio, individual investors have to be comfortable with this degree of volatility as we are not advocates of a market timing approach to creating long-term value. It is simply too difficult to time tops and bottoms in the stock market as we discussed in detail in our last letter. We sympathize with how this historic rolling and ill-defined financial crisis has unnerved virtually all investors, and always recommend that each investor maintain sufficient liquidity, or “rainy day” fund to maintain equanimity. We have had many financial crises in the U.S. and survived them, and we will do so again.

Bear markets are always painful but keep in mind that the stock market has declined in 12 of the past 58 years since 1950 and risen in 46 years. The average loss in the seven bear markets that coincided with a recession was 31% and the S&P 500 is now down 36% from its prior peak one year ago. The bear markets that include recessions lasted on average fifteen months. So by our count, we are at a buyable bottom on price today (as of the date of this letter) and may have another three months in time as institutions and retail investors reduce their borrowed money in their stock portfolios. Tremendous undervaluation of equities only occurs during these periods of fear and panic near the end of long bear markets. We believe we have reached that level of fear in this historic sell off of the entire U.S. market in the last two weeks. The Federal Reserve, in a series of unprecedented actions, has expanded its balance sheet by $2 trillion dollars, injecting massive amounts of liquidity into virtually every corner of the credit markets. These actions, when combined with the Treasury’s recently approved $700 billion TARP program will restore confidence to the credit markets within a few months, not years. Patience and courage are very difficult to muster in the face of this kind of unexpected worldwide credit collapse and intense short-term media coverage. Two points to remember: one, the U.S. economy will be the first to recover, and two, investors in stocks at today’s prices will earn large returns with two to three year time horizon instead of the market’s current two to three week horizon.

We thank you for your patience and support in this most difficult environment and we welcome your calls and emails at any time.


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.