PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +6.40% +3.78% +5.38% +5.27% +8.51%
2nd Qtr 0.0% to -2.0% -2.0% to -4.0% -6.64% -6.51% -10.19%

The second quarter brought to a close the first 13 month leg of the powerful bull market rally from March 2009 to April 2010. The S&P 500 closed out the first half of 2010 at -6.64% after posting a positive first quarter performance of 5.38%. The stock market always leads the real economy and this time was no exception; the U.S. economy started to recover last summer and continues a very slow recovery into the summer of 2010. Following a virtually uninterrupted +70% stock market recovery on a very strong performance in corporate profits, it is not surprising for the S&P 500 to have a normal mid-course “correction” of about 15% from the April high to the June/July low. The stock market overshot our economy’s growth this Spring, but is now more attractively priced to provide modest appreciation within our forecast range of 6% to 13% by year end (+12% to +20% from recent lows). The projected S&P 500 earnings of $80.00 for 2010 and $90.00 in 2011 leaves the U.S. stock market undervalued by about 12%. Our year end target projection remains the same at 1200 on the S&P 500 (15 times $80 and a little over 13 times on 2011 estimated earnings) in what is likely to continue to be a volatile and slow growth year for the markets and the economy respectively.


In our first quarter letter we devoted a good portion of our discussion to the future headwinds the U.S. economy and markets would face from both old problems and new challenges. These headwinds (healthcare taxes, cap and trade energy taxes, bank taxes, capital gains taxes, Medicare, taxes on investment income, dividend taxes, and estate taxes) did not go away as their potential negative impact came back into focus this Spring. Real gross domestic product (GDP) probably grew an underwhelming 3% to 3.5% in the first half of this year, and will be growing even more slowly in the second half of 2010 and 2011. Our estimate for the next several quarters is a modest 2% to 3%, clearly a sub-par recovery. WHY?


First we had a Housing Bubble, then a Mortgage Debt Bubble followed by a Financial Market/Credit Crisis. Very simply, the Consumer Debt Bubble will take at least five years to restore for individual balance sheets. We are only two years into this massive deleveraging, so we have at least three years to go. The consumer makes up about 70% of U.S. economic growth in normal economic times, but these are not normal times and the consumer will not be able to carry the recovery. The housing market is down at least 25% on average from the top and is only bumping along a depressed bottom with millions of foreclosures yet to come. Thus housing, the former piggybank for the consumer, will not play any important role in economic growth for probably another three years. Too many homes were built and sold to many unqualified buyers and no amount of government mortgage mitigation will shorten or soften this workout period. Structural unemployment in the economy is at a record level with underemployed (people who want a job but have given up looking) and unemployed at 16% and likely to continue at an uncomfortably high level for the next several years. WHY?

The U.S. is now beginning to focus on our latest and biggest bubble, namely a Government Debt Bubble, similar to what we now see afflicting many European countries. The end game can result in wrenching and painful fiscal discipline through massive budget cuts for countries dependent on continuing government spending (Greece, Italy, Ireland, Portugal, Spain, UK, France).

Indiscriminate government stimulus forever does not work, does not create new permanent private sector jobs, and has recently been rejected in the Toronto, Canada G-20 meeting of the European Community. The mature euro zone economy is likely to see very low growth, at best, with several of these European countries in recession. Government balance sheets in the U.S. and Europe must be restored to health with severe fiscal discipline and, very simply, that means slower domestic growth until that objective is accomplished.


We are assuming no double-dip recession despite all the negatives and headwinds we have discussed today and in previous letters. We have three primary reasons for this conclusion:

  • We have a reasonably strong but uneven global recovery underway that is not likely to be sidetracked by slow growth in the U.S. and Europe. Emerging markets and growth countries like Brazil, China and India, play a much more significant role in world economic growth today.
  • We have a strong recovery in corporate profits with major corporate balance sheets very strong and liquid. The industrial side of our economy along with exports should support the modest domestic growth we are forecasting.
  • Interest rates are zero and likely to remain lower longer than previously expected given more deflation than inflation in the U.S. for the next two to three years. With government spending out of control and higher taxes being imposed at every level in our local, state and federal government, the FEDERAL RESERVE has little room to raise rates and no need to do so right now.

This seems all too nice and too easy, there must be a WILDCARD? Yes there certainly is, and the outcome is difficult to predict: POLITICS AND POLICY. We have no idea how politics will change government policies this coming Fall in the November elections but we do know, that like Greece and other euro zone members, STATUS QUO IS NO LONGER A VIABLE OPTION. The bond markets have spoken and will not finance this political prolificacy without reigning in the growing debt burdens of these undisciplined countries. The U.S., while a much larger and more diverse economy than the euro zone, has $13 trillion of debt, growing worse by the day and expected to hit $20 trillion in less than ten years. Once again, status quo is not going to work and major political and policy changes are coming quicker than most of us now realize. HOW DO WE INVEST WITH THIS UNCERTAINITY?


It is very hard to remain agnostic to all of the economic noise and swirling events that create volatility for those of us managing bottom-up portfolios of equities. We are not economists but we have to make assessments of the framework in which we choose the best company values for our portfolios. As most of you know who have been with us through these past three years, we have defensively focused on companies who have unassailable dominant business models with wide economic moats around their models. We own:

  • companies that are number one or two in their primary markets,
  • companies whose balance sheets are strong,
  • companies without heavy debt,
  • companies with access to the financial markets,
  • companies whose businesses earn more than their cost of capital,
  • companies with above average returns on assets and equity,
  • companies who repurchase their own shares consistently,
  • companies whose management own significant shares in their company,
  • companies with free cash flow who pay and grow dividends.

There is both good news and potentially bad news on the dividend front. We can avoid some of the bad news if and when it comes to fruition (tax policy could change after Fall elections). The good news is that a widespread recovery is under way among many dominant global companies with revenue sources from around the world. Since January, 136 companies in the S&P 500 have either increased their payouts or started new dividends, collectively increasing dividends by $11 billion for these 500 companies. Only two companies decreased or suspended their dividends since January, a significant reversal from 2008 and 2009. The largest 1500 non-financial companies in the S&P 500 index have more than $1 trillion of cash on their balance sheets from which to repurchase shares, invest in acquisitions, or to pay dividends to shareholders. If you remove the bank and financial stocks that cut their dividends during the Great Recession, dividend-paying stocks have done quite well and are outperforming the average S&P 500 stock.

The potentially bad news you have probably seen is the current administration’s commitment to effect the largest tax increase in the history of the U.S. by not extending the previous administration’s tax cuts. One of these tax “increases” is to increase the tax on dividends from 15% to possibly as high as 35% to 40%. This attack on capital is counterproductive. It will prove once again that whenever the government overtaxes, it receives less than it expects because of human behavior and dynamic decision making as opposed to static Congressional Budget Office (CBO) analysis. Our expectation is that both Politics and Policy will play a huge role in whether these tax increases are allowed to be put in place for 2011 (politics in November may well hold down any dividend tax increase to 20%, up from 15%). In any event, if this misguided tax increase does become law, the better strategy will be to hold more of the income/dividend paying stocks in your IRA’s and other qualified retirement accounts than your taxable accounts. We will make adjustments as necessary and continue to combine tax efficient Master Limited Partnerships (MLP’s) along with our dividend paying growth companies in taxable accounts.


Abbott Laboratories (ABT) is an excellent example of a current portfolio holding that has a fortress business model with world class leading products, substantial free cash flow, and directly rewards shareholders with increasing dividends and share repurchases. Abbott is a $30 billion (revenue) global, diversified healthcare company, devoted to the discovery, development, manufacture and marketing of pharmaceuticals, nutritional products for children and adults, and medical products, including devices, diagnostic tests and instruments. The company employs over 80,000 people and markets its products worldwide. ABT has a high growth portfolio of medical products and services: number one in infant formula (Similac) in the U.S. and a leader in adult nutrition (Ensure); number one in blood screening and diagnostics worldwide; a leader in Vision Care with Lasik and intraocular lens implants; the leader in autoimmune diseases like rheumatoid arthritis (Humira); and the number one drug-eluting stent for coronary artery disease (Xience Prime). ABT’s valuation is very attractive at under ten times estimated earnings for 2011 with a 3%+ yield, future dividend growth of 8% to 10% and double digit earnings growth. Our two year target is $60/share, up 30% from current price of $46, or 30% plus another 6% from dividends.

We would like to close this mid-year review with the thought that it will continue to be a challenge to make money in this current environment. This is not going to be a “V” shaped recovery and the “new normal” post the Great Recession has not yet been defined. Despite the “fast forward” cacophony of short-term news bites that surround us everyday, it is critical to understand the rewards and potential wealth creation from being a patient long-term investor in companies like Abbott Laboratories. Companies returning cash to shareholders from growing dividends with yields of anywhere from 3% to 7% must be viewed positively in relation to the low and static yields of less than 1% on cash and 3% on 10-year Government Bonds.

You will find enclosed with this letter that Five Mile River Investment Management, LLC Privacy Policy and Proxy Voting Policy. Please call if you have any questions regarding these policies, or any other questions that you may have. Thank you for your support.

Sincerely, Lee Todd Martha

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.

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