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%
3rd Qtr +8.5% to +10.1% +8.6% to +10.0% +11.30% +14.89% +10.94%
4th Qtr +7% to +8% +7% to +8% +10.76% +12.00% +15.90%
YTD +14% to +18% +12% to +13% +15.09% +16.91% +25.31%

The fourth quarter stock market rally actually started in early September when the political winds pointed to a sea change in November. The momentum continued throughout the final seven weeks of the year, posting an impressive +6.68% for the quarter. With this strong surge, the S&P 500 total return for the year was +15.09%, comfortably exceeding the upper end of our forecast of 1200. FMR’s taxable and retirement portfolios were very competitive (see above) as many of our large capitalization dividend paying stocks outperformed along with the prior strength in our large master limited partnership positions.

Perspective: How far have we come?
2010 was a better than expected year, and to put it in proper perspective it is worth remembering the often quoted saying: “Bull markets always climb a wall of worry.” Never has this old axiom been more right than for the past 21 months since the bear market bottom. While there have been an abundance of issues to worry about and problems that seem intractable, stock markets discount the future, not the past, and the future looks brighter. To recap, despite all of the worries that came with this Great Recession, the stock market (S&P 500) is up 85% from the low on March 9, 2009. Smaller companies (the Russell 2000) were up 130% from the lows, refuting the widely heard prognostication of permanently low expected returns for the U.S. stock market. Emerging stock markets around the world have done equally well from this most recent bottom as the appetite for risk assets has not disappeared. While it is true that large capitalization stocks gained only 1.5% annualized over the past 10 years, this period was not the “lost decade” for every U.S. investment. We know from our own sizeable investments in energy-based master limited partnerships (MLPs), and from real estate investment trusts (REITs), that there have been several large sectors with the opportunity to outperform the S&P 500 benchmark index. Market timing continues to be a very difficult “two decision” strategy to implement. Trying to time the market, even if implemented successfully, would create short term tax liabilities offsetting the expected performance enhancement.

Optimism to a Bubble: What is left? Are Bonds still a buy?

One year ago investor optimism was virtually impossible to find, but as we noted at the time, valuations of the largest, most dominant and profitable companies were far too low, given their growing business in emerging markets around the globe. While March 2009 felt perfectly awful for almost all investors, staying fully invested in these safe companies with above average dividend yields that were growing worked out a lot better than bailing out at the bottom. Since 2001, individual investors have put about $1 trillion dollars into fixed income. Ironically, money flows into these bond funds accelerated over the past 12 months based on both fear and the need for “safe” income while this huge 85% stock market rise was picking up steam. While it is true that bonds returned anywhere from +5% to +7% a year over this past decade, handily beating large cap stocks, the biggest bond flows took place in the last year of this decade after the U.S. stock market had been given up for dead.

With interest rates at historical lows this year, what is the probability that bonds outperform stocks going forward from January 1, 2011? Our answer would be very low and improbable. We would argue, as contrarians, that the good news for bonds is behind us and that recent investors in fixed income will be disappointed as interest rates rise. In fact, since our Federal Reserve Chairman announced “Quantitative Easing 2” (QE2) in the early fall, Treasury bond prices have all gone down as interest rates have risen with the specter of the FED printing money to save the economy. Our skepticism that this maneuver would work was discussed in our third quarter letter, and there is divided opinion even within the Federal Reserve. It should come as no surprise that for the first time in years, redemptions of bond funds started up in November.

Pessimism to Acceptance to Optimism: Where are we on the timeline for stocks?

We expected a potentially bumpy ride this past fall as the intense political uncertainty of an important mid-term election, combined with the biggest tax increase in our country’s history, resolved itself favorably for both investors and businesses. Unfortunately, the resolution was only a two-year agreement, and this fight will be rejoined, once again, as the Presidential race gets under way in the spring of 2011. As we have seen, the stock market responded with a big rally and expectations for real GDP growth have risen from the anemic 1%-2% range to 3%+ in just two months. Consumer net worth increased $1.8 trillion in the fourth quarter, for a cumulative $7.7 trillion increase from the low in March 2009. With unemployment stubbornly stuck at 10%, the fall election results reinforced the inconvenient fact that government spending and bigger deficits did not create permanent new jobs and are far less effective than private-sector expectations and confidence. Simply put, no confidence, no capital investment, and no jobs. So the good news is that uncertainty has declined significantly and should lead to higher growth in the U.S. economy. The bad news is that this battle will likely have to be fought again and that process undermines confidence. Never the less, at year-end 2010, investors appear to have moved beyond their chronic recession pessimism to at least acceptance of the potential for better opportunities in 2011. Skepticism has been replaced with the beginnings of outright optimism. Given the historic size of this stock market advance from the low, and two back to back ‘up years’ for stocks, it is only reasonable to plan for a more subdued increase in 2011. We do not have the pessimism and severe undervaluation of March 2009, which means that the best performing companies are going to have to deliver both respectable revenue growth and profits to attract new investors.

While we devote the vast majority of our research efforts to individual companies that offer attractive total returns, we once again make a conservative market forecast for 2011. As we begin a new year, the lower end of this range (+9%) seems more likely given the imminent and rancorous budget/deficit battles. We estimate 2011 S&P 500 earnings of $90 to $95, and a price earnings multiple of 15x, that produces 1350 to 1425 for this index, a +9% to +15% advance including dividends. This target range is still significantly below the previous high set on October 9, 2007 at 1565 because we have major unresolved structural problems facing both the U.S. and European economies. Reaching or surpassing the old market highs will have to await a defensible and sustainable long-term resolution of these issues and, at the best, that time is several years away.

Dividends: The Single Factor that delivers tangible value.

We like to receive substantial cash dividends along with share buybacks while we are waiting for valuations and profits to rise. Now that the threat to tax dividends at 40% instead of 15% has passed, we believe the market will put higher valuations on those free cash flow dominant businesses who payout good size dividends, grow their dividends, and repurchase their own stock. Our crystal ball cannot be sure whether our fiscal policy will be properly fixed or our monetary policy will work as advertised. However, we do know that bank CD rates cannot keep up with the real inflation most consumers see every year in their energy, food, and healthcare costs. The Consumer Price Index (CPI) does not show we have inflation now because the rent (housing) component is such a large weighting in the index, but we all know that the prices for these above categories are going up every year. Low yields on savings will not maintain purchasing power in what appears to be a game rigged by the dealer (the Federal Reserve). We want to hold stocks with some hedge against both deflation and inflation but as we discussed in our fall letter our FED Chairman is a student of the Great Depression, consequently our investment spectrum includes companies that will benefit from inflation as Bernanke will err on the side of inflation. Thus we own some exposure to gold and other hard assets which maintain a high correlation with inflation. We also own stakes in businesses that can pass inflation on to customers and consumers while at the same time passing some of the profits back to us as shareholders through increased dividends. As we have discussed many times in the past few years, our portfolios are not structured to totally rely on capital appreciation, as we have a wide variety of stocks in several different sectors that yield anywhere from 3% to 7% with cash dividends you can spend or reinvest. As long-term investors, this is not a “zero return” endgame for our clients because we want dividend payers in our portfolio when the going gets rough. Short-term volatility without an anchor can take your breath away and we definitely try to avoid that kind of outcome.

Example: Entertainment Properties Trust (EPR)

EPR is a real estate investment trust (REIT) that owns 95 megaplex movie theaters with over 1700 screens and 350,000 seats in 33 states and Canada. They also own public charter schools, vineyards, a ski area, and entertainment retail centers. Their predominant assets are the theaters leased to 12 different theater operators, the largest of which is AMC (American Multi-Cinema, Inc.). EPR owns the theaters but does not operate them. EPR is the leading entertainment-related specialty real estate company with a national footprint and access to capital throughout the recent recession and financial crisis. Their long-term objective is to increase shareholder value by acquiring or building assets that have predictable and growing funds from operations (FFO) and, thereby, growing dividends. REITs do not pay corporate taxes as long as they pay out at least 90% of their income, which means their dividends are taxed at ordinary income tax rates. Any portion of a REIT’s dividend that exceeds its net income is return of capital and subject to long-term capital gains taxes only after you sell the shares. While we have owned EPR in taxable accounts at times when REITs were out of favor and undervalued, in most cases it makes sense to own REITs in a tax-deferred account like a 401k or IRA. We like entertainment assets such as movie theaters because they are less affected by recessions as a convenient and inexpensive form of entertainment. EPR was yielding over 7% at the beginning of 2010 and appreciated 31% for the year, a total return of 38%. With its secure $2.60 dividend, it is yielding 5.6%, a significant premium over most REIT’s. While EPR was no longer undervalued at year-end 2010, our one-year target is $50/share, offering 6% appreciation potential plus the dividend for a total return of +11% to +12%, which is very attractive as a defensive income oriented holding in tax-deferred accounts.

We appreciate your support and wish you and your family a happy and healthy New Year. We encourage you to contact any of us at any time with questions about your investments and our portfolio strategy.


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.

Please remember to contact Five Mile River Investment Management if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations. Please also advise us if you would like to impose, add, or to modify any reasonable restriction to our investment advisory services.