PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +8.03% +4.62 % +5.92% +7.06% +7.64%

The stock market low on March 9, 2009 seems like a distant bad memory after a stunning first quarter S&P 500 gain of +5.9%, the second biggest first-quarter gain since 1998. The Nasdaq rose +4.8% and the smaller market capitalization companies in the Russell 2000 advanced the most at +7.6%. The S&P 500 was just about double (+96%) from the level two years ago when many investors were abandoning stocks in droves for the safety of cash or bonds. Our target for the year remains 1350 to 1425 for the S&P 500 index, so at the current level of 1332 the upside for the balance of the year is +1.5% to +7.0%. As a frame of reference, our previous high on October 9, 2007 was 1565 (17.5% higher than present). We can certainly get back to that level with, for example, $100 of S&P earnings and a mid-teens PE multiple of 15x-16x, but we believe it will take a comprehensive and bipartisan deficit reduction plan that addresses the serious structural problems the country faces.

The Five Mile River taxable and retirement portfolios performed well in the first quarter with materials, energy, industrial, and technology sectors strong because of double-digit earnings growth projections.

The "risk trade" is now fashionable, so do you sell your bonds and buy stocks?

The stock market rocketed ahead despite the onslaught of major negative world events in the first quarter. These included:

1. Riots, protests, and civil wars in Egypt, Bahrain, Yemen, Tunisia, Syria, and Libya
2. Earthquake at 9.0, the tsunami that followed and the nuclear tragedy in Japan
3. Eurozone solvency (debt) issues in Greece, Ireland, Portugal and Spain
4. Oil and commodity price shocks that raise the specter of inflation

Investors, led by Bill Gross, one of the largest and best known institutional bond managers in the U.S., shifted out of U.S. Treasury bonds. Meanwhile, mutual fund flows reversed from last year as money flowed out of bonds and into equities. To be fair to Mr. Gross, his bond funds did not actually buy equities but he made it clear that he sold all of his U.S. government treasury securities and that is enough of a warning signal to warrant further discussion. The point we want to make is that the first quarter rush into equities after the market doubled in two years looked too easy to us as value investors. It was as if the better news on the economy was an "all clear" signal that the market would just keep going up and double again. Not so fast! Corporate profits are up a very nice 13% in the first quarter and the Labor Department reported 216,000 net new jobs for the month of March, the only source of real wealth creation. While the good news is that there were about 100,000 fewer discouraged workers in March, the percentage of Americans out of work for at least six months increased to 45.5% from 43.9% (6.1 million people). Our recovery has been largely fueled by easy monetary policy with interest rates near-zero for 28 months, supplemented by aggressive Treasury bond purchases to keep rates low.

We are uncomfortable with the recent herd mentality two years after the bottom because, at this point in time, there is no longer an abundance of universally undervalued equities. This two-year doubling is the biggest gain in a short time frame since 1933. To reiterate the concern stated in the FMR year end letter, the structural deficit and employment problems that the U.S. faces have not been resolved and are going to be difficult fixes given the 2012 presidential election cycle. The conservative and more defensive investment strategies we have been employing during and following the Great Recession continue to be prudent as this asset shift away from bonds to stocks builds consensus that stocks are still cheap. The consensus is typically not contrarian and can create unrealistic expectations and even bubbles (housing, as an example) as we saw in 2007-2008. Stocks were cheap two years ago in March 2009, but they are not cheap today! Rather, the market is fairly valued today and "some" stocks are cheap, but certainly not all stocks as was true two years ago. Selectivity in stock holdings will therefore play a more important role in our 2011-2012 performance.

Budget deficit, debt, and inflation, do they matter?

We are not institutional bond managers but we said we would try to address why the best-known bond manager in the U.S. has sold all of his government bonds. That leads to answering the above question: and the answer is YES, the budget deficit, debt, and inflation matter a lot for investors and consumers! The cost of TARP to save the banks, AIG and GM was $2 trillion. The FED has created $2 trillion in money since 2008 from its own balance sheet expansion. The government added $5.5 trillion in new debt in just three years ($14 trillion+). Future budget deficits are on track for another $1.3 trillion a year on average. The FED is printing $3.3 billion a day through June under QE2 (quantitative easing #2). Too much debt and structural deficits cannot be ignored without tough consequences for our standard of living. The good news is that the numbers are so awful and so large that they have to be addressed. The timing is problematical given the start of the 2012 election season. These issues will be the intense focus of our media and the headlines for the next 18 months, so expect increased volatility. We are very comfortable with our investment strategies as represented by the companies in your portfolios because they can grow with above average profitability in both good and bad weather. The watchwords should be familiar from our past letters in which we discuss dominant business models that are: ranked one or two in their markets; have free cash flow in excess of requirements to run a competitive business; pay growing dividends which provide an anchor in volatile markets; and have managements whose incentives are aligned with shareholders

This QE2 exercise that caused a $600 billion expansion of the FED's balance sheet is supposed to end in June and the two unanswered questions are: what happens to interest rates when it ends and does this money printing produce inflation. Perhaps one of the reasons Mr. Gross has sold his bonds is that longer duration Treasury yields climb about 80 basis points for every 100 basis point increase in core inflation. Core inflation is low and not a problem according to the FED. However, in the real world, consumers know that not only are inflation expectations on the rise, but that inflation is real as gasoline and food costs are up sharply. To be blunt, the President of the N.Y. Federal Reserve, former Goldman Sachs partner William Dudley, recently gave a speech where he also said core inflation was stable and not a problem, and gave an example of the new Apple iPad 2 that has twice the capabilities for the same price as the original. An astute member of the audience commented: "Great, but I can't eat an iPad!"

Producer prices are up 35% in the last six months and many commodities are at historical highs (corn, silver, gold, cotton, copper). Higher inflation leads to more volatility in the economy and higher interest rates (bond prices go down). These concerns explain why the great bond rush is most likely over as bond investors move some of their assets to stocks. We do not subscribe to selling all bonds and investing only in stocks, but we do believe bonds are expensive. It is time to be selective in our stock purchases and to have some hedges against inflation which is why most of our diversified accounts have anywhere from 5%-10% in real assets (gold, copper, iron ore, coal, natural gas, oil).

DIRECT TV

Finally, we always like to briefly talk about one of our portfolio holdings and our rationale for the position, so here are some comments about DIRECTV (DTV).

The DIRECTV Group is the largest satellite-based pay-TV service in the U.S. with over 19 million subscribers and a rapidly growing Latin America service with six million subscribers (PanAmericana, Sky Brazil and Sky Mexico). A brief history of DTV is interesting as DIRECTV was called the Hughes Electronics Corp until 2004 when it began trading under its new ticker, DTV. The precursor Hughes (the infamous Howard Hughes) was incorporated in 1977 and was subsequently acquired by General Motors in 1985 and was wholly owned. In 2003 GM monetized a portion of its holding in Hughes by issuing new shares called GMH (tracking stock). It seems ironic now that perhaps GM's most valuable jewel was disposed of to reinvest in the less attractive car business.

Nevertheless, one of the pioneers of the satellite cable TV industry, Dr. John Malone, did not waste any time in investing in DTV and eventually gaining control of this rapidly growing free cash flow business. We started our initial investment in DTV in September of 2009 as Dr. Malone was consolidating his control over DTV in conjunction with his holdings in his main media investment vehicle, Liberty Media. The market began to recognize the undervaluation in 2010 as the market underestimated both the operating and financial leverage inherent in this dominant business model. DTV continues to take U.S. pay-TV market share from weak competition with innovative sports packages such as NFL Sunday Direct (pro football). The recent launch of its enhanced DIRECTV Cinema in December 2010 has also claimed market share. The latter product introduction generated their best month ever in terms of revenues from movie buys. Latin American growth for this product is much faster than the U.S. as they have added almost 400,000 new subscribers in the latest quarter.

The Malone family now owns approximately 24% of the total voting power of DIRECTV's common stock and a 3% economic interest in DIRECTV. In most of our accounts we like to follow free cash flow, even more than following earnings per share, and DTV had $2.8 billion free cash flow in 2010. The management of the company, led by recently recruited Michael White, President and CEO (formerly Vice Chairman of PepsiCo), repurchased $5 billion of DTV shares in 2010. DTV also just announced that they would buy another $5 billion of stock back by year end 2011. They have about 833 million shares outstanding so it looks like they will retire another 100 million shares over the course of this year with a current stock price at $46.

Clearly, management's interests and Dr. Malone's are on the side of shareholders. Management has projected that they will reach their desired level of leverage in their balance sheet by the end of this year and estimate they will earn $5.00 per share in 2013, up from $2.48 last year. We continue to purchase DTV for new accounts because we have a one year target price of $55 and a three year target price of $72 (+17% and +53% respectively). This rare combination of huge free cash flow and significant management stockownership are the types of ingredients that we feel make an attractive investment.

Thank you for your support. We always welcome your comments and questions and appreciate any referrals that you believe are mutually appropriate.


Sincerely,

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.