PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +4.65% +7.09% +12.58% +20.96% +12.06%
2nd Qtr -4.54% -5.12% -2.75% -5.06% -3.83%

For the past two years, the early stock market rallies of the first quarter have been short lived and have given way to increased uncertainty and investor mood swings to the “glass is half empty.” This year’s April to June period has been similar but with less downside volatility (-10% from April to early June) as we end the second quarter. Leading the list of “worries” this spring has been the worsening recession and financial crisis in Europe. However, one important difference this year is that the stock markets around the world have mostly assimilated this onslaught of negative Euro news as status quo for months, if not years, to come with no easy solutions in sight. We agree that there are no easy solutions either for Europe or the U.S., but the hard realization that status quo government policies are NOT a long-term option is here right now, not years down the road. Neither the European Central Bank (ECB) nor the Federal Reserve can reverse the unprecedented pile up of government debt and deficit spending by themselves. Government fiscal policies will be forced by the markets to take a new path. While nobody has a crystal ball when it comes to anticipating positive fiscal solutions, the balance is tipping toward a favorable outcome this fall, which would not surprise us given that the consensus now views the current stalemate as the apocalypse.

So faced with real structural impediments to faster economic growth and historical +8% to +10% common stock returns, we believe investors need to think differently about asset allocation between bonds and stocks, as well as, moderating their return expectations. Selectivity becomes more important with repressed interest rates as income should be increasingly valued. As all of our clients are now familiar, we have chosen to emphasize high dividend yields from common stocks as a way to mitigate both market volatility and the effect of low yields on fixed income investments. This approach has allowed us to see “the glass as half full” with our S&P 500 forecast of 1350-1425 for 2012 amidst the current gloom. The S&P 500 closed the first half at 1362 (+9%) versus 1257 at the close of 2011. We expect a tight trading range to continue into the fall producing positive returns for long-term investors focused on dividend growth.

During the summer of 2010, the S&P 500 index was -16%, and in 2011 the summer correction was -19%! The 2012 summer correction so far has been -10%. Importantly, overshadowed by the negative headline news, dividends paid have hit a new record in the second quarter with 505 dividend increases, up 14% from 444 in 2011. Some company managements and their boards now realize that to reward and keep long-term shareholders, versus attracting short-term and quantitative day traders, they have to distribute a growing portion of their earnings in the form of dividends. FMR looks to invest in dominant corporate business models, with free cash flow, and very profitable. While absolute dividends paid out are at an all-time record high, the percentage of earnings those dividends represent (payout ratio) is at a historic low. Therefore, we expect dividend growth to continue.

Valuation Perspective

Our present bear market began in 2000 with a price/earnings ratio of 28 times (historic high) and a dividend yield of 1.2%. Twelve years later, the S&P 500 market index is trading at 13.5 times (P/E ratio) with a dividend yield of 2.4%! Sustained periods of positive returns begin from low, not high valuation levels.

This S&P 500 dividend of 2.4% beats the 10-year U.S. Government Bond by 0.9% in nominal terms, but more importantly, by almost 3% in real terms! Real means inflation adjusted and inflation affects not only our daily standard of living but also our future real purchasing power. Not only are dividends paid out in cash quarterly, but those dividends grow annually, protecting your income stream from the eroding effects of inflation. With bond yields at 1.6%, you could still hypothetically make a nice capital gain if its yield fell to 0 in a deflationary policy miscalculation, but we judge the probability of that happening as nil.

With the exception of a few months at the depths of the 2008-2009 Great Recession, the stock market’s dividend yield has not paid more than the long U.S. government bond since 1958! While we still have a number of headline “event risks” before this year ends (elections, fiscal cliff, debt ceiling limit, Europe), we remain convinced that our approach of focusing on dividends and dividend growth is a very competitive long-term investment strategy.

Five Mile River Performance and Holdings

FMR taxable and retirement account performance for the second quarter 2012 was -4% to -5%. Year-to-date first half performance for the taxable accounts was flat at +0.5% to -0.5%. The first half performance for the retirement accounts (IRAs) was +2.5% to +3.5%. The primary reason the retirement accounts outperformed the taxable accounts for the first half of the year is our large exposure to the energy sector with our several holdings of energy infrastructure (pipelines, storage terminals) master limited partnerships (MLPs). These can only be held directly in taxable accounts, not IRAs. The Alerian MLP index (measures performance of only the MLP universe) total return for the first half of 2012 was -3.7%. These tax deferred, high yielding partnerships are little affected by short-term changes in commodity prices, but they often trade up and down with the energy sector and the spot prices of oil and natural gas. Our master limited partnerships are basically “toll collectors” that collect a fee based on volume for moving, storing or processing petroleum products irrespective of the commodity price. Our MLPs have already bounced back +10% from their June lows, outperforming the market in July.

The dividend distributions of our energy master limited partnerships have continued growing at +5% to +10%, and typically 80% to 90% of these distributions are tax deferred return of capital. With potentially automatic steep tax increases on all income tax brackets, dividends, and capital gains starting January 1, 2013, we believe the value of these master limited partnerships and their distributions will only increase and are attractive buys. The planned internal growth projects of these MLPs foreshadow continued strong distribution growth over the next five years.

Our persistent focus on companies that pay significant dividends that are growing is a very effective strategy for long-term investors in this extended slow growth environment. The primary difference last year between the stock market’s flat performance and our taxable account performance of +6.6% was the excellent performance of our MLPs and high dividend stocks. With the dividend yield of FMR portfolios significantly above the long U.S. government bond yield, we have the support and comfort of both growing real income and lower volatility in market corrections.

We welcome any questions about our strategy or your portfolio holdings and thank you for your support. We wish you an enjoyable summer season.



Lee Todd Martha Colleen

*The performance information above *  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.