Quarterly Newsletter - 4th Quarter, 2012
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%
3nd Qtr +7.08% +4.09% +6.35% +6.17% +4.88%
4th Qtr -3.80% -3.26% -0.38% -3.10% +1.42%
YTD +7.52% +7.18% +16.43% +19.62% +13.03%

The S&P 500 was up 16% for 2012. Despite all of the uncertainty, worry and volatility during an eventful year, this broad market index closed the year within a point of the upper range of our forecast (1425) at 1426, and not far from the all-time high of 1466 in 2007. The record five-year old high of 1466 in the S&P 500 was broken the second week of this new year as investors committed more money to stocks seeing the “fiscal cliff” temporarily averted. Not surprisingly, the fourth quarter was flat as the focus shifted first to the election, and second to the “fiscal cliff.” Last, but not least, in all of this drama was the Federal Reserve’s commitment to keep interest rates at “zero” until unemployment reached 6.5% and inflation 2.5%. To accomplish this interest rate objective the Federal Reserve has now opened the printing presses and is agreeing to a monthly purchase of $85 billion in U.S. and mortgage bonds, virtually all of the new government debt issued. Our reaction to this policy is simple: unproved, untested, unnatural, and likely ineffective against reducing unemployment. This latest Quantitative Easing Policy (QE3) actually creates major future uncertainty as to how and when the Federal Reserve will unwind an expected $4 trillion plus dollars of securities from their own balance sheet without a major impact on financial markets.

Five Mile River taxable and non-taxable performance for 2012 ranged from +3.4% to +3.7%. FMR’s performance for the first nine months of 2012 met our expectations given our more defensive, income-oriented strategy, even though we lagged the more growth oriented S&P 500. The 2012 full year results for FMR were below our expectations for portfolio growth of +6% to +8% because of underperformance during the fourth quarter of a number of our dividend stock holdings (Coke, IBM, Intel), as well as, our Master Limited Partnerships (MLPs). We attribute this to the fact that there was an acute fear that dividends would be taxed at 45%, not the current 15%, which caused people to exit the higher dividend paying stocks. While we did not expect a significant increase in the tax rate of dividends, the severe political divisiveness unsettled many short-term investors who sold these positions before year end. That issue is now off the table. The compromise left the 15% qualified dividend rate unchanged, but raised the dividend tax rate and the capital gains tax rate to 20% for joint incomes over $450k ($400k for individuals). We commented in an earlier letter that the dividend tax fear was overblown. FMR’s MLP equities and other dividend stocks have bounced back strongly (double digits) early in 2013, outperforming the S&P 500. As an example, Kinder Morgan Energy Partners is +15% from its December low, as the search for yield continues to be a dominant theme.

Energy MLP’s were designed to encourage the development of the U.S. energy infrastructure. Some believed that changes in tax policy could alter the favorable tax structure of the energy MLP’s, a view we did not share. What did happen was the 4th quarter brought a decline of most MLP’s, providing a great buying opportunity for adding to existing positions, given investors’ income needs and the substantial tax-deferred yields of 5%-7% (80% of these quarterly distributions are tax-deferred until sale as they are a return of capital from excess depreciation and amortization). MLP’s are growing in acceptance as dependable income securities, and are an effective hedge against inflation (see the next paragraph on Magellan Midstream Partners). We do not see these securities as short-term investments, but rather as long-term “income growth anchors” to your portfolio that are particularly attractive in the current “zero” interest rate environment. Annual distribution growth of 6%-10% in our favorite MLP’s (Kinder Morgan, Magellan Midstream, Enterprise Products, Plains All American Pipeline and Williams Partners) provide a total return well ahead of current U.S. government bond yields of 2% or less.


We have owned MMP as one of our core holdings in all taxable accounts since the inception of Five Mile River in 2003. MMP is a master limited partnership whose business is the transportation, storage, and distribution of refined petroleum products (gasoline, diesel, jet fuel, crude oil) and ammonia. This partnership owns about 9,500 miles of petroleum products pipelines, including 51 terminals. It also owns 7 marine and 27 inland storage terminals along with a 1,100 mile ammonia pipeline system and 6 related terminals. The market capitalization of MMP is $11 billion with 226 million shares outstanding, and its public shares trade close to a million shares a day. MMP’s business model is predominantly a “toll taker” that generates fee-based cash flows from moving and storing other owners’ petroleum products. MMP has a lower cost of capital than normal “C” corporations giving it a competitive advantage raising new capital for organic expansion projects and acquisitions. Magellan’s pipelines that carry crude oil and other products receive automatic rate increases that are tied directly to inflation (Producer Price Index) plus 2.65%. The fact that their revenue growth rate is higher than inflation enables their cash distributions to grow at least as fast as inflation. This is one of the reasons why we make the argument that MMP has a business model which is a direct hedge against inflation. In 2003, their annual distribution to shareholders was $1.11 and this year it is $1.94, up 19% from $1.63 a year ago. MMP stock price was $34 at the beginning of 2012 and is currently $48, up almost 50%. Our strategy has been to moderately reduce our weighting and realize profits when the position becomes too large as a result of very significant appreciation. MMP remains a large core holding because they have an excellent slate of new growth projects which should allow them to increase the annual distribution by 8%-10% for each of the next several years. All individual investors should look at their potential returns after-tax, so it is important to remember that a key strategic advantage with these MLP’s is that 80% of their distributions are tax deferred until sale. The compounding effect of these larger and growing distributions in a higher tax rate environment is compelling whether you are taxed at a 15% rate or the new higher income hurdle of 20%.

THE TAX RELIEF ACT OF 2012 (the Fiscal Cliff deal)

We said in our third quarter letter that we did not expect much higher returns in 2012 unless the Congress and the President agreed to definitive long-term structural reforms of our broken fiscal policies. True to form, the two parties “kicked the can” down the road from the edge of the fiscal cliff late into the night on January 1st, passing a compromise package that reinstates the top 39.6% tax rate on taxable income above $450k (joint filers) and $400k (individuals) with permanent extension of tax rates for taxable income less than $450k (joint) and $400k (individuals). This legislation results in fiscal tightening of around $250 billion or 1.5% of GDP. Since all working Americans will experience a tax increase due to the reinstatement of the payroll tax (4.2% to 6.2%), we expect slower consumption and slower growth for the U.S. economy. The automatic sequester (spending cuts) were postponed for two months and their resolution on implementation remains an open question. Whether the sequester spending cuts are a mix of 50% defense and 50% social programs or not, this will reinforce a slower growth economy for at least a couple of quarters.

This last minute, backroom deal done between Senator McConnell and V.P. Biden produced $600 billion in tax increases with essentially no spending cuts, and made it virtually impossible to reach a grand bargain as the battle resumes with the sequester and debt ceiling (U.S. debt at $16.5 trillion and ramping to over $20 trillion in next four years). The Republicans are not likely to cave in on anymore tax increases and the Democrats do not want any spending cuts so the scene is set for more dysfunction and destabilizing rhetoric over the next two months. We have lived and invested in such an environment for several years now, and the uncertainty will continue to put a damper on domestic GDP and employment growth. Until we witness real structural reform of our unsustainable entitlement programs (Medicare, Medicaid, Social Security), the full potential of the U.S. economy will be significantly restrained to the 1%-2% growth and 7%-8% unemployment (understated) we have experienced over the past five years.


This unsettled backdrop for developing and implementing a long-term investment strategy is fortunately a familiar one for us. We have been successful investing our clients’ assets through strategies anchored by risk aversion and preservation of capital. This uncertainty reinforces our commitment to equities over bonds, and in particular, dominant companies that possess business models with strong balance sheets, free cash flow, and dividends that grow consistently.

While short-term returns in any one month, one quarter, or one year, could be tempting to shift strategies, we have consciously chosen a more risk adverse path since our experience from the last housing bubble makes us cautious as we watch the early innings of the U.S. Government’s debt/deficit bubble. This major, unresolved structural problem is self-inflicted, but can be made right with courageous and fundamentally based tough medicine, versus the present status quo of “kicking the can” down the road. Until that magic moment arrives, we expect to continue to invest in growing annualized dividend income from both our MLPs, and our dominant free cash flow business models. Short-term market volatility is inevitable with the country’s muddled fiscal outlook. But safe, consistent dividend growth that puts real money directly into your pocket or portfolio is a sustainable long-term, less volatile strategy with lower downside risk.

We spend the majority of our time analyzing individual companies for our FMR portfolios and a relatively smaller amount of time estimating S&P market levels. Having said that, here is our projection for 2013: with 1%-2% economic growth, near zero interest rates, and an unresolved debt/deficit bubble, we project the S&P 500 range in 2013 to be from 1400 ($100 in 2013 EPS x 14) to 1540 ($110 in 2014 EPS x 15), or flat to +8%. However, we will reaffirm our previous upside for much higher stock prices (1760, +20%) if we see real, comprehensive fiscal reform beyond current low expectations. While +8% might seem like a low number for many fearless investors who would like double digit returns and low risk, 8% represents a real return (after inflation) of +6%. Our investment strategy of emphasizing dividends and dividend growth makes this objective realistic and achievable.

We thank you for your support and welcome any questions that you may have about our investment strategy or your individual portfolio holdings.


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.