Quarterly Newsletter - 2nd Quarter, 2013
PERIOD FMR* Taxable FMR* Retirement S&P 500 DOW Russell 2000
1st Qtr +11.98% +6.50% +10.61% +11.92% +12.03%
2nd Qtr +0.43% -2.26% +2.90% +2.91% +2.73%
YTD +12.51% +4.12% +13.82% +15.19% +15.09%

    The U.S. equity market (S&P 500) rose from a new high at the end of the first quarter (1569) to reach another record high of 1653 on May 24, 2013, up another 5%. A May/June correction followed this unsustainable and uninterrupted market run-up. The second quarter ended with this broad market index at +2.91%, with first half 2013 performance at +13.82%. Five Mile River taxable and qualified account performance ranged between +4.12% and +12.51% for the first half of the year, within our market forecast of +8% to +23%.

    WHY? The seemingly unstoppable +10% market advance of the first quarter kept going until reaching +16% at its top in May before coming to a halt with what we will call “the reality test of the Federal Reserve’s quantitative easing (QE) strategy.” The stock market kept going up as long as the Fed’s money printing exercise continued and had no end in sight. We said in our first quarter letter that stock market valuations for most companies were fairly valued given fundamentals, but that the Federal Reserve’s zero interest rate policy was unsustainable and we did not know how long it would last. 

    The Fed Chairman, Ben Bernanke, attempted to answer this question at the June Fed meeting having stumbled just two weeks before at his Congressional testimony. He said in essence that it appears the economy can grow on its own without so much monetary stimulus and that the Fed would consider “tapering” its bond purchases over the next 12 months, if economic conditions warrant. While his language was more obtuse than that, markets around the world took this pronouncement to heart and sold off dramatically. It appeared from his communication that his intention was not to further stoke what has been only a credit-fueled recovery, but signal to the market that the FED’s bond buying could end in the second half of 2014. So far, most investors and even our dysfunctional political class recognize that this has not been a robust normal fundamental growth recovery in GDP, revenues, profits, and employment, and it is in fact the slowest economic recovery on record! 

    Speculation that the Fed chairman will not be reappointed next winter has most likely served as a catalyst for him to not want to be the man responsible for another artificially created “bubble” in our economy. Subsequent back tracking by various FED operatives following the market’s plunge has for now pacified the overly concerned short-term investors and day traders. 

    Where does this leave our equity market and our FMR investment strategy? We take comfort in staying focused on preserving and growing capital at a rate that exceeds inflation by maintaining our dividend growth model. We have no interest in getting carried away with our ability or lack thereof to forecast volatile market swings. With over half the daily volume of the stock market being driven by short-term trading models trying to game the market in minutes and even seconds, our strength is focusing on business models that generate free cash flow, buy back shares, and pay growing dividends. We are staying with our stock market forecast of +8% (S&P at 1540) to +23% (S&P at 1760). Recognizing the latter optimistic forecast is predicated on limited political combat this Fall over debt/deficit/entitlement spending, and achieving some real long-term reform. We admit the probability of such an optimistic outcome with a dysfunctional Washington is not currently high. 

    Stock buybacks and dividend increases. According to Standard & Poors, from 2007 to the end of 2012, dividends increased 14%, outpacing inflation. Over the past five years, companies that buy back shares delivered average returns of over 10%, double the S&P 500’s 5%. Companies buying back shares decrease the number of shares outstanding, reducing the stock’s price/earnings ratio (PE), and theoretically pushes up the stock price so the company’s shares trade in line with their historical average PE. BUT, the benefits of buybacks can be elusive if instead of retiring shares outstanding, they simply turn around and issue them to insiders in the form of stock options. In the fourth quarter of 2012, there were 317 S&P 500 companies which spent $100 billion to repurchase their own shares. However, 203 companies actually had outstanding shares rise! Many companies use buybacks to control dilution from options issuance, NOT to actually shrink the share count and raise earnings per share. In contrast, when companies pay dividends and increase those dividends annually, you receive real cash directly, not indirectly. Our FMR investment strategy model is predominantly looking for both dividends (growing) and buybacks that are real. Johnson & Johnson (JNJ) was highlighted in the first quarter FMR letter, and during the second quarter JNJ increased its dividend 8.2%, the 51st straight year of dividend growth. Kinder Morgan (KMI), raises its dividend quarterly rather than annually and increased its dividend 2.7% on April 17th. KMI’s year over year rate is up 18.8%. 

Weyerhaeuser Company 

    Our most recent second quarter portfolio purchase was Weyerhaeuser (WY), one of the largest public owners of timberland in the U.S. with 6.6 million acres of trees located primarily in the Pacific Northwest and South. WY is organized as a REIT (real estate investment trust) which means it must distribute 90% of ordinary income annually to shareholders. REIT distributions are taxed once at the shareholder level. WY’s other businesses include wood products, cellulose fibers, and a top 20 U.S. homebuilder called WRECO. We bought WY with its huge tree resource base for five reasons: 

  1. U.S. housing market recovery with demand exceeding supply for three to five years 
  2. Chinese demand for North American export saw logs 
  3. Timber not sold for housing or export is not harvested and grows in size and potential value 6%-7% per year 
  4. Constrained Canadian timber supply from British Columbia because of damage by mountain pine beetle 
  5. Growing biomass demand for power generation     

    The net asset value of these real assets in WY, using the sum of the parts approach, is $35-$36 per share. Management has announced a strategic exploration of unlocking the value of its homebuilding business (WRECO) that could lead to a merger or sale/spin-off of this business. The stand-alone value of WRECO could be worth $8-$9 per share, which would focus investors on the substantial value of WY timberlands. A recent dividend increase of 10%, providing a 3% yield on a $27 stock, adds to the attractiveness of this conservative investment for those who want to own real assets with a growing dividend. Finally, a new CEO from the WY board, Doyle Simons, will take over August 1, 2013, from the retiring CEO. He ran Temple-Inland for five years prior to the takeover by International Paper, and has a good track record as a value creator. Our price target for the end of 2014 is $32 plus a 3% growing dividend or +20% to +25%. 

    Thank you for your continued support of Five Mile River. We welcome referrals of friends and family that you feel could benefit from our conservative value/dividend approach to preserving and growing capital. We welcome all questions and comments about our holdings and investment strategy. Our best wishes for an enjoyable summer.


Lee                                        Todd                                        Martha                                   

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.